Sunday Morning Note (Sept 13, 2015) …

As usual we start with this past week’s data.   Although nearer term oil prices (2015, 2016 and 2017) moved down slightly on the week reflecting continued concerns about the current supply overhang, longer term prices either held steady (largely the story for 2018) or, in fact, advanced (2020) as the market appeared to come to rest for the moment on the belief that the current oversupplied condition isn’t a permanent affliction and that, at some point, the market will start reflecting the long-run marginal cost of production.

Here is the chart reflecting the closing prices this past Friday (an explanation of the source of the data is here) :

Even the near term price drops compared with last week’s data (summarized here) were moderate.  Both October 2015 WTI and Brent dropped less than $1.50 (WTI: $46.05 v. $44.63; Brent: $49.61 v. $48.14), with the 2016 and 2017 drops largely narrowing to less than a dollar.  Both 2018 WTI and Brent stayed close to even, with Brent even trending up slightly (WTI: $56.89 v. $56.87; Brent $62.43 v. $62.47). And both 2020 WTI and Brent showed an uptick, albeit slight, with WTI crossing back over the $60 threshold and Brent continuing to move back toward $65 (WTI: $59.85 v. $60.06; Brent $64.71 v. $64.87).

This data largely reflects the prognosis outlined in the monthly analyses released this week by the federal Energy Information Administration (EIA) and the International Energy Agency (IEA).

In its September Short Term Energy Outlook, EIA said that near term prices continued to reflect “concerns about lower economic growth in emerging markets, expectations of higher oil exports from Iran, and continuing growth in global inventories. ”  For its part, IEA’s September Oil Market Report noted near term price levels remained depressed as the “supply overhang grew and concern deepened over the health of the global economy, especially in China.”

Both reports, however, noted that production levels are starting to drop, a sign that supply is beginning to respond to market signals.

In an extended discussion, IEA put it this way:

The big story this month is one of tightening supply, with the spotlight firmly fixed on non-OPEC. Oil’s price collapse is closing down high-cost production from Eagle Ford in Texas to Russia and the North Sea, which may result in the loss next year of half a million barrels a day – the biggest decline in 24 years. While oil’s recent volatility has been unnerving – Brent crude jolted from a six-year low below $43/bbl to above $50/bbl in the space of days – the lower price environment is forcing the market to behave as it should by shutting in output and coaxing demand.

The question remains, however, when the reduction in supply will bring the market back into balance, and as importantly, at what price that balance will be struck.  On the timing question, IEA offered this:

Our balances show the world only starting to siphon off record-high stocks in the second half of 2016. [Even] at that point Iran could be producing more oil, provided sanctions are lifted following implementation of the nuclear pact it secured with the P5+1 group.

and EIA this:  “Crude oil production is forecast to continue decreasing through mid-2016 before growth resumes [in response to demand] late in 2016.”  Those observations put the recovery of supply and demand balance toward the end of 2016, or possibly into 2017.

Neither monthly report offered price forecasts when the market begins to balance.  The current futures market appears to peg the price in the range of ~$60 at that point (Brent), with further recovery toward $65 by 2020.

Recent statements by producers and others, however, put the marginal cost of production — and thus, price, when supply/demand balance recovers — closer to $70.

In an especially insightful column (“Big Oil CEO: ‘A Few People Are Going To Drown’“), Forbes Christopher Helman explains why US shale oil is likely to act as the marginal source of supply once the current supply overhang dissipates and then quotes one oil executive as saying that, due to cost reductions, his company is now “able to generate the same free cash flow … at $75 oil and $3.75 natural gas, as they used to get from $90 oil and $4 natgas.”

Of course, whether prices in that range remain the marginal cost of production once the supply overhang dissipates is an open question.  Spurred by cost cutting induced by the current price regime, oil companies and their service providers are finding more and more ways to cut costs.   In an article yesterday on The Motley Fool website, three writers offer their observations on “3 Game-Changing, Cost-Saving Oil-Drilling Innovations That Are Keeping Shale Alive“.

Marginal cost is a function of just that — cost.  If producers and their suppliers continue to drive production costs lower during the current supply overhang, the marginal cost that emerges once the overhang dissipates may be different than anticipated now.  Put in terms some use these days about age, by that time “$60” may be the new “$70.”

In one other market event of this past week worth noting, CME group, one of the largest trading platforms in the world and whose prices we use in preparing our weekly analysis, announced that it is combining with Japan’s RIM Intelligence, a provider of energy price and information services, to develop an exchange trade-able Japanese liquefied natural gas (LNG) contract.

For reasons that I will explain in subsequent notes, such a market, if it works, could have the effect of facilitating a break in the long-term link between LNG and oil prices.   The introduction of the same sort of mechanism in US gas markets in the 1980’s and ’90’s ultimately facilitated a break in the link which had existed for some period between natural gas prices and No. 6 fuel oil.  While that development has tended to favor consumers (by reducing prices below the previous linked price levels), they have resulted in increased volatility and lower prices for producers.

Previous efforts to establish a traded market in Japanese LNG have proven unsuccessful and there is no guarantee that this effort will reverse that trend.  It is worth watching as CME’s effort comes together, however.  The exchange has a strong track record in the area, appears to view interest in such a trading vehicle as strong and its adoption inevitable. CME seems focused on being the first to deliver it to the market.

In other important events this past week, conflict is appearing to build between the state and other owners regarding the Alaska LNG project.  In an interview published during the week in trade publication Natural Gas Week, ExxonMobil Chairman Rex Tillerson said this about the current status of the project:

You can’t take a project that is going to take five, six, seven years to execute and require $50 billion to $60 billion of capital and decide every two years you’ve got a different way to do it …. We’ve had two good chances in the last 10 years to get [monetize Alaska gas], and as soon as you had an election that ended it. Alaska is their own worst enemy ….

Governor Walker responded in an interview with the Alaska Dispatch (“Tensions rise between Alaska, Exxon as governor heads to Japan to pitch natural gas“).

As we have made clear elsewhere from time to time on these pages, achieving a successful LNG project is a critical component of Alaska’s fiscal future.  Below is the support for a sustainable budget level of ~$4.5 bilion. Take the Alaska LNG project (the blue skin) away and the number becomes roughly $3.75 billion. Put another way, broad based taxes likely will be needed to backfill the blue space if the Alaska LNG project fails.

As Governor Walker is fond of saying, he — and others — have been pursuing an Alaska LNG project for 30 years, see  Walker: My 30-year history driving LNG projects vs. Parnell’s recent epiphany (Oct. 7, 2014).  But it is equally true he has been pursuing it without success for that entire time.

There is no successful precedent in the modern LNG industry for a fully government owned — or even a fully government and customer owned — project.  All successful projects have involved at least some producer participation.  The fact that Bill Walker now is Governor — instead of the project director of the Alaska Gasline Port Authority — does not make a significant difference in the outcome.  Successful LNG projects result from solid economics, driven by the alignment of those with financial interests in the outcome.

One can read — and some have — Tillerson’s use of the past tense (” … and that ended it”)  as drawing a line under the current effort.  I doubt that is the case.  But it is clear there is conflict.  Hopefully, involved legislators will help keep the effort on track.  There is nothing — not even resolving the state’s current fiscal crisis — more important to Alaska’s fiscal future.

This coming week will be focused mostly on fiscal issues.  In addition to my normal spot at 7:15am Tuesday mornings on KBYR’s The Michael Dukes Show also on Tuesday I will be appearing with organizer Cliff Groh on this week’s Alaska Public Media Talk of Alaska to discuss Saturday’s forum on Alaska’s Fiscal and Economic Future.  Finally on Saturday I will be participating in the forum as one of the four citizens presenting proposals.

The flyer for the forum and agenda follows: