Is There Light at the End of the Oil Price Tunnel?

A new report from the IEA raises hopes.

Global oil prices have soared nearly 50 percent since early February on hopes that the collapse in oil industry spending in 2015 and continuing into 2016 will finally lead to a correction in the world’s oversupply situation. These hopes were boosted recently with the release of the International Energy Agency’s Oil Market Report for March.

The language of the agency’s report, however, conjured up President Harry Truman’s famous lament that what was needed was a one-armed economist since he was tired of hearing “On the one hand, it could be this. On the other hand, it could be that.” 

While stating that oil prices may have passed their low point for this cycle as high-cost production is falling and Iran’s production ramp-up is happening more slowly than previously estimated, the IEA cautioned that this should not “be taken as a definitive sign that the worst is necessarily over.” Yet it relied on optimistic language throughout the report, such as “possible action by oil producers to control output,” “supply outages in Iraq, Nigeria and the UAE,” “signs that non-OPEC supply is falling,” “no reduction in IEA’s forecast of oil demand growth,” and “recent weakness of the U.S. dollar.”

All of these comments support a more bullish outlook for a bottoming of the current oil price with prospects heightened for a sustained upward trajectory going forward. 

On the other hand (sorry, Mr. Truman), the agency cited world oil production being 1.8 million barrels a day higher than a year ago as a slight decline in non-OPEC output was offset by OPEC gains. As a result, the IEA now expects non-OPEC production to fall by only 750,000 barrels a day in 2016, 100,000 barrels a day less than in their prior month’s forecast. On the demand side, while the agency hasn’t changed its projection for 2016, it did comment on the dramatic deceleration in demand growth, particularly in the U.S. and China, during the fourth quarter, traditionally a seasonally strong demand period. 

Hedging Its Bets?

One wonders whether the agency is hedging its forecast for 2016 in response to the sharp rally in global oil prices immediately prior to the report’s release. U.S. West Texas Intermediate oil prices climbed from the mid-$20s a barrel in early February to the upper $30s at the end of the second week of March.

The volatility in oil prices during the early weeks of 2016 has been nothing short of amazing. Since the beginning of January there have been four distinct moves in oil prices, translating into an initial 28 percent drop, followed by a 27 percent rise, and then another 22 percent decline. From that February low, WTI’s price has soared over 47 percent. 

Why the optimistic take on crude prices? It’s all tied to views about a resumption of healthy oil demand combined with a belief that the current U.S. production slide will accelerate due to the absence of new drilling. The collapse in oil prices at the end of last year and in the early weeks of 2016 has forced producers to slash their capital spending programs once again. Not only are they not spending money on new wells, they are selling assets to generate cash to strengthen balance sheets groaning under the weight of vast amounts of debt.

Moreover, companies are cutting staffs, signaling that managements are embracing a new fiscal discipline toward spending that will extend for some time. The concern always remains, however, as to how long this spending discipline will hold if oil prices climb back above $45 per barrel. 

The resiliency of domestic oil output last year surprised everyone. But the steady decline in prices increased the financial pressure on companies to do something. Managements were faced with limited options in responding to this pressure. They could recognize that what they were doing was not economic and they therefore needed to hunker down, i.e., stop drilling and stop spending money. Or, if financial pressures were great enough and in order to keep the lights on, they simply plowed ahead with new wells targeting their most prolific formations in hopes of generating more revenue despite lower prices. 

Competing Strategies

The strategy of essentially sitting on one’s hands made the most economic sense, but it also called for executives to make extremely difficult decisions, like laying off staff. And those layoffs needed to be substantial in order to materially impact company finances.

Recently, Anadarko Petroleum, one of the last holdouts against layoffs and with a history of avoiding staff reductions in prior downturns, finally announced a 17 percent cutback. The magnitude of the cut, especially from a company known to be disciplined in spending and with a record of steady management throughout industry cycles, highlighted the extent of the financial damage being done to the global oil industry by the sharp price decline. 

The action, however, may also signal how blasé oil executives had become toward financial returns following four years of $100/barrel oil. That attitude may also have evolved in response to the demand for production growth by investors to the exclusion of maximizing profitability. Executives must always remain disciplined when accepting advice (freely given) from investors about how to run their companies because those shareholders can always sell their shares and disappear. Unfortunately, employees and assets accumulated in an effort to satisfy shareholder demands remain as a reminder of the bad advice offered by those now absent investors. 

For those companies who elected the second strategy, drill and produce to maximize near-term cash flows, the decision reflected their need to generate cash to meet interest payments. Since oil prices did not return to lofty levels during the second half of 2015 as initially envisioned, these companies may have destroyed some of their long-term value by tapping their best prospects during a period of ultra-low oil prices, resulting in balance sheet restructurings with their debtholders or, absent any agreement, court-protected financial restructurings. As one commercial banker employed by one of the top holders of energy company debt put it, “Chapter 11 is one of the worst ways to restructure.”

Of course, from a lender’s perspective the protections afforded managements under Chapter 11 strengthen their negotiating position against bankers and debtholders. These court proceedings also delay, and possibly for an extended period of time, payment of delinquent loans. For many companies, extending the resolution of loan problems into the future offers the possibility that industry conditions may change for the better, allowing restructuring conversations to become less contentious and more constructive.

Fed Policy to Blame

The U.S. energy industry’s financial problems are a direct result of the Federal Reserve’s “easy money” policy, implemented to help the nation’s economy recover from the 2008-2009 global financial crisis and resulting recession. Cheap capital, seeking positive returns, focused on the emerging shale revolution given the prospect of $100/barrel oil and $5/thousand cubic feet natural gas prices. 

Capital flooded the energy sector. Between 2004 and 2014, the high-yield bond market doubled while the amount of bonds issued by junk-rated energy companies grew 11-fold to $112.5 billion. By ignoring the prospect of the huge upfront capital costs of shale wells, producers were convincing investors how profitable they were.

In fact, during this boom, many of the E&P companies were spending $2 to drill wells for every $1 they earned in output. High oil and gas prices, coupled with huge initial well outputs, offered the prospect of companies involved in shale plays becoming immensely profitable in the future. Unfortunately, future profitability goals were crushed by collapsing oil and gas prices in 2015. 

Recovery in 2017?

The IEA’s March report also suggested it will take into 2017 for industry conditions to be restored to a semblance of balance. In other words, falling oil output this year coupled with rising demand should result in a drawdown of the record inventories currently overhanging the global market. As inventories shrink, prospects for higher oil prices grow. It is the prospect of higher prices that excites commodity and energy stock analysts.

On a cautionary note, the pattern of oil price movements so far this year mirrors the pattern of price movements during the first six months of 2015. What’s different this time is that there are clear signs of U.S. oil production falling. The risk to a sustained oil price recovery this year is that leading oil-producing nations fail to limit their output growth and thus overwhelm the natural supply response from sharply curtailed capital spending and drilling activity. If production discipline holds, however, the oil industry will be embarking on the long road to recovery. – MarEx