Oil Prices on Brink of Structural Down Turn, is Gas Market next?

We have been proponent of softening in global oil prices for some time now, which weare seeing happen over the past few months. While Modi-government in India is passing the benefit to the consumer and fuelling further confidence.  This slowdown is, however, hitting the oil industry and this will have profound impact on wealth transfer between oil producing to oil consuming states, a change seen after a long time. I believe that oil market is undergoing structural change and prices will continue to soften over prolonged period of time. This is due to two key global developments – supply side addition of US shale gas and tight oil and slowdown in Chinese demand.

US shale gas, tight oil supplies and its cost curve in recent years has an instructive tale. The shale gas boom, a technological advancement for drilling of oil, actually took place in two phases. The first focused on natural gas extraction while the second on ‘tight oil’ – extraction of oil from same formation. The natural gas phase has already gone full cycle and its impact is reflected in the collapse of natural gas prices in the US. The extraction of tight oil phase has just begun.

There is a strong notion that collapse of oil prices will stall the shale gas extraction and oil prices would revert to their back to higher prices. Let me dispel few notions related to breakeven prices of the gas. First, only 4% of US shale oil production and 3% of global oil production has a break even rate above US $80/bbl. Second, about 16% of the US oil production has break even at $60/bbl. Moreover, the high initial cost of developing wells has already been incurred by the operators thereby putting marginal break even at much lower price.

The shale gas and tight oil revolution is going global. Russia has 75 bn barrels of recoverable shale oil (1.5x the US at 58 bn). China has 1100 cu trn of shale gas (2x of the US and 32 bn barrel of shale oil).  Russia has huge conventional sources hence will not be tempted to exploit but China has begun the exploration of the shale gas and tight oil, albeit at slow pace.

Hence, this indicates that oil supply will keep prices remain depressed for considerable period of time.

China is the world’s largest importer of crude oil, accounting for a third of annual global oil demand growth over the last 12 years. However, average net addition of 800,000 bpd by china till crises in Yr 2008 is likely to settle to 200-250,000 bpd from now onwards The slowdown in the China is also driven by manufacturing and construction, heavy user of oil sectors.  The lesser known fact about the reason of decline in oil prices has been improvement in intensity of oil consumption by china over the last decade. The government targeted 20% decline in the overall energy intensity/GDP from Yr 2005-10 and achieved 19%. The target for 2010-15 is further improvement of 16%. The current oil intensity is about 75% of its 2005 levels. This means that oil consumption will rise only 75% of GDP growth. Hence, the old assumption of oil consumption based on GDP growth rate not hold true.

US will export gas to Asia. One of the unintended impact of decline in the oil prices will be acceleration of export of natural gas by the US. The incentive to withhold the permission under Homeland Act has lessened. The current Asian LNG prices are around $15/mmbtu, Europe at $10-12/mmbtu, while the US is about $4-6/mmbtu. Considering the $4-5/mmbtu of shipping cost from the US to Asia, this makes a business sense for the US companies to export gas and bring price equilibrium with structural long term decline in the Asian market. India is one of the significant beneficiary of the structural decline in oil and gas prices thereby giving the current government an opportunity to repair the balance sheet of the country.

Manish Bhandari, CIIA is Managing Partner and CEO of Vallum Capital Advisors, an equity investment advisory firm based in Mumbai. He is reachable on manish.bhandari@vallum.in.


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