Oil price prognosticators are out in full force these days. We have heard comments like “Dramatic declines in drilling in Canada and the USA will impact production later in 2015 and bring the market back into balance”, or “OPEC producers like Iran and Venezuela have no choice but to increase their production to fund their government budgets” and “Russia will keep the flood gates open too”. The decline in oil prices has rocked Alberta’s economy leaving financial forecasting very difficult for companies doing business in the province. What oil price forecast should companies be using to formulate their revised budgets? The answer is not easy but we have to start addressing the issue somehow.
Let’s start with the fundamental basics of supply and demand. As long as an individual producer can make money at the market price, it will continue to supply the market. The aggregate of each individual producer’s production decisions constitutes global supply. So, one logical way to figure out the longer-term equilibrium price of oil is to examine the underlying break-even economics of all individual producers.
Right now, OPEC is attempting to curtail the growth of the American oil shale producers. Granted US oil shale plays have different economics, but a recent analysis done by Citigroup’s oil analyst, Ed Morse, shows that several US oil shale plays including the Eagle Ford, Bakken and Marcellus have breakeven costs ranging from USD$50/bbl to $60/bbl (today’s price is USD$56/bbl). A similar analysis by Morse shows that the breakeven price for every international oil company project through 2020 is around Brent $65/bbl. Outside the USA, most OPEC companies have break-even economics below USD$50/bbl.
A more important factor for determining the supply curves of OPEC countries is to examine the break-even oil prices required to balance their budgets. Most of them are above US$100/bbl. For instance, Russia is $98/bbl and Saudi Arabia is $106/bbl. Iran and Venezuela require $131 and $118/bbl oil prices, respectively, to balance their budgets.
What does this all mean? This means that oil prices are not going back above USD$90/bbl anytime soon. Despite greatly reduced drilling activity in the USA in 2015, American shale production can still grow persistently at prices below USD$70/bbl. This also means that OPEC countries must continue to produce at full capacity to deal with their budget deficits.
The worst may be over but I believe entrepreneurs in Alberta should not forecast oil prices to rise much above USD$70/bbl for the next 24 months. TD Securities just released its revised oil price forecast last week and concurred that oil will settle in at $53/bbl in 2015, rise to $65/bbl in 2016, $75/bbl in 2017 and $80/bbl in 2018. Being an Albertan, I hope my oil price forecast is wrong but there is logic in my base case. I have recommended my clients doing business in Alberta to build their revised budgets on muted oil price increases.
Gene Vollendorf is the President of Melrose Inc., an Alberta-based financial consultant providing financial acumen to entrepreneurs.
Energy producers in Alberta are no strangers to volatile commodity prices. So with the price of oil plummeting recently, most have responded quickly by cutting their dividends and reducing their 2015 capital expenditures. This contraction will ripple through Alberta’s economy. First, oilfield service companies will experience slower activity as well as lower prices for their services. Then, the real estate market will soften, financial services will slow, businesses services will decline and household incomes will suffer leading to lower retail, restaurant and entertainment sales. The picture looks dismal…. Or does it?
As a financial consultant who assists entrepreneurs in maximizing the value of their businesses, I have found that it is often during these low periods when the value creation process occurs most. Companies rid themselves of non-core assets, refocus on their core competences and invest in innovation to make themselves more resistant to future economic downturns. Motivated by economic survival, companies can achieve amazing productivity and catapult to new heights.
Business restructuring, recapitalization or rationalization are all positive steps for companies. I have found that there is more owner-employee alignment during lean times, enabling organizations to rise quicker to the challenges they are facing and formulate more enduring solutions.
Scarcity of resources, whether human or capital, is an important necessity to ensure they are allocated to the most productive use. Often, during good times, companies can lose sight of this principle, waste resources or channel them to unproductive ventures. However, tough times reinforce this basic axiom leading to more rigorous decision-making and ultimately more prosperous times. For sure, Albertans will need to work hard during the downturn we are facing, but from my experience, economic downturns are not all bad. In fact, they are usually my busiest and most satisfying times.
Gene Vollendorf , President of Melrose Inc.
Provider of financial acumen to entrepreneurs.