Dead Cat Bounce in Nigerian Oil Market?


Friday, July 24, 2015 10:04 AM / ARM Research

We shift focus to the commodity section of our core strategy document – the Nigeria Strategy Report. Today’s piece reviews developments in the global crude oil market over H1 15 as well as delineate our expectations for the second half of the year.

Commodity Stability: inevitable reprieve or awaiting the next wave?

Considering the depths plumbed by commodity prices in H2 14, it only appears logical that the markets pause for breath sometime after. Whilst the recurrent theme of early signs of recovery suggests a floor is being found, demand supply dynamics remain broadly bearish for prices and indicate downside risks may not be fully washed away.

Surging Iranian production sends OPEC production higher

OPEC supplies rose 1.1% from H2 14 to 37.41mbpd in H1 15. The increase was primarily driven by higher output from Iran and Saudi Arabia.  Iran benefited from lessened sanctions and saw its output hit a three year high of 2.88mbdp in April, even as Saudi Arabia maintained production levels above 10mbpd after a high of 10.3mbpd in March.  Similarly, in Libya, production levels held steady despite tensions in the country, touching a high of 600kbpd mid H1 15.  These increases offset production pressures from other OPEC nations such as Angola, allowing aggregate OPEC output to push above the 30mbpd benchmark in H1 15.

As non-OPEC output shrugs off declines in parts of North America

Non-OPEC production rose 0.35% to 57.9mbpd in H1 15 (H2 14: 57.7mbpd) as higher output in the US, Russia and China—more than offset declines elsewhere. Interestingly, despite increased idling of oil rigs in response to depressed oil prices, US output—still driven by light tight oil—hit a 40 year high of 9.6bpd in H1 15 as producers focused on the cheapest (and highest) yielding shale formations. In addition, with a large share of shale output hedged at elevated oil prices, producers were better able to weather the low oil prices, even as industry breakevens trended lower. In Russia, output broke previous threshold levels to reach 11mbpd and China continued to increase production following the oil spill at its Penglai field in 2011.  Meanwhile, high breakevens on tar sands played a part in moderating production in Canada while an explosion at the Pemex’s Abkatun Permanente platform in the Gulf of Mexico on April 1 weighed on Mexican output.  Overall, total crude oil supply remained relatively flat (+0.6%) at 95.31mbpd relative to H2 14 and increased 2.93% YoY.

Demand slows relative to H2 14 but improves YoY

Global demand in H1 15 shrank 0.64% from H2 14 to 92.85mbpd, but increased 1.33% YoY, with lower oil prices positively impacting car sales in Europe and US.  With lower transportation costs, Europe’s oil demand growth hit a twenty year peak of 3.9% YoY in Q1 15 and in the US, auto sales hit a 13 year high at 17.79 million with pickup trucks and SUVs making up a majority of the gains.  Asian regions mainly followed the path led by Europe and US, with India’s demand for crude oil peaking at 4.2mbpd, benefiting from a combination of strong economic growth and lower oil prices.  Meanwhile, China’s demand rose as the government increased offshore and onshore reserves and was further bolstered by increase in diesel oil for infrastructure projects.  In contrast, demand in Japan decreased as the country moved away from dependency on fuel and crude oil to alternatives such as natural gas, whereas in Mexico, oil demand fell due to the decreased use of fuel oil in the power sector.  Nonetheless, the increase in demand on a global front was not enough to narrow the excess supply which increased 97% from H2 14 to 2.46mbpd (H1 14: 0.95mbpd).  

Despite the persisting oversupply, oil prices inched higher in H1 15 after bottoming at $53.52 in January, for Brent Crude. In many ways, the recovery reflected a bet that oil would rebound from the sharp fall in H2 14 with money managers, in particular, maintaining their bullish outlook on rising oil prices by increasing their net long positions by 39% from H2 14 to 222,357 lots as at May 2015. The steady spread between Brent Crude and WTI Crude over H1 15, at an average of $6.37, suggests the positive sentiment was broad-based and non-sensitive to the supply vagaries in diverse regions.  In contrast, the premium typically enjoyed by Nigerian Bonny light over Brent crude collapsed to become a $0.06 discount in H1 15 (H2 14: +$0.46) with implications for domestic revenues.

Compliant Iran and new shale dynamics could boost supply further
Going into H2 15, OPEC is likely to boost crude oil production in a bid to maintain its market share even as the date set to resolve the issue on Iranian sanctions approaches[2].  As Iran waits on the decision, it currently has 30mb of crude on tankers[3], waiting to be shipped should the sanction be lifted.  Evidently, the recent 3-year high could easily be surpassed and we expect production to increase by 1mbpd over the next 8 to 12 months.  Similar expectations are attached to US crude oil production, given the prolonged cutback in rig counts did not appear to interfere with further production rises. However, this partly reflected the usual lag (~23 weeks) between when rig counts fall and the impact on crude oil production materializes, similar to the pattern in 2008 when production levels initially rose slightly before tempering.

Nonetheless, as oil rig counts broke their 29 week decline in July, factors other than the lag suggest recent production gains might not be so fleeting. First and foremost, while the widely accepted ~$80/bbl breakeven for shale oil had been central to expectations that shale production will wilt after the crash, more recent indications are that shale production is sustainable at as low as $60/bbl. The lower breakeven prices stemmed from technological advancements by shale producers as they moved away from less efficient to more efficient oil wells and rigs, implying more is being done with less. In addition, producers reduced labor costs, allowing some key players to slowly return to the market. This is not to say that the impact of oil price crash has not materialized at all; however in-the-money hedges supported cash flows and provided operations lifelines.

Nonetheless, with high debt levels, little chance of recreating similarly profitable hedges and likely financing challenges for smaller fields imply that the reprieve might be temporary, as five shale companies declared bankruptcy in this same period of overall improvement in production. Hence, the key takeaway is that aggregate prognosis for shale producers appear better than initially feared with a couple of other factors boosting the central support from lower breakevens. In all, whilst lagged rig count impact means production will likely fall by Q4 15 in the US, it will likely regain traction in H2 16 as shale producers adapt to the low priced oil environment, with breakevens expected to fall further as a result of technological improvements.  Whilst OPEC and, in particular, Saudi Arabia’s strategy might impair the least efficient producers, in conjunction with likely on-streaming of Iranian output we envisage aggregate supply will remain elevated going forward.

Even as demand hotspots cool off
Despite revisions to its projected growth, China overtook the US as the world’s largest oil importer in May 2015 as it continued to build reserves during H1 15.  Whilst we expect demand to increase in China, we believe the rate of increase will slow, due to the difficulties the country faces as it changes the structure of its economy to be more consumption driven vs. investment driven.  Similarly in Europe, the tensions in Greece following its default on its IMF loan could result in a ripple effect across the continent’s economy, thereby weighing negatively on demand.  However, like China we only expect the rate of increase in demand to slow the extension of low oil prices and the peak driving season in the summer months providing support.  In India, which recently passed Japan as the third largest oil importer in the world[5] even as it also surpassed China as the world’s fastest growing economy, the uptrend in economic growth is expected to continue into H2 15.  This positive growth would support demand as the country continues investments in infrastructure and refineries. 

Competition for market share will extend excess supply into H2 15

The competition for market share in H2 15 could widen the excess supply gap as OPEC pushes crude production levels higher and shale producers become more efficient in extracting their product. Whilst the potential boost to supply from shale could be short-lived, based on reports that indicate conventional oil fields depreciates by 2%-5% (life can average 100 years) following the first year of production, compared with shale fields could depreciate up to 70% YoY (life can average 3-30 years).  The development of new fracking methods which essentially extend the well life means this is another layer of the fabric expected to smother shale output fraying away. At the very least, shale supply boost should continue into H1 17 and possibly beyond if mergers & acquisitions come back on the table.

Earlier M&A expectations largely failed to pan out because most companies were valued using oil prices above $90/bbl based on the higher oil prices. With the expected regime of prolonged depression in oil prices, it is logical to expect valuations to compress in tandem, allowing M&A plans to resume possibly as early as H1 16. This should in turn fuel the competition for market share, drive the exploitation of scale and ultimately keep oil supply flowing.  The weather forecast adds to the gloom. In H1 15, in addition to higher car sales, increased demand was aided by the longer and colder-than-expected winter season.  Given the shorter winter season in H2 15 relative to H1 15, demand could be even weaker and further weigh negatively on prices.  Accordingly, we expect oil prices to resume declines in H2 15 possibly back to the January lows of $40-$45/bbl.

Related News from ARM’s Nigeria Strategy Report

1.       FPI flows yet to find clear pattern

2.      Softer Commodity prices aggravate Africa's slowing growth...

3.      Stalling US momentum leaves global growth stuck on the runway – July 21, 2015


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