Is there any light at the end of the tunnel for oil producers? It's now two years since prices began plunging in late 2014.
There was some hope that the Organisation of Petroleum Exporting Countries (OPEC) would get together and cap production, but they've been talking about it for two years and not much has changed. Even though the US rig count has halved, OPEC has maintained its production, while Russia ramped up its output to take advantage of its hugely devalued Ruble. Now Iran is looking to return to the oil market for the first time in decades as sanctions against it are lifted.
Shares of companies like Woodside Petroleum Limited (ASX: WPL), Oil Search Limited (ASX: OSH) and Santos Ltd (ASX: STO) have been correspondingly hammered, but as yet it seems few producers have gone out of business globally. Indeed both global production and consumption of oil have grown steadily in recent years.
According to figures from the US Energy Information Administration (EIA), global supply and demand are actually pretty closely matched, yet prices remain depressed. After two years, it now appears that the likely way prices will recover is the hard way:
- Production declines
Bankruptcies won't necessarily decrease oil output, as productive assets will be bought up by other companies. Field decline is a real thing though, as many oil producers are using their most productive fields now in order to maximise their cash generation to pay down debt and maintain profitability. That'll come home to roost, because…
- Capex is low
Oil producers have cut their capital expenditure ('capex') to the bone, meaning they're not doing much exploring or drilling. This saves money now, but could go so far as to lead to a gas shortage in 5-10 years, because new wells are not being discovered or exploited.
- Increasing demand
Demand for oil has been rising at around 1% per year for the past few years. Too small to be relied on as a primary cause for a re-rating of price, it'll nevertheless play an important part in repricing oil, especially if production growth starts to slow.
Foolish takeaway
It's very easy to see how commodities are a cyclical business when you see the relationship between capital expenditure and commodity prices. Higher prices lead to more capital expenditure and thus more production, which perversely leads to oversupply, lower prices, lower capital expenditure, and lower production.
As early investors in the market have discovered to their chagrin, re-rating prices in this manner can take a lot longer than anyone expects. There are some promising signs, but I said that a year ago too.
