News

By Steve Smith, CA and Steve Ripplinger, CFA
Norrep Capital Management Ltd.

With oil prices currently hitting new post-2009 lows we wanted to provide some perspective.

The prevailing consensus view we see today is overwhelmingly negative with the vast majority predicting oil prices will be “lower for longer” with little hope for a recovery anytime soon. We think this type of thinking is too narrow. If there is one thing for certain, it is that the future is uncertain. The fatal flaw of many prognosticators is they only allow for one possible future and inevitably turn out to be wrong. It is human nature to seek out or form a singular vision of what will happen in the future because the alternative is to say “I don’t know” and uncertainty is frightening. In reality there is always a wide range of possible scenarios that could unfold. To make matters even more challenging, many possible outcomes are not fathomable by most people today (for example, even the most bearish forecaster in 2014 didn’t think oil prices could drop below $40). This is important to keep in mind when commentators argue the merits of their version of the future.

What is clear to us, at least right now, is that the distribution of current oil price predictions is far too concentrated around the scenario of oil prices staying low for a long period of time. The likelihood of a different or more “extreme” scenario materializing is far greater than most people think. One such scenario (one of many possible), is something happening that would cause oil prices to move materially higher. One only needs to scan the news headlines to be reminded just how many different scenarios could unfold in the future: Russia’s economic woes combined with its thirst for power and expansion, Saudi Arabia’s civil unrest and budget deficits, Venezuela’s economy and political turmoil, China, the war in Syria, Nigeria and Boko Haram, ISIS, etc. One should be prepared for all possible futures.

To illustrate how the future can differ from expectations, we looked back at one of the previous major oil downturns that occurred from 1997 to 1999. There are a number of parallels (and possibly lessons) that can be applied today. On March 4, 1999, TheEconomist published an infamous cover story with the headline “Drowning in Oil” and the lead story entitled The Next Shock?. At the time, oil was $13 per barrel after steadily declining over the previous two years when it was as high as $28 per barrel.

Reasons touted for the decline in oil prices in 1997-1999 include:

Weak demand from Asia
OPEC increased supply
Technology reducing cost of new production
Fear of a certain Middle East country increasing production
Sound familiar?

The Economist’s article is worth the read as it goes through the collapse in oil prices in 1997-1998 and outlines the popular view at the time. The author goes so far as to proclaim without reservation that “oil prices will remain low”and “we may be heading for $5”.

What actually happened in the year following this article? Oil prices tripled.

The similarities between 1999 and 2015 are striking. Much of what is happening today is not unique. This is not the first time oil price has fallen more than 60%. Nor is this the first time OPEC has tried to increase market share. There have been worries over growth in Asia before and technology has unlocked new supply constantly in oil and gas history.

So what happened in 1999 for oil prices to reverse course and triple within a year or so? Primarily:

Demand was stronger than expected as the Asian and US economies performed well.

OPEC cut production in March 1999 with Mexico, Norway, Russia, and Oman joining in on the agreement to reduce output. Of note: “Saudi Arabia was able to drop quietly an ineffectual market share/production level maintenance strategy without the appearance of abrogating principles” (IEA Oil Market Report; April 1999).

Below, we contrast 1999 with 2015 in more detail. However, note that comparing 2015 to 1999 is not to predict that current oil prices are going to triple over the next year. There are many different possible futures that could materialize and what happens post-2015 may be very different than post-1999. With that said, the comparison is certainly interesting.

1999 Vs. 2015:

Oil price direction:

1999:  Oil prices have declined over the last two years, with prices falling more than 60% from peak-trough.

2015:  Oil prices have declined over the last year and a half, with prices falling more than 60%.

1999:  Predictions that oil prices may fall even further. “We may be heading for $5. […] Last week Algeria's energy minister declared, with only slight exaggeration, that prices might conceivably tumble “to $2 or $3 a barrel.””(The Economist; Mar 4, 1999).

2015:  Predictions that oil prices may fall even further. “Banks such as Goldman Sachs predict [oil prices] could fall further to as low as $20 per barrel as the world produces more oil than it consumes and runs out of capacity to store the excess.” (Reuters; Dec 4, 2015).

1999:  Oil prices unlikely to recover. “After two OPEC-induced decades of expensive oil, oil producers and the oil industry as a whole have more or less given up hope that prices might rebound soon.” (The Economist; Mar 4, 1999).

2015:  Oil prices will be “lower for longer”. “Cheaper oil is here to stay, and energy companies need to adjust to that reality, British Petroleum's CEO said on Tuesday. "I do think the industry needs to prepare for lower for longer," […] For Dudley, prices could linger at these levels for "several years."” (CNBC; April 21, 2015). More recently: ““The lower-for-longer scenario that oil companies are predicting is going to become lower-for-even-longer,” said Philipp Chladek, a London-based oil sector analyst with Bloomberg Intelligence.” (Bloomberg; Dec 8, 2015).

Demand

1999:  Demand worries over economic troubles in Asia. “A more lasting [reason] is the economic troubles of Asia, the region that had been expected to drive oil-company profits for years to come. Even such sceptics as David O'Reilly, one of Chevron's bosses, who continues to pooh-pooh what he calls a temporary “price siege”, still worry that, because of Asia's crisis, demand might not rebound.” (The Economist; Mar 4, 1999).

2015:   Worries over China’s economic growth slowing. “Oil prices fell in Asian trading hours on Monday as analysts expected weaker demand from China in upcoming months. […] in Asia, the possibility of slowing demand in China dominated trade […] with growth faltering in the world’s second-largest economy.” (BusinessDay; Nov 2, 2015).

1999:  Warm winter (El Nino) impacting demand for petroleum products. “The warmer-than-normal winter weather in all of the northern hemisphere kept distillate and fuel oil prices under downward pressure in all major product markets, and gasoline lost some of its earlier strength in US and Asian markets.” (IEA Oil Market Report; March 1998).

2015:  Warm winter (El Nino) impacting demand for petroleum products. “As winter approaches, stocks of diesel - the heating fuel of choice for Europe and the US Northeast - are now brimming. […] But the current forecast is for a mild winter in Europe and the US. If it turns out to be true, bulging stock levels will add further pressure and oil market bears may choose not to hibernate.”(IEA Oil Market Report; Nov 2015).

1999:  Shift to renewables could impact demand. “There is another threat on the demand side: worries over global warming. Although the science remains inconclusive, rich countries agreed at the Kyoto summit in 1997 that it is worrying enough to warrant pre-emptive action. So they have agreed to binding targets to reduce their emissions of greenhouse gases. Whether or how countries will hit these targets is unclear. But demand for oil (though not for cleaner gas) in the rich world is likely to be one casualty.” (The Economist; Mar 4, 1999).

2015:  Shift to renewables could impact demand. Worries over “Climate Change” policies and the impact of global environmental initiatives to reduce reliance on fossil fuels. Paris Conference in December 2015 aims to do that.

Supply

1999:  Technology has reduced the cost of oil supply.“Rapid technological advances have pushed the cost of finding, developing and producing crude oil outside the Middle East down from over $25 a barrel (in today's prices) in the 1980s to around $10 now.” (The Economist; Mar 4, 1999).

2015:  Technology has reduced the cost of oil supply. Horizontal multifrac wells, etc., have unlocked new resource and allowed for increased supply especially in North America. Due to service cost reductions and increased efficiencies, the breakeven oil price for the top producers in North America has fallen from ~$80 down to ~$50.

1999:  Fear that Iraq will increase production.“OPEC members fear that Iraq, whose UN-constrained output rose by 1m barrels a day in 1998, may some day be able to raise production further.” (The Economist; Mar 4, 1999).

2015:  Fear that Iran will increase production when its sanctions are lifted in 2016. “OPEC has had its ups and downs over the years, but now appears to be falling apart completely, mainly because of Iran’s nuclear deal with the west. Iran expects to the West to lift sanctions that have prevented Iran from selling oil. As a result, Iran plans to come to market with a tsunami of oil next year, which may push the price of oil down into the 20s.” (Breitbart; Dec 8, 2015).

1999:  Fear that if oil prices rebound, new supply would come on stream and push prices back down.“Nor is there much chance of prices rebounding. If they started to, Venezuela, which breaks even at $7 a barrel, would expand production; at $10, the Gulf of Mexico would join in; at $11, the North Sea, and so on. This will limit any price increase in the unlikely event that OPEC rises from the dead.” (The Economist; Mar 4, 1999).

2015:  Fear that if oil prices rebound, shale oil production in the US will ramp up and push prices back down. ““Shale will be a new swing producer of sorts," said Yasser Elguindi of economic consultants Medley Global Advisors. "Because of its shorter investment cycle, […] when prices go up, they will also be the first to bring up production.”” (Reuters; Sep 23, 2015).

OPEC

1999:  OPEC is in disarray.“Meanwhile OPEC, which masterminded the supply cuts that pushed prices up in the 1970s and 1980s, is in complete disarray. […] The cartel is already moribund, and unless Saudi Arabia can bring it back from the dead, which is highly unlikely.” (The Economist; Mar 4, 1999).

2015:  OPEC is in disarray. “The 13-member Organization of the Petroleum Exporting Countries, which pumps about 40 percent of the world’s crude oil, took no action to shore up the market and observers said it appeared to be in disarray after meeting in Vienna.” (AFP; Dec 5, 2015).

1999:  “The latest oil-price shock has come at a sensitive time for the Saudi ruling family. Power is passing from the ailing monarch, King Fahd, to his brother, Abdullah. The autocratic family has had problems with dissent in radical Islamist quarters. Low oil prices crippled the Saudi economy in 1998: output shrank by nearly 2%, both the current-account and the budget deficits soared to nearly 10% of GDP and debt approached 100% of GDP. This year will be worse. The choice is simple. Either the Saudis must cut back their welfare state, by slashing benefits and raising taxes, or they must find a way of increasing oil revenues. But the ruling family's delicate domestic situation makes the first option difficult. So instead the Saudis may now do what once would have been unthinkable: throw open the taps.” (The Economist; Mar 4, 1999).

2015:  The latest oil-price shock has come at a sensitive time for the Saudi ruling family. King Abdullah died in 2015 with the crown passed along to King Salman, reportedly 80 years old and in poor health. There is reportedly dissention among the royal family with pressure for the King to step down. "Saudi Arabia […] will have a budget deficit of 20 percent of gross domestic product this year, the International Monetary Fund estimates. While the kingdom has been able to tap foreign currency reserves and curb spending to cope with the slump, financial assets may run out within five years if the government maintains current policies and prices stay low” (Bloomberg; Oct 20, 2015). In addition, Saudi Arabia faces issues such as the war in Yemen, civil unrest in certain areas, a one-product economy, and demographic/social challenges.

The opinions contained herein are those of the author as of the date hereof and are subject to change without notice and may not reflect those of Norrep Capital Management Ltd. Every effort has been made to ensure that the contents have been compiled or derived from sources believed to be reliable and contain information and opinions that are accurate and complete. However, neither the author nor Norrep Capital Management makes any representation or warranty, express or implied, in respect thereof, takes any responsibility for any errors or omissions which may be contained herein or accepts any liability whatsoever for any loss arising from any use of or reliance on this article or its contents. This article is not to be construed as an offer to sell or a solicitation for or an offer to buy any securities.