EY: Oil price outlook - reset or recycle?

By Susan Grissom, Senior Strategic Oil & Gas Analyst, EY

It seems the oil and gas industry has always been characterised by booms and busts. By its very nature, it offers a wild ride – the adrenaline rush of exploring, conquering challenges, mastering the elements whether it’s in the middle of a remote desert, miles below the ocean surface or on the vast tundra of Siberia – it can be an inhospitable and complex environment.

Yet, despite all of its challenges – physical, operational, technical – the potential payoffs attract the adventurous souls willing to face physical challenges and take financial risks. The temptation of the boom allows the memory of the bust to fade. At least that is the way it’s been. But is this the same old cycle?

Since the beginning, the oil market has been “actively managed”, whether by Standard Oil, the original seven oil companies, the so-called seven sisters that dominated the industry for much of the middle part of the twentieth century, or by governments and national oil companies (NOCs), hands behind the scenes stabilising the price of oil.

The question today – is that picture changing?

After plummeting below US$30/bbl earlier this year, oil prices moved higher in February on news of unplanned supply disruptions in Iraq, UAE and Nigeria, declining US production, (now just below 9 million barrels per day vs. almost 9.6 million barrels per day last July), and low US oil rig counts; now the lowest since 2009.

In March, prices retreated on news that Iraq had increased crude output to record levels. In early April, unexpected stock draws and declining US production – and the hopes of an agreement among OPEC and some non-OPEC producers to cap production – caused prices to rally. As trading in April came to a close, crude oil futures prices hit a new 2016 high, buoyed by news that the US Federal Reserve would not raise interest rates.

Brent crude oil prices rose by almost 20% at one point in April. Needless to say, prices continue to be very volatile. The CBOE Oil Volatility Index – the Oil VIX – remains persistently elevated relative to historical levels, although it has come down since late 2015.

The most recent hope for price support was the April meeting in Doha at which OPEC and some non-OPEC producers gathered to consider a production cap. For a time, it appeared that a white horse in the guise of an agreement to freeze production at January 2016 levels would stabilise prices.

However, with Iraq unwilling to participate, no agreement was reached, and production continues to outstrip demand. Ironically, the strike of oil and gas workers in Kuwait slashed the nation’s output and caused prices to rise. And although the strike has been settled, prices remain strong.

While higher prices make it tempting to hold that the “bottom is in,” the reality is that crude oil prices will continue to move in a range, a much lower range, reacting to ongoing market conditions, including real supply and demand balances, expectations for demand and geopolitical tensions.

Some peg the range at US$30 to US$50, others from US$40 to US$60. The range is a function of how much production leaves the market and the price at which production jumps back in. Perhaps time and the June OPEC meeting will yield a clear direction. It the interim, we wait and watch.

Until the supply-demand balance shifts, either because sufficient supply has been removed from market, and/or because demand increases to absorb the supply overhang, this scenario will continue – this is the new normal.

Most industry watchers expect supply and demand to become more balanced sometime in 2017, earlier in the year if sufficient production is forced out of the market because of lower prices or if production is “managed”; later in the year if production is resilient and there is no action to cap or reduce it.

In the longer term – post-2020 to 2040, oil remains an essential part of the energy mix and is key to meeting global energy demand – absent some disruptive event, innovation or way of thinking or living that greatly reduces or eliminates demand for fossil fuels. While renewables and natural gas are becoming a more significant part of the energy mix for power and utilities, absorbing some percentage of demand growth, petroleum products continue to dominate transportation fuels.

To capitalise on the long-term opportunities, companies must change their approach.

In the past, as the price of oil dropped, companies reduced headcount, capital expenditure and put pressure on costs across the supply chain. "Cut, shift and hold on until the next upswing” is not a viable plan this time around.

This new environment doesn’t just call for adjustments, it calls for fundamental changes. Where yesterday’s stakeholders demanded growth, today’s stakeholders have turned their focus to capital efficiency that will deliver returns regardless of market conditions. The metrics of success have changed and stakeholders are demanding a major overhaul of the industry. The same old tactics aren’t enough.

Companies must consider ways to reinvent themselves. Simply tinkering with the supply chain will not do; it’s time to move beyond adjustments and even consolidations and (re)discover the potential of vertical integration. The rise of digital also offers opportunities for transformation. We’ve barely scratched the surface of the transformative power that digital technology offers to improve operations across the industry.

Nor have we truly leveraged the power of big data and analytics. The industry has access to an overwhelming amount of data and could put that data to work more effectively. Now is the time to harness that information to power better and faster business decisions.

The game has changed and those who resist the new reality won’t survive. Transformation is key.

This publication contains information in summary form and is therefore intended for general guidance only. It is not intended to be a substitute for detailed research or the exercise of professional judgment. Member firms of the global EY organisation cannot accept responsibility for loss to any person relying on this article.