Brent over $80 a barrel always seemed too good to last, defying the fundamentals. The sharp retreat in price may turn out to be a good thing, injecting a healthy dose of reality to the industry at just the right time.
We expect Brent to average $66 a barrel in 2019. That is a tad down on 2018 though still a price that allows companies to generate free cash flow and continue to strengthen finances.
It may sound benign, but numerous identifiable risks and uncertainties lurk in the shadows. I picked out ones Wood Mackenzie’s analysts worry could threaten our base case.
Economic Slowdown and Oil Demand
Alarm bells are starting to ring. Demand growth has been a pillar of strength for the oil market since prices fell and demand growth has exceeded 1 million barrels per day (b/d) every year since 2012.
We forecast demand growth of 1.1 million b/d in 2019, but the trend is at risk. China-US trade conflict and political tensions are dragging the global economy down.
An inversion of the US yield curve, where short-term borrowing costs exceed long-term, is imminent. Inversion has proved a reliable indicator of recession in previous cycles.
A modest slowdown in the global economy would push oil demand growth down by 0.8 million b/d in 2020 compared with our base case. A severe recession could wipe out oil demand growth altogether by 2020.
Tight Oil Upside
Can US Lower 48 production outperform again? Tight oil stunned the oil market in 2018, not for the first time. Volumes increased by 1.5 million b/d, delivering 0.5 million b/d more by the end of the year than we had forecast at the start, mostly from the Permian. Operators completed more wells and were able to get the oil to market despite pipeline constraints.
We forecast 1.1 million b/d of growth in 2019, and again there could be upside risk. Big M&A deals in 2018 – such as Concho Resources/RSP Permian and Diamond/Energen – are all about creating value from scale. Operators that doubled down on the Permian will want to justify their acquisitions with guidance-beating production growth in 2019.
OPEC and Iran
Iran’s exports plunged from 2.8 million b/d in April to 1.1 million b/d by year-end as buyers withdrew to comply with US sanctions imposed in November.
Exports could increase by 0.3 million b/d under the terms of the 120-day waivers granted to China, India, Italy, Greece, Japan, South Korea, Taiwan and Turkey.
When the waivers end in May, the outcome is potentially binary. Renewal may force OPEC, at its June meeting, to cut production again in the second half of 2019. No renewal takes more Iranian crude off the market, opening the door for OPEC to lift its self-imposed production constraints.
Compounding Effect of Underspend
Oil supply may be the least of the market’s problems at present. But are we in danger of sleepwalking towards a supply squeeze?
A fifth year of low global conventional spend and cherry picking the best projects leaves hoppers increasingly depleted. The retreat in oil price likely nips in the bud any urge to relax capital discipline. Good for near-term returns, but not for the sustainability of the business in the longer term.
A return to organic growth must come at some stage to deliver the new volumes to meet a looming supply gap beyond the mid-2020s. Full-cycle exploration returns, back in double digits, are attractive again. Given lead times from discovery to production, the industry may come to rue its present lack of investment in exploration.
Downstream and the IMO
The entire refining value chain needs to adjust in the next 12 months for the 2020 regulation on marine fuels. Sulphur content must be cut from 3.5% (high Sulphur fuel oil, or HSFO) to 0.5% (very low Sulphur fuel oil, VSLFO).
This is a big deal for refiners, affecting 3.5 million b/d of HSFO volumes. It will affect crude prices, differentials, product prices and refining margins. There are huge uncertainties. What will be the level of global compliance? How many ships will install scrubbers to allow them to burn HSFO? How much VLSFO can refiners produce and what will be its price?