The changing oil dynamics

IN August, Petroliam Nasional Bhd (Petronas) president and group chief executive officer Tan Sri Shamsul Azhar Abbas warned the market that falling crude oil prices will hurt earnings in 2014, even as the national oil company boosts its production.

Brent crude oil had then traded at around US$105 a barrel.

Shamsul predicted back then that global crude oil prices should be well supported at around US$95 a barrel.

Two months down the road though, Shamsul is proving to be right but his predictions are mild compared to what the market is experiencing now.

The commodity was traded yesterday at around US$87 a barrel – near cheapest levels in four years.

Brent crude oil, the benchmark price for products in Europe and Asia, tumbled to a low of US$85.40 on Wednesday.

The global crude oil market is reeling from a combination of factors – booming shale supplies in North America, a strong US dollar and weakening economic growth outlook in Europe and China that is reducing oil consumption with it.

The US energy market has seen a dramatic 65% increase in production of oil and gas over the past five years mainly from extraction from hydrocarbon-rich underground shale layers.

Official figures show US oil production is around 8.8 million barrels a day, about a million barrels higher than last year. Saudi Arabia, the world’s biggest oil producer, is producing about 9.6 million barrels a day.

But extracting oil from mudstone layers using horizontal drilling and hydraulic fracturing methods is an expensive venture.

Paris-based International Energy Association (IEA) estimates that oil from shale formation costs between US$50 and US$100 a barrel to produce, while the production cost is substantially cheaper – at US$10-US$25 a barrel – for conventional oil producers in the Middle East.

But despite the cost disadvantage amid falling prices, coupled with technical challenges of extracting shale supplies, US Energy Information Administration (EIA) expects oil outputs to continue to grow in all major shale sites in November.

With its own domestic supply growing, the United States is cutting down on imported crude.

Imported energy made up about 30% of US consumption a decade ago. It is declining at a steady pace to just 4% by 2040, according to a recent report by EIA.

As the combined output from Opec producers rose to a 13-month high in September, the supply glut situation may worsen.

In an unexpected move, Saudi Arabia early this month, began offering discounts for its crude oil to defend its market share.

Unconventional plays

Investments in the oil and gas industry have almost tripled since 2000, as oil majors go deeper and into harsher environment in search of new crude supplies.

Earlier this month, Petronas together with its partners said the Gumusut-Kakap floating production facility sited in waters up to 1,200m deep offshore Sabah had started oil production. The project would add 135,000 barrels a day when production hit its peak and account for up to 25% of the country’s total output.

Until last month, global crude oil prices were holding steady at above US$100 a barrel since June 2012. The recent drop in prices have sapped oil majors’ appetite to undertake risky projects.

Petronas has already warned that it is prepared to put off the massive US$11bil (RM35.8bil) shale gas project in Canada if the terms are unfavourable to the company.

Royal Dutch Shell Plc also recently said it would again delay its Alaska exploration project. Other companies like BP Plc, ExxonMobil Corp and Statoil are also trimming down new investment or looking to divest assets as part of their strategy to protect profits.

A recent report by consulting firm EY put the total number of megaprojects bankrolled by oil majors at around US$1.1 trillion. Most of these projects are already behind schedule and over budget.

Documents related to development of marginal oilfields in Malaysia cited by StarBizWeek previously was based on the assumption that crude oil would stay above US$100 a barrel.

CIMB Research reckons that Petronas’ capex “would not be affected by short term fluctuations in oil prices unless it goes below US$60 per barrel.”

That is about the same level for unconventional projects to be worth the effort and investment for oil majors.

The economics of oil

The dynamics in the oil and gas industry are changing. The tight supply situation that persisted for decades is being relieved by the unconventional boom that is helping the US economy to recover.

The prospect of a stronger US economy is driving up demand for the US dollar, which weakens the prices of greenback denominated commodities.

At the same time, the market is grappling with slowing growth in Asia and worsening outlook for Europe.

The emerging divergence prompted the International Monetary Fund (IMF) this month to downgrade its global growth forecast for both this year and the next.

Weaker growth translates to slower consumption. The IEA, EIA and Opec have already responded by lowering their forecasts for global oil demand.

It looks like falling crude oil prices is a chilling sign of economic slowdown, while at the same time prices are being pressured by rising crude production.

Cheaper fuels could help boost economic growth.

At home, published profits at Petronas for the first half of the year continued to be buoyant, as they are yet to be hit by the recent sharp decline in crude oil prices.

The Government, 29% of which annual revenue depends on the oil and gas sector mainly through dividend payments from Petronas, estimates that crude oil prices will average at US$105 a barrel in 2014.

“Lower oil prices will definitely have an impact on Government’s revenue, but at the same time there will be savings in terms of reduced subsidy bills,’’ Malaysian Rating Corp Bhd chief economist Nor Zahidi Alias said.

The Government, on Oct 1 made a surprise move to cut subsidies for fuel sold at local pump stations.

“We estimate that the breakeven of the global crude oil price is at an average of USD84.80 per barrel if RON95 remains at RM2.30 per litre without government subsidy,’’ AmResearch said.

Meanwhile. a free fall in crude oil prices may result in further cutbacks by oil producers. That is dire news for companies involved in the sector.

Panicky investors are already dumping shares in contractors like SapuraKencana Petroleum Bhd and Bumi Armada Bhd on worries that future growth may be stunted as the industry adjusts to cheaper oil.