Fundamental tightness in oil supply to continue to support prices

TheEdge Wed, Jul 20, 2022 02:00pm - 1 year View Original


RECENTLY, the investing fraternity was shocked by a projection by Citigroup that crude oil prices could drop to a low of US$65 per barrel by the end of this year and US$45 in 2023.

Citi argues that this is possible in a scenario where Opec+ did not intervene in the oil market and a decline in short-cycle oil investments. Further weakness in demand could also spell higher inventories, which could weaken crude prices going forward. Opec+ consists of the Organization of the Petroleum Exporting Countries and 10 other oil-producing countries.

On the other hand, JPMorgan sounded the alarm after the Group of Seven (G7) countries promulgated to impose another form of sanction on Russia, by capping the price of its crude oil. JPMorgan warned that if Russia retaliated by dramatically slashing its crude production, the crude oil price could surge to US$380 per barrel.

JPMorgan argues that even if Russia slashed its oil production by half to around five million barrels per day, the economic repercussions for the country would not be as severe as the West would have liked. Crude oil at US$380 per barrel could in fact send many countries into recession.

Clearly, the global situation is still very uncertain. If one were to take the view that the global economy is heading towards a recession, with all else being equal to the current situation, one would forecast that the crude oil price would plunge towards the end of the year.

Nevertheless, industry players are sceptical that crude oil prices will plunge to the levels forecast by Citi. There is a fundamental “tightness” in the supply of crude oil going forward, so much so that even if the economy is slowing down towards a soft landing, crude oil prices could remain steady over the longer term.

“There may be pullbacks in the price occasionally in response to the markets reacting to certain items of news flow but, eventually, the fundamental tightness in supply will support a recovery of the price,” says Hibiscus Petroleum Bhd group managing director Dr Kenneth Pereira in an email response to questions from The Edge last Friday.

This fundamental tightness in the production of oil and gas (O&G) does not just stem from the disruption brought by the Covid-19 pandemic and the Russian invasion of Ukraine. Instead, it is a result of long-term underinvestment in oil production and exploration, which was only exacerbated by the current crises.

Pereira explains that production from O&G fields naturally declines by 5%-15% per annum unless significant capital is applied to replace the resources being utilised each day. And since 2015, not enough capital has been deployed to build capacity in both the upstream and downstream sectors.

This inertia to invest was initially driven by a period of low oil prices between 2015 and 2018, caused by the shale oil boom in the US.

During this period, Opec+ intervened by introducing quotas among members and partners to stabilise prices. With quotas introduced and production curtailed, there was little incentive to make the long-cycle investments normally associated with oil and gas projects, he says.

Brent crude averaged above US$100 per barrel between 2011 and 2014 before plunging to a low average of US$43 per barrel in 2016. This period of low oil prices continued until 2020 when the Covid-19 pandemic hit, before starting to jump in 2021.

“Once again, execution of large-scale capital projects in their traditional business area of exploration and production of hydrocarbons was neglected or deferred. This extended period of lack of investment in both exploration and production has now caused a tightening of supply even before the effects of the Russian incursion into Ukraine took place,” he notes, adding that it takes two to seven years to sanction and execute an O&G project.

Therefore, in the interim, given the long period of non-investment into the sector, and more recently the effects of sanctions related to the Russian invasion of Ukraine and the post-pandemic economic recovery being seen, albeit mitigated by the effects of fear of recession and inflation, he believes that O&G prices will remain relatively strong.

Another O&G executive says the US$65 per barrel forecast is too bearish because it assumes that the whole world will not do anything to support the economy and avoid a “hard landing”, barely two years after the last recession brought about by the Covid-19 pandemic.

In addition, once the Covid-19 situation in China is resolved, the country will do anything in its power to ensure high economic growth returns to the country.

“China is not like us; we can survive with just 4% to 5% GDP growth, but for China, it needs higher growth because of the sheer size of the country and its population. Why would it be good for China or anybody else to get into a hard landing?” asks the executive who does not wish to be named.

He also believes that good sense will prevail with regard to further sanctions against Russia, as the West, especially Western Europe, could not survive without oil and gas from Russia, as well as if the crude oil price jumped to US$380 per barrel.

He is of the view that the crude oil price at slightly below US$100 is a more realistic target for 2022 and 2023.

In a July 6 report, Fitch Solutions revised upward its Brent crude forecast to average US$105 per barrel in 2022, up from US$100 previously, and US$100 per barrel in 2023 from US$90 previously.

It stated that the revision reflects a strong price performance over the second quarter of the year and expectation of greater and more persistent tightness in the global oil market than it had previously anticipated.

A sharper decrease in Russian production — as a result of the Western sanctions — has partly contributed to the more persistent tightness in the global oil market than previously thought, Fitch Solutions says in the report.

In June, as part of its sixth sanctions package, the European Union (EU) agreed to a partial ban on Russian oil imports. Seaborne crude imports will be banned effective December 2022 and fuel imports effective February 2023.

Pipeline imports will enjoy a temporary exemption, a compromise that was necessary to prevent Hungary vetoing the move, while Bulgaria will be allowed to conti­nue importing crude until the end of 2024 and Croatia vacuum gas oil until end-2023.

The bloc is also banning EU companies from insuring oil tankers carrying Russian crude, which will further raise the cost and complexity of international trade with Russia, although other insurers will likely step up helping to mute the impacts over time, Fitch Solutions notes.

However, Fitch Solutions has not factored in the proposal to cap the price of Russian crude by G7 into its forecasts, given that such a cap would be highly challenging to implement and enforce, and could see Russia reduce exports in retaliation, driving prices significantly higher.

The inability of Opec+, of which Malaysia is a member, to increase production and meet its self-imposed production quota shows the under-investment in the O&G exploration and production space.

 

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