The Premise - Oil like other commodity has been in a sharp down cycle, as in any commodity cycles, they are bound to turn up. Usually the the U curve of these commodity plays lasts anywhere between 2-5 years. If we look at the basic commodities, they have been on a downcycle since the subprime crisis in 2008 - since there had been easy money and over investment in particular by China. However oil held its own and in fact went to as above USD110 in 2013. Since then it has fallen to USD30 as of early February 2016.
Picking Bottoms - It is hazardous to say the least but at USD30
we are probably in the last quartile of correction. The justification
being the cost of production. The cost of production below was in 2014,
as of today we can impute a higher cost of between 10-20% based on
weaker economies of scale and USD strength.
Cost of Production By Country - We can surmise that Saudi Arabia
wanted to crush Iran and the latter’s cost of oil extraction is between
USD15-16, which would indicate some downside could be in store. Iran has
received a lifting of sanctions which would see their current export of
500,000bpd to escalate to 2 million by April/May 2016. At below USD30,
the number of players still operating profitably will just be among the
Middle Eastern producers.
If you were to look at The following two charts above, it will tell you that the surge in oil prices above USD110 over the last 4 years have largely been by increased US production. By and large, we can argue that Saudi’s move to weaken oil prices was two pronged: to kill off the shale producers and weaken Iran’s power - the former has been well achieved and the latter has also shown to be effective.
The Rebound Limit - Yes, we are probably in the last quartile of
the trough but one thing is clear there will be a limit in a rebound as
Saudi will not want the shale producers to restart their production
easily again. Hence if you look at cost of production chart, that
objective can be attained by keeping the rebound range to USD45-60 over a
sustained period.
Since the fateful November 2014 OPEC decision to maintain output, defend
their market share, and kill off high-cost producers around the world,
particularly North American shale and oil sands - we are left with
Saudis crushing Iran being the last objective. However since the lifting
of sanctions for Iran the Saudis would know that it is almost fruitless
to continue doing so. As the cost of shale is at least USD60-70 on
average, most have closed shop and declared bankruptcy.
Consensus Estimates - If you were to look at the average
consensus estimates by EIU, IMF and other international agencies, its
between USD60-65 over the long run. They could all be wrong, and even if
you were to discount their estimates, it should still be in the range
of USD50. That should be where we should be looking at over the next 2-4
years.
The Breakeven Factor - On the first page we have looked at the
extraction cost of oil per country. But that is not the key factor,
every country have differing needs and diversification of industries.
The more reliant you are on oil, the more it will be impacting the
country’s budget. Hence even when Iran have their sanctions lifted, and
technically it can ramp up to 2mn-3mn barrels a day, plus their
extraction cost is below USD20 per barrel - it does not mean they are
laughing. Iran needs oil to be at USD140 to balance the budget. If you
think (like me) that part of the reason the Saudis are letting oil price
crash is to hurt Iran, then the Saudis are in no mood (yet) to let oil
price rise at a time when sanctions has been lifted.
Hence almost all the Middle Eastern countries have very high breakeven
levels, but some have ample reserves to see this through for sometime
still. Namely Saudi Arabia, Qatar, Kuwait and UAE. The rest are finding
it very tough.
Saudi Arabia's net foreign assets have been dropping at almost $8
billion per month meaning the company has only 5-6 years of reserves
left. While the company's Saudi Aramco IPO might raise much needed cash,
it is a show of desperation that might not be best for the country.
More so, compared to other countries, Saudi Arabia has the best
situation. Other countries like Libya, Venezuela, Iran, and Nigeria are
in much more need of cash. Non OPEC producers such as Russia might be
looking to get in the action and make a deal to cut production. A
relatively minor production cut of 1-2 million barrels per day could
easily push oil prices back up to $60 or more barrels per day.
Saudi Arabia might call it a day since the sanctions has been lifted for
Iran as it probably not much use to keep oil prices below USD30 for a
persistently long time. Saudis’ strategy now lies in achieving its other
objective, to dismantle the US/Canada shale oil production infra. But
you can see that US oil production is still high and is taking its time
to reduce, hence I think the Saudis will wait a few more months to see
further declines in US production before reversing oil price trend.
The Big Picture - Why are we in the present predicament? Global
capital spend for big miners was just US$4bn in 1991, that went to
US$14bn in 2001. China was a key factor after it entered WTO in 2001.
Global mining capex went from US$14bn a year in 2001 to US$125bn a year
in 2012. The over investment largely by China has to work itself off. In
a slowing global economy and a substantive slowing in China growth can
explain a large part of the commodities down cycle over the last 5
years.
http://malaysiafinance.blogspot.my/2016/03/oil-usd25-usd40-for-next-2-years.html
