Tis the season in our industry to take some time off and to spend it with our nearest and dearest. It is also a good time to take stock of all the comings and goings in the past year and to look ahead into the future. A client of mine has asked for some predictions for the oil price for 2016 to use as talking points with his investors. And, as is ever the case in the life of an economist, these predictions have to be qualified with the key associated risks (i.e. things that can go wrong which will prevent the forecasts from playing out.) I thought it was an interesting assignment and it triggered a number of conversations both internally and with colleagues out in the business. I thought it would be a good idea to share the key points of the report, having stripped it of any sensitive information. So here is my prediction for the oil price for 2016 and the key risks associated with it.
It will be a topsy-turvy year for oil prices. 2015 has been tough for most upstream players. However, for those in the business of predicting the oil price, it has actually been rather straightforward. It went down, with some minor bounces, and it is looking to finish the year at, or near, new lows. I suspect that 2016 will be dramatically different. I am tempted to call it a year of genuine price discovery. While it is an open secret that the marginal cost of production has been dropping dramatically due to new technologies (mostly US frack fields), the industry as a whole has not yet worked out where exactly it is. It is clear that the actual cash cost of lifting and shipping the oil is somewhere around $18-20 for most efficient players, but clearly some projects, like deep sea oil and oil sands, are way above that. It is still, however, an open question whether the latter will actually be needed in the near future, as re-fracking or applying fracking tech to the old wells for the first time will ensure that there is plentiful supply out of the US and potentially from elephant fields elsewhere in the world.
The key dynamic of 2015 has been exemplified by a reluctance of producers to initiate a supply response. People kept postponing production cuts until it was clear that the soft prices were there to stay. Separately, Saudi Arabia has decided it has had enough of being the swing producer, and at this point no one has stepped up to take that mantle from them. In this environment it made sense for all the producers to produce, as long as every incremental barrel was cashflow-positive to well head, since those still standing at the time of a price rebound will be the winners in the longer run. This was coupled with continued efficiency gains by most fracking operators, so as time progressed that point of cashflow break-even at well head has been moving lower and lower, which in turn has lowered the floor for the price. At the time of this writing the floor has not been established even at $35.
So here is where 2016 becomes interesting – we will discover the floor and we will see the supply response. Cashflow break-even points are all good and well in the short run, but in the longer term every company must be cognizant of their funding costs, exploration costs, R&D and the rest of their corporate overheads. This will mean that once the floor for the price has been established, we will see dominoes of production cuts starting, followed shortly by the pick up in the price. I think we will see a bounce to the high of 2015 very shortly after. Furthermore the market will re-test both of those extremes as it figures out the new balancing price.
The detailed prediction: We will definitely see a 2-handle on the price, potentially as low as $22. And only shortly after we shall see a $60 high. We will be oscillating between those extremes for the rest of the year. It will be tough, but my numbers seem to suggest a balancing price close to the $50-60 range. The bounce back from the low will be dramatic. I would not be surprised if a $10 move up within a week will follow the touching of the floor. It would be a 50%-ish snap back right there. All in all I would not be surprised to see vols well in excess of 60 on the key oil contracts (to compare realized peak realized vol on a 3 month rolling basis was 44 this year).
The key risk is political. There is no doubt in my mind that we would have seen a very different 2015 had OPEC been acting as it had in the past. Now though, we are transitioning into a post-OPEC world. Not necessarily a world without OPEC, but rather a world where its role in setting the oil price is much reduced. If they were, however, to work out a collective way of cutting production and taking upwards of 6mbpd off the market between them on a net basis, clearly, this would be enough to swing the supply/demand balance into deficit and send the price to way above $60 quickly. Conversely, if OPEC were to disintegrate completely, the first (depressed) part of the oil price dynamic I see for the year would likely be sustained for a while longer.
Despite the holiday season (and against the better guidance from my wife) I will be around. So if you have comments and/or questions I would be more than happy to respond.
Finally, I would like to take this opportunity to wish the OilPro members and their families all the very best for this holiday season! Merry Christmas! Happy Hanukah! Happy New Year! Happy Festivus to those celebrating! And if you are celebrating a different holiday, I hope you have a great one too!