Prepared in July 2015
While current macroeconomic figures have a bearing on short-term decisions regarding production and the financial performance of companies in the oil sector, investment decisions and strategies are structured primarily around long-term predictions, whose horizon is noticeably longer than the average investment cycle in the sector and often encompasses long-term demand and supply conditions, where the price of oil fluctuates around (marginal) production costs (the most expensive 3-4 million barrels of oil a day).
Long-term forecasts, showing how a company perceives the future of the environment in which its strategy will be tested, are therefore of key importance to understanding and evaluating development strategies in the oil sector. Crucially, rather than foresee the future, which is always uncertain, such forecasts are meant to illustrate the links (how the elements are connected and what they affect) between various factors which shape the company’s environment. Thanks to such correlations, the factors do not change independently and tend to follow specific scenarios over time. If we properly recognise the processes shaping the environment and the key factors responsible for its changes, we will be able to review a wide variety of alternative scenarios and concentrate only on those which are important to the company’s strategy. The aim is to make the best use possible of emerging challenges while maintaining safe exposure to risk.
Business strategies and future drivers
Among the oil industry’s drivers there are unpredictable factors (new, game-changing technologies, conflicts, disasters, and other ‘shock’ events), which provoke long-term adjustment processes when materialised. While the shocks themselves cannot be anticipated, especially the time of their occurrence and scale, we know quite a bit about the oil industry’s and the economy’s reactions to past shocks, which consisted in adjustments to lasting changes in the price of crude oil and refining products, involving both demand and supply. The knowledge of how the immediate environment of oil companies works is in fact an understanding of how they, as a whole, adapt to lasting changes in the price of oil, its products, the US dollar exchange rate movements, and costs. With this kind of knowledge, we can predict how companies will react to price changes in the future, or in other words – how the environment in which we operate will change.
For instance, a steep decline in crude oil prices makes all companies involved in the upstream business review their investment projects. If the price slump is caused by excessive production potential, as is the current situation, low prices can be reasonably expected to last for a relatively long time, which should compel companies to scale down their investments in production. It can therefore be expected that the surplus potential will disappear over time, driving prices up. However, companies involved in already advanced investment projects can be reluctant to quit given the costs incurred and expectations that the prices will increase in the future. Such decisions are easier to make at the beginning of the investment cycle, when abandoning a project is the least expensive. A company launching a new upstream project may be unwilling to back down, concluding that the price of oil can rise again before the project is complete. In effect, it may well turn out that despite the price decline caused by surplus production capacities, the upstream sector will not reduce the planned increase in production potential on the expected scale and the price of oil will remain unchanged for a long period of time. Such a scenario is just as probable as the base one, which assumes that upstream companies would scale down their investment projects in anticipation of lower prices, thus driving the prices up in the near future. The process, known for many years, whereby oil supply adjusts to market demand, was complicated by the appearance of North American operators producing from unconventional deposits, whose adjustment process is much shorter than standard (about 90 days rather than several years).
Companies create their own strategies to plan how they are going to use their growth opportunities and increase their resistance to various threats, and such strategies transpire in the expected scenario of external developments. Whether such a strategy is original depends largely on subjective expectations on whether certain unforeseeable events occur which may drastically change the course of the relevant scenario and, among other things, increase the company’s exposure to risk. To refer to the previous example, it is possible that amid the currently ambiguous price signals the strategic plan of the majority of upstream companies is to ‘wait and see how other companies adapt’.
To evaluate the oil sector’s growth prospects in a 5–10 years’ time, we should first diagnose what stood behind the decline in crude oil prices in the second half of 2014 and behind the high sensitivity of prices to change despite there being no visible upward trend, and then progress to discuss alternative future pricing scenarios.
From a long-term perspective, the oil price slumps seen since mid-2014 mark the last stage of the oil supercycle, which IHS believes to have begun in 2000 with a demand boom and supply bottlenecks. The first stage of the supercycle came to an end in 2007, gradually progressing into the second phase (ended in 2011), which was about breaking the supply barrier. At that time, the price of oil grew rapidly – from USD 55/bbl in 2005 to over USD 111/bbl in 2011. While oil prices grew amid fears that the fast-growing demand would outstrip supply, the brisk pace of this growth opened the way for new and expensive deepwater drilling, horizontal drilling and fracturing technologies. The oil rush also inspired exploration efforts in geopolitically unstable areas, such as Central Africa. As a result, 2012–2014 saw an upsurge in oil and natural gas production from new sources outside OPEC, which marked the third phase of the cycle. The 10 years of uninterrupted price growth – from USD 38/bbl in 2004 to USD 109/bbl in the first half of 2014 (over USD 5 a year) – resulted in substantial and lasting reductions in demand in developed economies. Oil prices remained high throughout that stage of the cycle, reaching USD 112/bbl in 2012 and USD 109/bbl in 2013, and were further cemented in the first half of 2014 on the back of geopolitical developments and production slumps in North Africa and Middle East. The third stage of the supercycle took place at a time when the global economy oscillated between stagnation and weak recovery, and oil demand was additionally undermined by China’s protracted business cycle. In these conditions, the second half of 2014 saw a marked decline in crude oil prices, which ushered in the fourth phase of the cycle, bringing still lower prices as the oversupply of oil was being absorbed by the market and the search for (the cost of) the marginal barrel continued.
The price decline will erode production potential, which will have to be adjusted to the new pricing conditions. The adjustment process will not be a smooth transition for several reasons:
Combined with a super-short investment cycle (90 days), the considerable increase in shale oil production potential in the US has removed OPEC from its position as a monopolist able to affect prices through decisions about production volumes and reserves. When the price of crude oil fell too low, the cartel used this ability to communicate to the markets the price level it was prepared to defend. Anchored price expectations facilitated taking positions on financial oil markets and had a stabilising effect on crude oil prices.
On November 25th 2014, however, the mechanism shaping crude oil prices changed. Acting to defend its market share, OPEC resolved to shift its position to that of a price taker, taking the anchor for crude oil prices away from the markets (contrary to their previous strategy, OPEC countries, Saudi Arabia in particular, did not limit their production despite declining prices, in fact increasing it; on May 19th 2015, Saudi Arabia’s production was the highest in 11 years). The market is currently striving to find a new equilibrium price. For now, we only know that the price is situated significantly below the abandoned anchor and is supported by the cost of producing the marginal barrel (the most expensive barrel for which there is demand). Searching for an equilibrium price following loss of the anchor provided by OPEC will make the price of crude oil more prone to change.
Adjustments have to take place on the physical market, which, given its long investment cycle (except in shale oil projects in the US), responds slowly to price signals, especially in a situation in which no relatively stable trends are visible and the oil market has lost the compass that OPEC’s strategy was and is now groping in the dark.
Although the search for the marginal barrel has begun on the American market, adjustments limited to that market will not be enough. The wide spectrum of production costs seems to suggest that the marginal barrel (indicating the equilibrium price) may be found outside of the US.
The information necessary to locate the marginal barrel is provided by the price signals from the oil market, which have progressed from the physical market (OPEC) to the much more volatile paper market (NYMEX).
Due to the appreciation of the US dollar, which is currently caused by factors not related directly to the oil market (improving condition of the US economy, expected increase in interest rates, and the accommodative monetary policy pursued by the ECB and other central banks), the price signals reach non-US producers markedly weakened (oil price decline is stronger in the US dollar than in other currencies).
The increase in the importance of financial oil markets is associated with the growing share of positions which are purely speculative rather than connected with transactions on the physical market. Such positions are taken in respect of anticipated price shifts and their only purpose is to secure financial gains. Players on the money market react sharply to any new information, share a herd mentality and tend to overreact. Characteristically, trends on the money market are derived from short-term processes, which are highly susceptible to change.
As regards the crude oil market, now deprived of the price anchor, we can expect prices to become more prone to change and to fluctuate ever more widely. Since price signals coming from the oil market are not only uncertain, but also weakened as a result of the appreciating US dollar, it is almost certain that the necessary adjustments on the physical oil market will require a longer time span.
It is uncertain how long the fourth phase of the cycle will last before oil prices rise again. Taking into account the oil market’s structure (paper and capital market transactions are prevalent in the US) and technological considerations (production sector reacts quickly to changes in price expectations), experts estimate that it may last for one to three years. However, looking at past events, we will remember that the price decline and the subsequent stagnation of prices at low levels which followed the second oil shock in the wake of the Iranian revolution persisted for nearly two decades.
PKN ORLEN’s expectations
PKN ORLEN expects that in the coming five years the price of oil will fluctuate around a low, but slowly growing, trajectory, while remaining highly volatile. In 2014 and 2016, the oil market will see further oversupply. We anticipate drops to below USD 45 per barrel, as well as rises, but with no clear-cut trend. An upward trend is expected as of 2017, once the excess supply has been absorbed. However, price growth will be decelerated by declining costs of exploration and production operations on the US market, following a downward revision of production potential and slump in demand for exploration and drilling work.
A slight downward revision of crude oil prices is possible after 2020 as a result of the slower pace of adjustment on the physical market in 2016 and 2017 and prolonged oversupply. During adjustment periods, such as the one we are currently going through, price expectations are not unlike self-defeating prophecies. The greater the expected strength and duration of the price slump anticipated by the market, the quicker and stronger the future supply reductions will be (more and more production projects become unprofitable, financing becomes difficult to obtain). As a result, future supply shrinks even more, driving future prices up. Oil prices are likely to remain below USD 80 per barrel for up to two years, but then will start to increase on the back of higher exploration and production costs. Growing oil demand will push the marginal barrel up the cost curve.
We take into account two alternative scenarios reflecting the possible scale of CAPEX reduction in 2015–2020. In the low-price scenario, the price of oil will fluctuate between USD 20 and USD 50 per barrel for a longer time than under the base case one. It will not stay below USD 20 per barrel for too long, this being the lowest known marginal cost of oil production in Saudi Arabia. An increase beyond USD 50 per barrel, on the other hand, would stimulate production in the US, potentially driving prices down. The accelerated adjustment scenario predicts that crude will likely cost USD 80 per barrel in five years, which is the price indicated by current futures contracts, and the slow upward climb will begin soon. As a result, oil prices will be higher at the end of 2015 than at its beginning, and the upward trend will continue in subsequent years. Indeed, the two forecasts are not contradictory and fit well within our understanding of the oil market reality.
The European refining industry is under structural pressure created by weak demand coupled with high taxes and costly regulations. The demand for refining products contracted by 2% last year and is expected to continue declining (according to the IEA). Factors contributing to the pressure also include competition from newer, more technologically advanced exports-oriented refineries in the Middle and Far East and from US refineries, which have the advantage of cheaper oil and lower energy costs. The pressure creates a low-margin environment compared with the operating conditions enjoyed by refineries in the US and Middle and Far East. Lifting the ban on oil exports in the US, expected in 2016, will result in a narrower BRENT/WTI differential and enhance the competitive position of European refineries against American ones. This will not be a significant improvement, however. Despite many refineries being shut down, surplus production capacities in Europe relative to fuel demand are estimated at above 10%. Also, the refineries are operating at less than full capacity, which additionally drives up the costs and constrains profitability. Although the unexpected rapid decline in crude oil prices has strengthened refining margins, allowing refineries to get a second wind, it has not solved the problem caused by excessive production capacities and by the demand and competitive pressure from outside Europe. The improvement in margins seen since mid-2014 is driven by declining oil prices. However, this downward trend has likely come to an end, and the potential for higher margins has thus been exhausted. Absorbing the oversupply of oil entails its processing into refining products, which is currently happening at an accelerated pace due to favourable margins. As the increase in margins and processing rates is not backed by higher demand, the market will see an increase in the stocks of refining products, which will in turn put pressure on their prices. In effect, refining margins will be reduced.
PKN ORLEN expects that margins will remain high for several quarters. According to the low price scenario, high (and volatile) margins will prevail for a longer time than in the accelerated adjustment scenario. They will then decline, but will not reach the low levels seen in late 2013 and early 2014, when the margins were under additional pressure from fear premium, driving up the price of oil.
Effect on the strategy
The PKN ORLEN strategy has been prepared on the assumption that the European refining industry’s difficult structural situation will not improve materially, which is why we have decided to extend the value chain on both ends. The expected low oil prices and decline in valuations of upstream companies support a strategy of growth through acquisitions, while the acquired assets safeguard us against the consequences of rising crude oil prices and their negative effect on downstream margins. Investments in gas-fired power generation and co-generation may help ensure energy demand and diminish the impact of oil prices on the Downstream segment’s performance.