By Mark Edwards
To wrap up our look at the current oil price environment, I show the reasons for optimism and reasons I believe that prices will not go much lower and will rise in the coming year.
Reasons for optimism that Alaska can withstand the current price shock:
- Deficit spending from savings, coupled with measured, incremental cuts to the state budget should be the fiscal solution that helps Alaska bridge the current low price oil environment without causing broader economic issues.
- Energy investors in Alaska understand that it takes a decade to explore and permit new oil production. Then they expect to produce from Alaska’s large fields for two to three decades or more. They are investing based on long term price averages, not on short-term price swings.
- Multi-billion dollar developments like Point Thompson, and new projects like CD5, and Site 2S at the Kuparuk River are not going to be stopped due to current price levels. There are development requirements with their state leases that must be met. There are expectations prices will be higher by the time this oil will be sold into market.
- The three largest producers made public pronouncements during the recent election they would support maintaining the current tax system with long-term capital investments in Alaska. If they backed off from these promises so soon after their efforts were successful they would lose serious credibility with Alaskan voters and politicians.
- The state government can withstand short term price swings because of our enormous savings accounts. What is most critical is the length of the price decline. Sustained low prices for more than a year will start to put serious pressure on government budgets.
- The state withstood a similar low price shock only five year ago. The current prices started to fall in September of 2014 from an average of $96 a barrel for Alaska North Slope crude (ANS), to only $61 a barrel average in December. During the national recession in 2008 oil prices followed a similar path. They averaged $102 a barrel in September and fell to a low of only $37.7 a barrel by December of 2008.
- The state Department of Revenue predicts prices will average $76 a barrel and $66 a barrel for the next two fiscal years, but return to averages over $100 by 2018. The U.S. Energy Information Administration (EIA) forecasts prices to rise by this summer and average $71 for West Texas Intermediate (WTI) in 2016.
- State oil production estimates are positive. The two decade decline in Alaska is projected to end in FY 2016 with a 15,000 barrel per day increase and then grow again in 2017 to a peak of 547,100 barrels per day due to new fields coming on line.
Reasons to believe prices will not go much lower and rise in the coming year:
- Prices are set by the marginal cost of supply. In the case of oil the world demands roughly 92 million barrels of oil a day. In the long-term prices will go no lower than the highest cost producers who supply the last million barrels. If those marginal producers cannot make a profit they will go out of business and the supply will drop. This causes prices to increase because demand is not being met by the now shorter supply. Once prices rise, marginal high-cost producers can re-enter the market.
- Inventories build up when the supply of oil grows faster than demand. This is an easy signal to investors in the oil futures market that prices should fall. In 2013, oil inventories were at the lowest level they had been in a decade. The price for ANS averaged $108 a barrel that December. However, the producers responded to over three and a half years of prices above $100 a barrel with a dramatic increase in production. In 2014, non-OPEC countries like the U.S. added over 2 million barrels per day (bpd) in production. Global oil inventories added 0.8 million bpd on average in 2014. This over supply sparked the price declines we have been experiencing. The U.S. Energy Information Administration (EIA) predicts the inventory build-up will continue for the first half of 2015 at a rate of 0.9 million bpd. They expect this to taper off by mid-year because marginal producers will not be able to profitably produce at these lower prices. Companies can only operate at a loss in the short-term by spending savings and using debt financing.
- The real demand drivers for energy consumption are global population growth and higher standards of living, which lead to more energy usage per capita. The EIA estimated global oil demand increased by 0.9 million bpd in 2014 and will increase another 1 million bpd each of the next two years. This is driven by global GDP growth estimates (weighted for energy intensity usage) by 2.9% in 2015 and 3.2% in 2016. These are both higher than the 2.7% GDP growth experienced in 2014.
- Demand growth for oil in the next two years is being driven by continued gains in consumption from China, India and other under-developed nations. The U.S. is ending a multiyear decline in demand for oil and is expected to increase consumption by 0.3 million bpd as our economy rebounds from a prolonged recession. Japan, Europe and Russia are projected to decline oil use due to economic problems.
- You can see the long-term black trend line in prices on the graph on page one and global demand on the graph on page 6 are both sloping upwards over time despite volatility in the short-run.
- Non-OPEC countries increased their production by 2 million bpd in 2014. The EIA estimates this will slow to only 0.7 million bpd this year and decline further in 2016. Production slowing is predicted in the U.S., Canada, Central and South America. 0.6 million bpd of unexpected supply disruptions have also occurred mainly in South Sudan, Syria and Yemen due to terrorism and political unrest.
Continued growth in global demand for oil, coupled with a higher cost of supply to meet that demand should lead prices higher in the coming year as oil inventories burn up. Alaska has sufficient savings to offset large current budget deficits. Needed cuts in state operating and capital budgets will likely create a 2% drag on the economy in 2015. Current events are always changing, so continued vigilance of this critical economic topic is required. If prices stay low longer than expected more serious issues could arise. In the near term Alaska oil production levels should be stable and multi-billion dollar investments from the energy industry are expected to continue through the low price environment.