IHS Energy Insight Insight 30 July 2015 ihs.com Swinging Lower Crude oil prices poised to drop further James Burkhard, Vice President Jamie Webster, Senior Director Bhushan Bahree, Senior Director1 Key implications Since the oil price collapse, global oil production has gone up, not down. Indeed, since the fateful 27 November 2014 OPEC meeting, aggregate production from the United States, Saudi Arabia, and Iraq has increased 2 MMb/d—far more than global demand. Oil markets are increasingly glutted. Last November is also when the United States inadvertently became the swing oil producer. Prices have not yet fallen far enough or for long enough for an appreciable US supply adjustment to occur. But it may not be far off, especially if oil prices fall further with additional Iranian supplies. • Oil prices will be under downward pressure until there is evidence the glut is shrinking. This will not happen quickly unless prices fall even further from recent levels. • For a decline in US output to appreciably erode the global surplus, prices would need to range in the low $40s or less for several months. In 2014, production from wells with a break-even cost of around $60 for WTI produced enough oil to offset declines from pre-2014 wells and keep US production flat with 2013. The rest of last year’s incredible growth came from higher-cost wells. But costs are lower this year—by about 20%. A break-even cost of $60 in 2014 is now in the upper $40s per barrel for WTI. This is why only lower prices will catalyze a more rapid supply adjustment. • With lower prices, US crude oil production in the second half of 2015 would record its first significant decline in more than seven years. A severe drop in prices, lasting several months, would then increase the likelihood of a significant price increase in 2016–17. Production growth from the rest of the world, including Saudi Arabia and Iraq, is unlikely to keep pace with demand growth if US production falls appreciably. Growing glut is prelude to another price drop The United States inadvertently became the world’s swing oil producer last November when OPEC decided not to cut production to prop up prices. The gut-wrenching drop in oil prices that followed was just the beginning of oil market turbulence. Now it is time to hold tight for another drop in prices, followed by an equally unsettling rise later. The reason: oil output, notably from the United States, Saudi Arabia, and Iraq, has risen 2 MMb/d since November 2014—far more than demand (see Figure 1). In other words, oil markets are increasingly glutted. If the United States truly has become 1. Paul Tossetti, Senior Director, also contributed to this report. IHS Energy Copyright notice and legal disclaimer © 2015 IHS. No portion of this report may be reproduced, reused, or otherwise distributed in any form without prior written consent, with the exception of any internal client distribution as may be permitted in the license agreement between client and IHS. Content reproduced or redistributed with IHS permission must display IHS legal notices and attributions of authorship. The information contained herein is from sources considered reliable but its accuracy and completeness are not warranted, nor are the opinions and analyses which are based upon it, and to the extent permitted by law, IHS shall not be liable for any errors or omissions or any loss, damage or expense incurred by reliance on information or any statement contained herein. IHS and the IHS logo are trademarks of IHS. For more information, please contact IHS at www.ihs.com/CustomerCare. IHS Energy Swinging Lower Signs of the supply glut are global. US crude stocks are up almost 80 MMbbl since January 2015. European stocks are near five-year highs. Singapore product stocks are approaching levels not reached since the recovery after the 2008 price crash, and there are reports that facilities in South Africa’s Saldanha Bay are now full. And oil inventories in China have been rising this year, on top of gains in 2014.   US production growth will not need merely to halt but to fall to around 9.0 MMb/d—or lower—to even begin an erosion of the global supply glut. As recently as April, US crude oil production was 9.7 MMb/d. Figure 1 Primary sources of crude production growth since 27 November 2014 OPEC meeting 2,500 2,000 Thousand b/d the swing producer, its output will fall as prices drop further. 1,500 1,000 500 0 Source: IHS Dec-14 Iraq Jan-15 Feb-15 Saudi Arabia Mar-15 Apr-15 United States May-15 Russia Jun-15 © 2015 IHS The IHS Performance Evaluator indicates that a drop to 9 MMb/d means the US oil-directed rig count falls to about 600 by the fourth quarter, and then to 400–450 rigs in 2016—the lowest since 2009, before the great revival of American oil production. Recent weekly data indicate that a drop in US production is under way. But how low will prices need to fall to spark a significant decline in US crude oil output? In 2014, production from wells with a break-even cost of around $60 for WTI produced enough oil to offset declines from pre-2014 wells and keep US production flat with 2013. The rest of last year’s incredible growth came from higher-cost wells. But costs are lower this year—by about 20%, so that a break-even cost of $60 in 2014 is now in the upper $40s per barrel for WTI. For US output to fall enough to appreciably erode the global surplus, this means prices in the low $40s to even $30s for a time. Such price levels would reduce cash flow even further, forcing an additional reduction in capital expenditures, and likely diminish even further the willingness of the capital markets to fund US upstream companies. Why the focus on the United States? World oil demand growth has increased more than twofold this year—jumping to an estimated annual gain of 1.3 MMb/d, more than double the 2014 pace. But even this higher level is inadequate to soak up the growth in supply. Global production is up about 2 MMb/d since the November OPEC meeting, driven by the United States, Saudi Arabia, Iraq, and to a small extent, Russia. Setting aside the United States, the other three countries have limited additional production upside in the short term; and Saudi Arabia and Iraq may actually show slight declines. However, while the production upside is limited, the downside is as well. As stated in our February Decision Brief Oil Change on OPEC’s new role in the market, there is little to no incentive for OPEC to reverse course and voluntarily give up market share in what would likely be an ill-fated quest for higher revenue.2 Indeed, given the Iranian nuclear deal, this action seems even less likely as Saudi Arabia and other Gulf producers would be unwilling to reduce production to make room for more oil from their rival. Instead it seems that OPEC will retain its view that high-cost producers should bear the brunt of the production decline to balance the global market. Yet US shale oil is not the world’s highest-cost source of supply. For example, heavy oil 2. See the IHS Energy Decision Brief Oil Change: A world without OPEC as we knew it. © 2015 IHS 2 30 July 2015 IHS Energy Swinging Lower projects in Canada and Venezuela and deepwater development have full-cycle costs higher than the average tight oil project. Instead, it is the unique, highly competitive, and price-sensitive US upstream industry that makes it the inadvertent swing supplier.3 The United States in the swing producer role is very different from OPEC. US tight oil drilling and production is more dynamic than other sources of upstream supply around the world. The US upstream industry is highly decentralized. Rapid oil drilling and completion times (approximately four months from planning to first oil) and high decline rates (approximately 50% in first year) can give the effect of a production cut as lower investment will cause declines that bring total production down. This is very different from the OPEC and Saudi Arabia strategy in the prior era of shutting in production. Given this role and context, a US production decline appears to be the most rapid avenue for an erosion in the supply glut—but this may send prices falling even further. 3. See the IHS Energy World Oil Watch Tight Oil Brings the Swing Era Back to the United States. © 2015 IHS 3 30 July 2015