Competitive drive will help whether oil slump
29 February 2016
The oil and gas industry is under sustained pressure. Prices have come down from $140 a barrel in 2008 to about $30 today. Company balance sheets have been hit and major oil-producing countries have had their credit ratings downgraded.
Just last week Standard & Poor's downgraded Saudi Arabia's credit rating two notches from A+ to A-.
Across the board, state-owned oil companies and multinationals are looking to cut costs by up to 30 per cent – shedding staff, sweating existing assets and slashing exploration expenditure.
Global expenditure in the oil and gas industry is down an average of 20 per cent in 2015 and 2016 and, for the first time on record, exploration expenditure has been cut in successive years.
This new period of low oil and gas prices and low expenditure is having a significant impact on Australia.
First is the impact on earnings. As the soon to be largest LNG exporter in the world, Australia is affected by the lower oil price as it is used as a benchmark for longer-term gas contracts. While the impact is somewhat offset by the lower Australian dollar, the $49 billion we are expected to earn annually from LNG exports from 2020 would be substantially greater if the oil prices recovered to previous highs.
Second, the reduction in exploration expenditure is affecting the pipeline of potential projects in Australia and the subsequent employment levels that were originally forecast for the industry. For example, the joint venture partners have delayed the final investment decision on the $40 billion Browse LNG project in Western Australia, citing the current price environment.
Third, lower oil prices are slowing the switch to renewables as companies and individuals are facing new cost-benefit equations that require greater subsidies to bridge the cost gap.
So why is oil and gas, an industry not unfamiliar to volatility, seeing such significant downward pressure on prices? The answer is a complex combination of supply and demand dynamics.
Every day the world consumes about 94 million barrels of oil. This is up from 84 million barrels just over a decade ago as population growth, rapid urbanisation and a burgeoning middle class has steadily increased demand. But what has changed more dramatically than demand is supply, with more than 96 million barrels a day now being produced.
In the past five years, more than 4.2 million barrels a day have come on stream from shale oil in the United States. Saudi Arabia, which produces on average 10 million barrels of oil a day, has lifted their production by 5 per cent in January alone. Iran, no longer the subject of sanctions, is producing nearly 3 million barrels a day with the expectation of lifting production by at least another million barrels a day.
The Iranians want no part of the Saudi-Russian plan to freeze supply, relishing, as they do, their first opportunity in many years to earn hard currency on global markets.
The Saudis, on the other hand, have other motivations for their initial ramp-up in production. Engaged in an increasingly tense stand-off with the Iranians, it is speculated by many here in Houston that Riyadh is seeking to grab market share at the expense of the leadership in Tehran.
At the same time, increased Saudi production is putting pressure on shale oil producers in the United States who face a break-even cost well above $30 a barrel. As a result, many shale producers are being forced out of business by the consistently low prices, leaving them to hand back their rigs and dismantle their crews.
The banks are also getting anxious, with more than $300 billion of outstanding loans to the shale sector. Many covenants have been broken as banks call in their loans and try to recover what is left of their loan book.
These pressures have, since mid-2015, seen a 60 per cent reduction in the rig count in the United States and a 400,000 barrel reduction in the amount of shale oil produced every day. Numbers that are likely to accelerate as prices stay lower for longer.
While most observers believe the Saudis will not succeed in driving shale producers out of the market completely, it will not be for want of trying.
So where do we go from here? The likelihood is that for energy producing countries, in the immediate term, the pain will continue. Barring a seismic geopolitical event that takes out one of the major producers, supply will continue to outstrip demand, keeping a lid on prices.
This ongoing dynamic emphasises the need for a country such as Australia to focus on what we can control – decreasing the cost of doing business as a means of boosting our nation's competitiveness. Streamlined regulatory processes, greater labour market flexibility and productivity-enhancing infrastructure projects are key. Encouraging innovation, automation and big data analytics, as well as de-risking exploration through the provision of government-generated geological mapping are also important.
In the end, the market will find its equilibrium. Higher-cost producers will be squeezed out, demographic trends will continue to enhance demand and exploration expenditure will recover in response. Australia, as a reliable and innovative energy supplier, will remain resilient in the face of these challenges and a world energy leader for decades to come.
Josh Frydenberg is the Minister for Resources, Energy and Northern Australia and is leading an Australian delegation to energy industry conference CERAWeek in Houston. The article was published in the Australian Financial Review.