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ECONOMIC REPORT 2015
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Saudi Arabia’s crude oil production in June was
reported to have reached a new record of 10.6 mb/d.
Its renunciation of any role as swing supplier to the oil
market has resulted in the steady build-up of inventories
for six consecutive quarters in 2014 and 2015 and a
diminished ability of the supply chain to continue to
absorb current production.
There is little doubt that Saudi Arabia will have seen the
signs of a reversal of US tight oil output, the recovery in
its market share in Asia and the sharp cut in upstream
capital expenditure in 2015 as the first indications of the
success of its new strategy. However, the impetus to cut
capital and operating costs among non-OPEC producers
and the incentive for other OPEC producers to maintain
export volumes may ensure that the battle for market
share is protracted and painful for high-cost producers.
By mid-2015, Iraqi production had risen to 3.9 mb/d,
the highest since 1979 and is believed to be capable of
further expansion. Furthermore, in July, the conclusion
of years of international negotiations over Iran’s nuclear
capability is expected to lead to the partial lifting of
sanctions after three years of restraint. This raises the
prospect of a gradual recovery in Iranian production and
exports in late 2015 and 2016 and further downward
pressure on international crude prices.
Demand Responds Slowly to Lower Prices
The collapse in oil prices acted as a welcome stimulus to
economic activity in oil-importing countries, including
the UK. By dampening inflationary expectations and
inducing a brief period of consumer price deflation in
early 2015 in some developed economies, the fall in oil
prices offered support to consumer expenditure and
postponed further the long-expected tightening of US
and UK monetary policy.
The collapse in crude oil prices did not feed through
to end-users uniformly because product prices were
slower to decline and, in many parts of the world, the
link between international prices and end-user prices
is muted by high taxes, exchange-rate movements
or government consumer subsidies. Nonetheless, a
demand-side response is now emerging in the US,
Europe and non-OECD Asia. After recording demand
growth of 0.7 mb/d in 2014, the International
Energy Agency (IEA) is now projecting an increase of
1.6 mb/d this year and 1.4 mb/d in 2016. This represents
above-trend growth over the last 15 years but is still
not sufficiently rapid to eliminate quickly the current
stock surplus.
Lower Prices in Investment Appraisal
The behaviour of long-dated oil futures prices provides
an indication of how the recent spot price volatility has
affected price expectations and how it may influence
future upstream investment.
Between mid-2014 and the summer of 2015, the
price of Brent futures for delivery in 2018 fell from
$100/bbl to $62/bbl (see Figure 3 overleaf) and the
futures curve moved from backwardation to contango,
where prices for forward delivery are above current
spot prices. While there is a tension between near-term
price falls and anticipation of a higher price in the longer
term, it is undoubtedly the case that investments are
being screened against much lower oil prices than have
been seen for a decade or more. Over the same period,
wholesale gas prices at the UK National Balancing
Point (NBP) for 2018 delivery have also declined, from
59 pence/therm (p/th) (or $10/million BTU (m BTU))
to 44 p/th ($7.30/m BTU), broadly in line with the shift
in forward oil-indexed term contract prices in
continental Europe.
Stronger Dollar Eases Impact of Lower Prices on the
UK Continental Shelf
TheUKContinental Shelf (UKCS), as part of the international
upstream industry, is largely a US dollar-based industry. All
oil revenues are dollar-denominated and gas revenues also
reflect the influence of continental oil-indexed contract
prices, even if the NBP-related revenues are denominated
in sterling. Revenues from oil account for about 70 per
cent of total UKCS operating revenues. The operating cost
base also combines both dollar-denominated and local
sterling-denominated elements.
As so often in the past, the recent sharp decline in dollar
oil prices was accompanied by a strengthening of the
US dollar against other traded currencies. This mitigated
the impact of lower oil prices on the terms of trade for
both oil-importing and oil-exporting countries. The
relative strength of the US recovery and anticipation of
a tightening of monetary policy and rise in US interest
rates in 2015 reinforced the rise in the dollar. Against
sterling, the dollar strengthened from 1.70 in mid-2014
to 1.50 in March/April 2015 (see Figure 4 overleaf).
The chronic Eurozone crisis and the anticipation of a
possible exit by Greece from the Eurozone accentuated
the appreciation of the US dollar against the Euro. The
effect of this dollar appreciation on UKCS producers was
to slightly alleviate the severe squeeze on cash flow and
margins arising from the fall in oil prices. At the time
of writing, the $/£ exchange rate had reverted to 1.55,
within the post-recession range of 1.50-1.70.
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