Oil prices drop, raising worries for debt-heavy companies
Oil prices have been steady or dipping in recent weeks, despite continued geopolitical turmoil. Calm prices are largely due to soft demand for oil globally – a situation that could pose problems for oil companies saddled with too much debt.
Oil demand for 2014 will be lower than previously expected, prompting the IEA to downgrade its forecast by 180,000 barrels per day (bpd) for the year. In the second quarter, global demand only increased at an annualized rate of 700,000 barrels per day, the slowest pace in over two years.
Flagging demand is helping to keep oil prices from spiking, which is fortunate, considering that violence in oil producing countries around the world is keeping a substantial portion of oil supplies offline. All told, around 4 percent of global oil supplies are offline because of conflict.
But, according to the IEA, “Oil prices seem almost eerily calm in the face of mounting geopolitical risks spanning an unusually large swathe of the oil-producing world.”
Libya has been in a state of political crisis for over a year, which has kept most of its 1.6 million barrel-per-day capacity offline since the summer of 2013. Nigeria has experienced sabotage to key pipeline infrastructure, knocking some of its production offline. Iran has been under western sanctions since 2012, which have capped Iranian oil exports at 1 million bpd – about 1.5 million bpd lower than pre-2012. And Iraq, despite continuing crisis and chaos, has remarkably kept its output fairly steady.
The fact that prices have remained unusually stable over this period of global unrest is a result of weak global demand. Demand growth in the U.S. and Europe has been much softer than expected. OECD economies – a collection of 34 industrialized nations – saw oil demand shrink by more than 400,000 barrels per day in the second quarter.
China has been the main driver in rising oil demand for years, so a slowing rate of consumption there could upend predictions about where global demand is going.
For oil companies, this is a troubling development. As oil becomes harder to find and more expensive to extract, oil drillers need prices to rise to continue to make a profit. The industry has steadily increased its spending over the last five years or so to fund drilling in more remote and expensive locations. As an example, The Wall Street Journal recently wrote about the lengths to which Anadarko is going to produce natural gas in Mozambique.
But the problem for the industry is that prices have stopped climbing even as costs continue to rise. At a Houston conference earlier this year, oil executives agonized over ballooning costs. “All of us are facing new realities and pressures,” John Watson, CEO of Chevron said. “Labor and capital costs have doubled over the last decade.” He added that many companies don’t make money unless oil prices are in the triple digits.
Until recently, higher production costs could be tolerated because prices were climbing. But with demand flat, prices have hovered around $100 per barrel, and there is plenty of oil sloshing around.
And that means higher debt across the industry. Unless oil prices rise significantly, there will likely be a shakeout. The most indebted firms will be forced out of the business, and others will have to cut back on drilling. At that point, supplies will tighten – forcing prices to resume their ascent upwards.
Of course, the fortunes of the oil industry could turn out much rosier than this scenario, if global demand starts to rise faster. And that is certainly possible: the IEA projected annual growth in oil consumption to increase to 1.3 million bpd in 2015 as the global economy expands. But considering the latest downgrade by the IEA, there’s no guarantee that will happen.
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