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Expert Speaks | November 2015

Will Oil Prices Persist at Low Levels

In the next few years, global oil prices will hinge on factors like global economic growth, China´s focus on heavy industries, US oil production, OPEC output quotas and additional future flows from Iran if sanctions are lifted.

Global oil prices have halved in the last 12 months. India is heavily dependent on oil imports. More than 80 per cent of total oil supply is from imports. Low oil prices are beneficial to the large oil-importing nation as the energy import burden decreases. Three key factors initiated the oil price decline last year: higher than expected oil production in the US, growing Organisation of the Petroleum Exporting Countries´ (OPEC) output and the International Energy Agency (IEA) cutting global demand forecasts after the International Monetary Fund (IMF) revised down its world GDP growth outlook.

What especially made oil prices drop like a falling knife is OPEC´s decision to maintain market share and leave production quota unchanged in November 2014. Crude-price volatility has increased sharply since last November, with even small signs of supply and demand imbalances triggering fluctuations in oil prices. Brent´s forward price curve flattened compared to six months ago, a sharp contrast with last year´s backwardation (when oil for immediate delivery costs more than later shipments).

Oil price is the single most important driver for an energy company. Oil and gas shares have underperformed the Morgan Stanley Capital International (MSCI) Asia Pacific Index in 2015. The common question in the minds of most energy investors and industry participants are how low oil prices can go and how long the current situation may persist.

Oil prices are determined primarily by the balance of production and demand. In terms of production, OPEC and the US are the two most important regions. OPEC´s output shows no signs of reduction, though the sustainability of high Iraq supply and the timing of flows from Iran are uncertain. Output from OPEC has consistently outpaced mandated quotas. The potential removal of nuclear sanctions on Iran may lead to a further increase in output from OPEC. So, it seems OPEC will continue to produce over 30 million barrels per day.

The next important factor is the US shale oil production. In the US, the rig count has fallen, but oil production is still at high levels. Monthly production only started to drop sequentially in Q2 (April-June 2015) after staying high for almost a year, yet it still grew in absolute terms year-on-year.

On the demand side, Asia is the most important oil consuming region, which is likely to remain the key driver in the foreseeable future. China has been the most important driver of incremental oil consumption. The country is shifting away from heavy industry to services and higher-margin manufacturing segments. It is becoming a less oil-intensive economy. The ratio of growth in oil consumption to GDP expansion dropped to only 0.5x last year, compared with an average of 0.7x over the past 30 years. The lower demand growth for crude in China may continue due to the underlying shift in Chinese economy.

Gasoline consumption is the bright spot in the breakdown of China oil demand thanks to greater car ownership. However, there are headwinds. Car sales growth continued to slow this year and in June, July and August, the rate dropped into the negative territory. Weaker car sales growth may indicate slower growth in gasoline consumption in future. Diesel is the largest component of China´s oil demand. In the first half of 2015, diesel demand only grew by 1.2 per cent, as China shifts away from energy-intensive heavy industries. The steel, coal and cement sectors are enduring year-on-year decline. So, the low growth rate is understandable and may remain weak in the future. China imported more oil as the country builds strategic petroleum reserve under lower oil prices environment, based on analysis by Bloomberg Intelligence.

Yet the biggest uncertainty is the sustainability of China´s high oil imports. Global oil supply continues to outpace demand, according to the US Department of Energy Information Agency.

The oversupply situation may ease in 2016 with the supply-demand balance dropping to 0.79 mbpd (million barrels per day) from 1.76 mbpd this year. The US´s EIA maintained its forecasts for Brent oil prices at $59 in 2016 in its October 6 short-term energy outlook.

Consensus expects Brent to remain below $65 through 2019. This outlook may be driven by concerns over the strength of global economic growth, China´s shift away from heavy industries, the resilience of US oil production, unchanged OPEC output quotas, and additional future flows from Iran if sanctions are removed.

Low oil prices have eroded operating margins and caused significant asset impairments of exploration and production companies. Cheap oil is forcing the upstream industry to concentrate on cost reduction and efficiency gains. The companies are cutting capital expenditure (capex), increasing efficiency and delaying exploration. The pullbacks in capex, focused mainly on reducing and deferring exploration, may hurt exploration and production (E&P) companies´ ability to replace reserves in the future, given the long-term nature of upstream oil and gas projects. Their cost reduction initiatives include freezing recruitment, cutting headcount, reducing drilling activities and negotiating with contractors for lower prices.

Cost reductions can partially offset the sharp fall in oil prices and ease the decline in operating margins. Low oil prices are also prompting upstream companies to begin divesting non-core assets to cut costs and focus on core operations. Some of the companies seek to preserve their financial strength by selling non-strategic assets. Should oil prices remain low for longer, the E&P industry will have to continuously adapt to austerity. Companies that have strong balance sheet and low costs are better positioned to endure the cheap oil environment.

- Author: Lu Wang, Asia Oil & Gas Analyst, Bloomberg Intelligence

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