Shifting To A New Normal For Oil
Normal is not a homonym, but it could be. It means standardisation, but it also alludes to a range of typical occurrences.
In statistics, a normal distribution is a set of observations that occur around a mean. In common society, normal is an acceptable form of behaviour.
Whatever the case, it means a range of events that centre on an average. The problem with ‘normality’ is that averages move. For example, fashions change. Music styles evolve. Normal dress from a century ago is no longer acceptable.
The same occurs in markets. Shocks force occurrences to morph, leading to corresponding movements in price ranges. A few years ago, pundits began using the notion of ‘new normal’. This meant that the market had shifted to a different range that would now be considered typical. Three years ago, high commodities prices were considered normal. Last year, plunging commodity prices became the new normal.
However, we are again witnessing a movement to a different normality.
Most visible in oil sector
Last year’s massive reduction in commodity capex set the stage for an eventual spike in prices. The situation has been most visible in the oil sector. At the end of 2014, many Wall Street firms began cutting their oil forecasts, calling for a “new normal”.
They cited the slowdown of the Chinese economy and overproduction in the United States and the Middle East for their pessimistic outlook.
However, they seemed to have forgotten the natural depletion aspects of commodities. Oilfields, mines and farms are not eternal. Production decays as the resources are depleted. Oilfields run dry. Mineral deposits are depleted. Nutrients are taken out of the soil. That is why commodity producers constantly need to plough capital into exploring for new mineral deposits and replenishing farms. This makes the sector extremely capital intensive.
Each commodity product has a different decay schedule. Offshore oilfields, for example, have a natural depletion rate of about 20 per cent per year. Meanwhile, some onshore fields have an annual depletion rate of only two per cent. Analysts estimate that the average annual global depletion rate for the oil sector is about 4.5 per cent.
It takes time
The problem is that the oil industry slashed capex by US$380 billion since 2014, reaching half of total sector capital investment in 2016. This means that oil production will decline at some point, with the effect accelerating in the years to come. The typical gestation period for a new oil project is about seven years, from the start of exploration to full production.
It takes time to do the necessary seismic surveys. Most of the new oilfields are in remote areas, which require the construction of facilities for workers. Heavy equipment needs to be deployed. Plus, transportation infrastructure – including roads, pipelines and ports – needs to be put in place in order to bring the products to market.
Oil, as well as most of the other commodity products, cannot be switched on and off. They require a great deal of time and capital to bring them to market.
Unfortunately, the decline is already materialising. The net decline in United States oil production is estimated at about 600,000 barrels per day (bpd) in 2016 and another 400,000 bpd in Latin America.
At the same time, the global economy is growing at a pace of about two per cent y/y. Hence, total demand should rise by about a million bpd. As a result, the two million bpd glut that was estimated at the end of last year will evaporate in 2016. This should bring oil prices to a more neutral equilibrium price of about US$60 per barrel before the end of the year.
However, it also means that oil prices will continue to move higher in 2017 and beyond.
Until we see a meaningful increase in capex, output will continue to decline. Therefore, we can expect prices to overshoot on the upside.
The results of this scenario are a boom for oil-producing countries, such as Venezuela. With annual oil exports of about 640 million barrels, an oil price of about US$50 to US$60 will allow Venezuela to produce annual exports of about US$32 to US$38 billion.
Venezuela and PDVSA’s annual bond debt service is about US$9 billion, giving the country between US$23 billion to US$29 billion to pay for imports. This is more than twice the minimum import levels that are estimated to sustain the economy.
As a result, the government will not need to recur to its supplemental liquid and non-liquid assets, such as international reserves, gold holdings, offshore refineries and PetroCaribe, to meet their external obligations.
Of course, other large oil-producing countries, such as Russia, Mexico, Nigeria and Angola will also benefit from the looming changes in the international oil markets.
Therefore, we are now moving the parameters for a ‘new normal’ that will be much more conducive for the emerging world.
Dr Walter T. Molano is a managing partner and the head of research at BCP Securities LLC.
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