10 December 2015, Stockholm, Sweden | News
Saudi Arabia's strategy to eliminate other oil producers has been highly successful, and will continue. However, the price of oil going forward will be governed by the progress of sanctions against Iran. There is a clear risk of further declines for iron ore and copper, according to Handelsbanken's commodity analyst Martin Jansson.
The strategy of Saudi Arabia and OPEC is quite simple, according to Martin Jansson. Instead of reducing their domestic output, they are increasing it to ensure an even greater surplus of oil in the market. There are two objectives to this: to limit the expansion of shale oil production in the United States, and to reduce investment in new production outside OPEC.
Reduced shale production in the US has a fairly immediate impact on the market, while reducing the incentive to invest in new production is a rather long-term way to increase their own market share.
"One year after the strategy was launched, we can see that it is working very well indeed – I disagree with those who claim that OPEC is losing its foothold. It might appear this way when oil is down 57 percent in one year, but shale production has decreased by half a million barrels a day, in absolute terms, from its peak," says Martin Jansson in a conference call with Catella Fonder.
The second objective of the strategy, to reduce the incentive to invest, has also succeeded. For the 16 largest oil and gas companies in the world, investment this year will decrease by somewhere between 20 and 30 percent, and is expected to decrease even further in 2016. This will be the first time in 30 years that investment in global oil and gas fields has decreased for two years in a row.
Oil-producing countries other than the US are less able to quickly adjust production.
"Russia has said that it is not as able as OPEC members to control its output: you cannot simply turn production on and off, and its lead times are much longer. If you switch off an oil pump in Siberia, it cannot be restarted at 30 degrees below zero. In addition, the prospects of managing to raise prices are challenging in the long term in a market with a new production source in the form of shale production. Whatever you remove will simply be taken up by a competitor who enters to take market share. So I do not believe that Russia is interested in cooperation with OPEC in this case," says Martin Jansson.
American producers of shale oil have been called the new 'swing' producers, able to easily increase or decrease their output. Unlike in OPEC countries, oil reserves in the US are not nationalised, which reduces the ability to control them on the basis of national interests.
"It is ultimately only about the profitability of the individual shale producer, and the production apparatus is more efficient than for conventional fields. The investment cycle is shorter, which means that when there are short-term price changes, like in April/May, interest immediately grows and a number of rigs are brought back into production. Similarly, rigs were removed from the fields in June. This has proven to be effective in both directions," says Martin Jansson.
A new factor in the oil game is Iran. The country is expected to eventually be released from sanctions by the West, and could start delivering oil shortly. Iran's importance to the price of oil is difficult to overestimate, according to Martin Jansson, especially since developments are difficult to predict.
The country has reached an agreement that will allow the lifting of sanctions which, according to political experts, may happen at the end of the first quarter of next year. The next question is what production volumes the country can deliver.
"It has been very aggressive and has said that within five to six months it can produce a full million barrels per day. This is as much as OPEC has managed to eliminate from the shale fields this year. If Iran has the full capacity it claims, then it will remove the entire effect the low price has had on shale production," says Martin Jansson.
But in the Middle East, it is not only Iran that wants to recover lost share. Iraq also has a long-term plan to restore the country's oil production, which stopped after the US invasion in 2003. So far it has been successful.
Oil prices have for some time been trading within a fairly limited range of between USD 45 and USD 50 per barrel for Brent crude. According to Martin Jansson, the trend in 2016 depends largely in what happens with Iran's production.
"Iran could affect oil either ten dollars up or ten dollars down. But I want to wait and see how it goes first, if sanctions are lifted in the first quarter and that Iranian oil starts to come onto the market in the second quarter. What has been clearly demonstrated this year is that any oil rally lasting more than two months is strangled by shale producers increasing production again. I am more comfortable with thinking that we will not see any oil rallies of more than 10-15 dollars, and that last for more than three months," says Martin Jansson.
Companies in the oil service sector have, entirely logically, had a tough time lately. A comparison with the mining industry shows that the oil industry is about three years behind in the cycle, according to Martin Jansson. Mining industry costs have been cut over three years, while production has been maintained or even increased. This demonstrates the magnitude of the costs that both commodities industries have incurred during the many preceding favourable years, when subcontractors to the oil industry have in many cases had 30 percent profit margins.
"If we compare this to the automotive industry, the most competitive of industries, they are quite happy if they have profit margins of 3 percent over a cycle. It's not the automotive industry that will become like the oil industry, but the oil industry that will become like the automotive industry. This journey has only just begun," says Martin Jansson.
As costs are cut, the breakeven level for how high oil prices need to be to generate new output also decreases. Martin Jansson says this is the downside to OPEC's strategy: by putting pressure on both prices and other players, the industry will become much more efficient. This means that the long-term oil price does not need to be as high to provide the market with new oil – and also means that the old high oil prices are unlikely to return.
Price decline has long characterised the market for base metals, but it may still be too early to conclude that the bottom has been reached for the mining industry. Or at least this is the belief of Martin Jansson, who foresees continued pressure, at least on iron ore and copper.
"For iron ore, prices have fallen to levels that should be enough for the market to begin to become balanced. The problem is that for iron ore the high-cost production is in China, where output is driven not only by economic forces but also with the involvement of government subsidies. At the same time, the giants Rio Tinto, BHP Billiton and Vale have chosen to continue increasing their production because it lowers their unit cost per tonne, making them profitable even in a low-price environment," says Martin Jansson, and adds that the prevailing scenario means that iron ore prices must either go even lower, or that there must be a thorough airing in China, with some of the country's excess capacity in iron ore and steel being closed down.
"Steel companies are doing so badly now that it could generate a severe economic crisis for China," says Martin Jansson.
For a long time, the copper price held up at comparatively high levels, but since the spring it has come under real pressure. However, it is not certain that the decline has thus far been sufficient to bring the market into balance. One reason is that it has been more difficult to increase copper production, as several of the large new mines have not yet been able to scale up their production due to various problems. But this may change in the coming year.
At the same time, demand from the world's largest buyer of the red metal, China, has slowed sharply. The country's copper consumption has gone from growth of 10-15 percent per year to zero growth.
"If the largest consumer, accounting for 50 percent of consumption, completely slows down its growth and mine output continues to increase, there will be a mismatch in the market. I believe that the copper price is likely to decline further – it is USD 4,600 per tonne today and I would not be surprised if we see 4,000 next year. But perhaps not much lower than that," says Martin Jansson.
If we look at the Swedish mining-related companies, the market has to some extent upped the prices of companies like Atlas Copco, Sandvik and Boliden. Does this suggest a belief in better times ahead?
"There are probably many commentators who believe that the bottom has been reached for the mining industry. I am not quite as confident, but there are certainly signs of it. I do not believe that nickel or aluminium will fall that much more, and zinc probably has more upside than downside. It's really just copper and iron ore that I'm uneasy about. But one should remember that copper and iron ore are most important to companies that supply the equipment, such as Atlas Copco and Sandvik," says Martin Jansson.
He adds that Boliden is something of a special case in this context.
"They have had an amazing journey. They are earning a lot of money on smelters and have relatively less exposure to copper and more towards zinc. So if you believe the 'story' that zinc will rise because of the closure of a number of large mines, then Boliden probably has unique exposure in the world right now."