How The Recent OPEC Meeting Will Affect Canadian Oilpatch Spending

By: David Yager

Article originally published by EnergyNow on December 9, 2015 and can be found here: http://energynow.ca/heres-how-the-recent-opec-meeting-will-affect-canadian-oilpatch-spending-david-yager-mnp-llp/ 

The OPEC meeting held December 4 in Vienna went worse than anticipated. Although there is no humor in what transpired, there may be something to be learned from the old joke about the scorpion and the frog.

Somewhere near the Persian Gulf, a scorpion wants to cross a stream but obviously cannot swim. So the scorpion asks a frog if it can ride across on its back.

The frog responds, “But you’re a scorpion and you can kill me with one poisonous sting.”

To which the scorpion replies, “But if I did that we would both drown. Why would I kill us both?”

This made sense to the frog so it allowed the scorpion to hop on its back and across they went. Halfway to the other side, the scorpion did indeed sting and poison the frog. In a dying gasp, the frog asked “Why did you poison me? Now we will both drown!”

The scorpion replied, “Welcome to the Middle East.”

Trying to understand why Middle Eastern oil producers do what they do remains perplexing for many in the west. The math is simple. Saudi Arabia is producing 10.3 million barrels per day and fetching about $45 per barrel or $463 million per day. Shutting in 1.3 million barrels per day could cause the price of oil to double. The result would be 9 million barrels at $90 per barrel or $810 million per day.

But, as always, it is more complicated than that. This latest OPEC meeting was a disaster for world oil markets in the short term. The Saudi Arabia-led cartel had maintained a 30 million barrel-per-day quota for some time but has actually been producing more like 31.5 million barrels per day. OPEC has produced above its official quota for over two years. At the meeting, the thought was at least the quota could be raised to match actual output, thus retaining some semblance of credibility for the organization. But according to a Reuters media report from Vienna on December 6, a major problem is now Iran, which announced its intention to ramp up production by 1 million barrels per day or more as soon as possible, OPEC quota or not.

The article quoted an OPEC source who said, “The ceiling issue was very controversial and they could not decide on it. Nobody was happy.” So the meeting adjourned with no official quota whatsoever. This means for the first time in decades OPEC has no formal production ceiling. It is every producer for itself. While the cartel has appeared to operate this way from time to time over the years, it has never done so formally. More commentators than ever are speculating if OPEC is not officially dead, it might as well be. “OPEC is dead” was the front page headline of the December 7 edition of the National Post.

Further complicating the issue is the increasing tension between Iran and Saudi Arabia for influence in the Persian Gulf region. The Reuters article said, “But the present Sunni-Shia conflicts setting Saudi Arabia and Iran at each other’s throats, particularly in Syria and Yemen, make the relationship between the two OPEC powers even more fraught.” A European investment analyst said, “The fact that Iranian–backed Houthi militants are squaring off against Saudi–led troops in Yemen is not helpful, as increased Iranian oil revenues are likely to find their way to Iranian military interests in Yemen, Iraq, and Syria.”

So why would Saudi Arabia voluntarily cut its output to raise prices for everyone when Iran intends to increase its output regardless? And Iran would use the extra cash from higher prices to forward its aspirations in the Middle East? The Saudi’s would not, which is exactly what happened.

If this analysis is indeed true, then oil has again become a weapon by certain oil-producing countries. In the past, high prices were meant to punish western countries – particularly the United States – for intervention in international affairs and pursuing what many in that part of the world consider to be a decadent lifestyle. Now it appears low oil prices are being used to punish other oil-producing countries at a great cost to both parties. Think scorpion.

The response by oil markets was predictable. While few thought anything really positive would emerge from the OPEC meeting, the fact the organization no longer has any quota at all was not anticipated. Prices started falling December 4 and the bloodbath continued December 8th. Combined with a massive buildup in crude oil inventories around the world, the bears have control of futures markets for the time being.

Prior to the meeting, some OPEC members thought increasing its quota to reflect current output might be the best possible strategy due to the daunting overhang of oil storage. Let demand rise, production fall and eventually markets will balance. But even a 1 million barrel per day decline in output might not reduce storage to historic levels for a year and eliminate the significant market overhang. OPEC analysts were said to be pessimistic about improving world oil markets before the meeting. Apparently, Iran’s announcement it was increasing production as much is possible regardless of what OPEC decided was a tipping point in the final disappointing outcome.

What does this mean for Canada’s oilfield service industry (OFS)? Probably the worst winter drilling season in recent memory. Although the futures price for WTI a year from now is still about US$10 higher than the current price, it is not high enough to materially increase producer cashflow. Therefore, no evidence is available to indicate producer cash flow available for reinvestment in 2016 will increase, barring an event so unforeseen no one has any idea what it might be. With bank credit facilities tightening and equity markets being terrible, exploration and production (E&P) companies will be living on cash flow, leaving no additional funds for increased spending. In fact, the events of December 4 are likely to cause operators to review budgets and spend even less money this winter than they had planned as recently as a week ago.

Analysts like Goldman Sachs have been very bearish on oil for some time. The foundation of the “lower for longer” thesis is high storage levels, unrestrained output by everyone and Iran adding more production as soon as sanctions are lifted. This combination gives traders no reason to believe the price of oil will rise anytime soon. In reading and analysing everything written about crude oil markets for decades, one important driver of higher oil prices is more investors believing the price should go up than believe it should not. Because of the significant amounts of oil in storage, there is no reason to see a shortage of oil any time soon, no matter what happens. And the strong U.S. dollar continues to put pressure on the value of crude oil and every other commodity.

Closer to home, political priorities are not pro-industry at this time. If there is a problem with Canada’s oil and gas industry, most governing politicians – with the exception of Saskatchewan Premier Brad Wall – believe it is excessive carbon emissions, not excessively bad economics and opportunities. Apparently Canada’s delegation to the Paris Climate Change Conference was in excess of 350 people, greater than the representatives of Australia, the United Kingdom and the U.S. combined. It appears politicians are out to fix the oil industry but not the way the people who work in it want them to.

The Alberta government has already raised fuel taxes, corporate taxes, carbon taxes, and income taxes. Higher levies on all forms of energy have been promised. The as yet unknown outcome of the royalty review should be revealed within a few weeks.

At the federal level, new Prime Minister Justin Trudeau is promising increased tax rates on high income earners as early as January 1. Ottawa’s carbon strategy is as yet unknown. However, after the language used in Paris, it is unlikely Ottawa will delay implementing any carbon taxes because Canada’s valuable oil and gas industry is under severe financial strain.

However, oil markets should eventually improve. Low oil prices will ensure more spending is cancelled or delayed. The decline in U.S. light tight oil production will continue and low prices will ensure consumer growth in oil demand.  Iran may have great plans to increase oil output but it will take time. Notwithstanding high storage levels, global crude supply and demand curves will meet then likely cross at some point in 2016.

But the challenge for E&P and OFS will be figuring out how to stay in business until market conditions improve. After the OPEC meeting, there is no relief in sight for the industry’s depressed activity outlook.