Prepare to Rethink Your Assumptions About the Global Energy Scenario, Says Michael Wilson
Please excuse me if I seem a bit more disgruntled than usual this month. It’s been a tough few weeks, and an expensive learning curve for me.
You see, I thought I’d got shot of my ailing oil shares portfolio in the nick of time – well, by last December anyway – and I was really quite looking forward to the prospect of watching the energy markets drift lower for another six months, before leaping in with one of my usual spectacularly well-timed contrarian buys. But I got more than I bargained for.
In the last month I’ve watched my BHP Billiton mining shares getting pummelled by the self-same bear rush that’s been trashing the oil majors. I mean, for goodness sake, what vulnerability does an Australian coal-and-gold-and-uranium-and-base-metals specialist have to the hydrocarbons industry? Yes, I know that the world fell off the commodities supercycle a couple of years ago, but how could crude oil at $49 be doing this much damage to a company that makes its money by flogging non-oil raw materials to the Chinese?
Memo to Self: Keep Up At The Back
That was where I had my come-uppance waiting for me. This very morning, I read that BHP Billiton has chopped its drilling rigs in the North American onshore shale gas market by 40%, from 26 rigs to just 16. And that most of its rivals are doing the same. And that BHP was axing 20% of its international oil exploration budget during 2015, and that it was due to make ‘impairments’ of $200m-$250m to its underlying profits because it had sold some of its assets in Louisiana and the Permian basin. And that its shares had now lost 6% in the first two weeks of January, bringing the damage since last July to 30%?
Slap forehead and say a very bad word. This old fool has been in this company too long, and I’ve let the grass grow under my feet. How else could I have missed the fact that a conventional, old-fashioned mining company might have decided to chance so much of its arm on smashing up the tectonic plates of the New World? An activity which it was eminently well suited to doing, considering its expertise in every other earth-smashing endeavour?
But there it was, and there it is. Anyone who hasn’t been keeping up with the energy markets over the last three years has been risking getting hung out to dry, because the global situation has been shifting in ways that would hardly have been believable five years ago.
First, the halving of the oil price in the last six months has got the economists in a twist. The last time it happened, in 2008, it turned out to be a portent of stock market and financial disasters that were to shake the world. Whereas this time all the papers have noticed is that it’s taken 30p off a litre of petrol and chopped Britain’s inflation rate to the point where the Bank of England Governor had to apologise to the Chancellor for not letting prices rise fast enough.
That’s weird. But not as weird as what it’s doing in America, where every company you meet is currently cock-a-hoop about its falling energy bills, apart from the oil industry itself, obviously. And even then it’s not so bad for the oil majors, who are still sitting on enough crude oil and gas to let them wait it out until sanity eventually returns and the oil price heads back upwards again.
But it’s a different story for all the tiny exploration and development companies that have been staking their claims in this 21st century gold rush. All those yee-haw oil tech companies, leveraged to the hilt and committed to a lot more than just a few picks and shovels.
All those tax-incentivised ‘Master Limited Partnerships’ that were flogged to the oil-unwary just six months ago, some of them with market capitalisations of below $100 million. All of them desperately hoping that West Texas Intermediate will be heading back up toward the $70-80 per barrel that they need to get their operations back up to break-even.
Choose Your Conspiracy Theory
And what are the chances of that? Well, it depends which conspiracy theory you believe in. For some, Saudi Arabia opened up a massive gulf last autumn (if you’ll pardon the expression), when it announced that it had no intention of reining back its own massive oil exports even though the world market prices for crude had crashed.
For the more primitive shotgun-toting cynics in Texas, this was tantamount to open betrayal by an ungrateful Saudi royal family which America had pledged to defend militarily, but which had now set out to destroy America’s shale gas producers by pricing them into submission. A mighty act of domination by the global giant which had all the best cards in its hand.
Up to a point, that’s true. Saudi Arabia has the world’s biggest oil reserves, and what’s more, they’re very high in quality and reputedly cheap to extract. So how does it look to Riyadh that America is widely touted to steal its crown within perhaps 20 years, thanks to its considerable stocks of much more expensive oil?
Now consider that Saudi Arabia normally acts as ‘swing producer’ to the OPEC group – generously cutting back its production when prices are low (to create a supply squeeze) and raising it when oil gets expensive enough to permit a little profit-taking. Riyadh is effectively working like a central banker to the OPEC community. Except that now, it isn’t. Saudi Arabia’s refusal to cut production in the face of falling prices is looking very damaging indeed – not least to some of its OPEC partners.
The Real Cost of Production
A recent study in the Wall Street Journal (http://graphics.wsj.com/oil-producers-break-even-prices/) reckoned that OPEC members Iran and Algeria require $130 per barrel for their economies to break even; that Nigeria needs $123, Venezuela needs $117, Iraq $101, the UAE $77, Qatar $60 – and non-OPEC Norway just $40 a barrel. Poor old Russia struggles below $98, it said.
But the big surprise comes from Saudi Arabia itself, which the researchers said needs $106 per barrel to make ends meet. Not because getting it out of the ground is expensive (it isn’t), but because the Saudi government spends its oil revenues so freely that everything would quickly crash without that sort of a world market price.
If that’s correct – and we have no reason to suppose that it isn’t – then the real reason why Saudi Arabia has opted not to cut production is not what we think it is. Rather than simply trying to face down the Texans in a poker game where Riyadh has a bigger pile of chips, Riyadh is looking real disaster in the face and has no real choice but to go for whatever money it can get. If it were a farmer, according to this argument, it might eventually be in danger of having to eat next year’s seed corn. Its alternatives would be few and far between.
That, of course, is a ludicrous extrapolation. Saudi Arabia could leverage its future oil production any time it felt like it. And anyway, a former government adviser called Mohammad al-Sabban told the BBC in mid-January that the country could easily withstand eight years or more of low oil prices, thanks to a fairly substantial set of government spending cuts and a cash pile of 3tn Saudi riyals (£527bn). That’s around £28,000 of cushion for every Saudi national in the country, by the way. Not bad.
The Saudi Succession
Still other conspiracy theorists point to a period of possible instability within the Saudi administration itself. King Abdullah’s death from pneumonia has now set the Saudi succession onto a new course – and sooner or later there’s going to be trouble in the ruling family. Trouble, not least, because all the remaining heirs to the throne are elderly, and factionalism and rivalry between them is rife.
Unlike most monarchies, where the crown passes to the eldest son, the Saudi kingdom passes from the eldest of the original King Abdulaziz’s sons to the next eldest. And, since Abdulaziz died in 1953, you can figure the rest out for yourself. Most of the current contenders are in their seventies.
Yes, we know that it was the eldest son, Salman (79), who got the top job this time, pretty much as family protocol dictated. But next time round it’ll get messy. In a break with tradition, the late King Abdullah had personally appointed his very youngest brother, Prince Muqrin, aged only 69, as deputy heir (after Salman) – thus leap-frogging a whole clutch of older brothers, all of whom who can expected to feel a bit upset. Rows are already rumoured over which concubine’s sons should take precedence over which others – and although we can expect the royal family to stay outwardly solid, you can bet that it will be boiling within.
That matters, because Salman is considered to be a particularly conservative character, which does not bode well for the country’s budding democracy movement. Saudi Arabia has other tensions with America – partly over the Arab Spring (which it took care to suppress on its own soil) and partly over Syria, where its heavily Sunni, anti-Assad and anti-Iran positions took it into supporting the armed resistance against Assad – part of which has unfortunately morphed into Islamic State. Very embarrassing.
Unsurprisingly, that particular alignment is effectively lapsing these days, and not before time probably – but now that IS has started talking about attacking its former sympathiser, the relationship between Riyadh, Washington and Assad has moved into John Le Carré territory. Some tinhats, indeed, are claiming that Barack Obama is secretly in league with the Saudis, and that everything else is just a cover story. For all the good that would do for both of them.
Rolling Out the Risk Scenario
And so the conspiracy theories roll on. It seems almost pointless to dwell on them when the thing that really stands out is how the collateral damage to the world’s oil markets is stacking up.
We’ve already seen that the worst damage is happening in single-industry states like Venezuela, Nigeria and Russia – all of which rely horrendously on oil and gas revenues. Nigeria alone gets 98% of its export earnings and more than 80% of its government revenues from oil and gas – which might explain a lot about the government’s present mess. Russia’s President Vladimir Putin hasn’t dared to try and extort political concessions from the West because he can’t risk losing the only thing that’s keeping his people’s larders stocked with food.
And here in Britain, with North Sea oil contributing so much to the economy of a certain northern country, this year’s 50% cutback in exploration, drilling and support activity is going to make life exceptionally difficult for Nicola Sturgeon – with oil towns like Aberdeen feeling the initial pinch, but with the central government coffers taking the strain as the year progresses.
As for America, I find it hard to see how the present price problem will do much more than take out some of the biggest and most over-leveraged gamblers. Unlike virtually every other country we’ve mentioned so far, the United States has a truly diversified economy with a mobile, solvent financial system that can lay off most of the future risk in one way or another.
But what if the low crude price sticks for another three years, as BP’s boss Bob Dudley forecast only the other week? That’s a prospect that will overturn many of our assumptions about the robust nature of the oil industry’s finances.
And beyond that? Can the alternative energy suppliers survive unscathed, with oil at $50 a barrel chopping away at their already weak state of price-competitiveness? What if a slowing world economy (down to 3.5% growth in 2015/16, says the IMF) should decide that it simply has other priorities right now than spending trillions on new energy sources?
We are in a new situation, and it would be a reckless commentator who pretended that we can expect a rapid return to business as normal. The convergence of economic, geopolitical and scientific factors is set to test everyone’s mettle, and the old assumption that the laws of energy supply and demand will resume their normal functioning deserves to be at least examined closely, and very probably challenged.