Friday, December 11, 2015

friday fretting - the downturn continues

One of the things I have found most peculiar throughout this downturn in the oil and gas industry was how long it took SLB executives to admit how extended this downturn would be. It was only in October during the Q3 earnings call, was it finally conceded that the downturn would stretch well into 2016.

I'm not saying 'I told you so', but for as long as OPEC has held their line about not cutting production, the fundamentals were not favorable to a turnaround in oil prices. And OPEC has definitely been holding the line. A week ago, one of the representative nation ministers admitted there was "no ceiling now" the group affirmed the position they've held for the past year that there would be no cuts at this time. This is a position they have held since at least November of last year and affirmed again over the summer. If anything, member production will trend higher as individual nations in tough financial situations will inch up their production in attempt to make up for the low prices.

Frankly, most of the OPEC members have gotten sloppy and undisciplined over the sustained high oil prices. We have lived in a generally long term oil boom since the early 2000's. The 2009 blip, while noteworthy, was not driven by sector fundamentals. Instead, it was driven by a lack of available credit and while the price of oil underwent a sharp decline during that time, it ultimately made just as sharp a recovery. Oil exporting nations (many of whom are in OPEC) have used these fat years to push various domestic programs and subsidies to their populations as a way for leadership to maintain power, but now many are struggling. Venezuela is the poster child for this and now the country is roiling as a result. But it's not just Venezuela. By some estimates, many OPEC nations need substantially higher oil prices in order to balance their budgets. Some of them, like Saudi Arabia, have large cash reserves to fall back on during this time, but most do not.

With OPEC refusing (or unable to internally agree) to cut production, US shale has become the swing producer. And the US market is highly responsive to market conditions. However, already sunk costs and financial obligations make it reasonable for many producers to keep producing even at lower prices. US production technically peaked in March of this year, but it has remained stubbornly high despite $40/bbl pricing levels. However, the spread in YoY production is shrinking and getting close to prior year levels. It is almost certain that US 2016-Q1 production will be lower than 2015-Q1 levels. In fact, that cross-over may occur for the current quarter, but the data is not yet available.

US production will finally drop in 2016 so prices will bounce right back and that's what SLB had been expecting all along, right? Maybe. I won't pretend to know what the C-suite is thinking (other than "transformation") but it's pretty clear activity is not going to bounce back in early 2016. Part of the supply/demand problem is that even with reduced US production, others will increase production, especially Iran which is eager to get back to pre-sanction production levels. On the demand side, the outlook is also murky. Part of this year's demand has been goosed by countries taking advantage of low prices to top off their strategic reserves. China has been a big participant in this trend. That's unlikely to continue much further so what happens when everyone's tanks are full and the ships have nowhere to go because there are no buyers?

If I knew the exact answer, I'd be making a killing on the futures markets. However, it does seem like the grim reality has fully set in for the oil and gas services sector. In discussions with friends of mine still in the game, it looks very grim. In SLB's case, going from 120K to 80-90K people is a tough process to be a part of and I wish my friends luck through this coming round of cuts.

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