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$1 Trillion In Spending Cuts Could Lead To An Oil Price Spike

Oil Rig

Are today’s spending cuts setting the global oil market up for a supply crunch in a few years?

An oil supply deficit may be hard to fathom given two years of surplus and rock bottom prices, but with the financials of so many oil companies badly damaged, upstream investment could come up short in the not-too-distant future, even if prices continue to rise this year.

Globally, the oil industry is set to cut investment by $1 trillion between 2015 and 2020 due to the collapse in oil prices, according to a new estimate from Wood Mackenzie. Spending on development will be $740 billion lower than the pre-crash estimate for that five-year period, and exploration spending is also expected be down by another $300 billion.

Dickson says that although “virtually every oil-producing country has seen some form of capex cuts” over the past two years, the United States has been hit especially hard. Spending will fall by half in 2016, dropping by $125 billion. The Middle East, on the other hand, has seen much smaller effects on spending. In a separate report, IHS projects U.S. oil and gas investment to decline by 35 percent this year, and while spending in 2017 should bounce off of 2016 lows, the recovery will be “long and drawn out.” Notably, IHS says spending in the oil industry in 2020 will still be 28 percent below the high watermark set in 2014. Related: Inventory Drawdowns Won’t Boost Oil Prices

Obviously, spending cuts will have very serious effects on production. Wood Mackenzie says that global oil production is already down 3 percent this year compared to 2014 expectations, back when high oil prices were assumed to remain high. Output is down 5 million barrels of oil equivalent per day (boe/d) this year compared to expected levels, and 2017 should see output down 6 million boe/d from prior estimates, or 4 percent lower.

“The impact of falling oil prices on global upstream development spend has been enormous,” Malcolm Dickson, principal analyst at Wood Mackenzie, said in a statement. “Companies have responded to the fall by deferring or canceling projects.”

But most oil companies do not have the ability to do anything other than slash spending and dial down their ambitions. BP’s CEO Bob Dudley recently stated that his company could continue to spend at their current reduced levels for three more years before production starts to fall. Now is not the time to spend aggressively to grow production, he argues. “Being a low-cost producer is the name of the game,” Dudley said on Bloomberg TV. “We’re getting very disciplined about capital.” BP plans to spend $17 billion in 2016, a nearly 40 percent cut from the $27 billion it spent just a few years ago, and more cuts are possible.

Most of the oil majors have prioritized the stability of their dividend payments above all. But that strategy has its downsides. Production will not increase and could even begin to fall. The reserve-replacement ratio at the oil majors has faltered, although part of that has to do with write-downs connected to low oil prices. ExxonMobil even lost its AAA credit rating when it prioritized growing its dividend ahead of halting its rising debt levels. Related: Oil Rallies With Risk-On Rebound

As companies retrench, global oil production could fall short of demand in the years ahead. After all, U.S. shale drillers have been hit hard by falling oil prices, but so have producers from around the world. A March 2016 report from Piper Jaffray & Co. warned about the supply crunch that is already starting to brew because of spending cuts, citing the falling rig count around the world, not just in the United States. The report concluded that there could be “grievous consequences” on the future oil supply from today’s cuts. “The fact of the matter is there’s a world of carnage unfolding and it’s increasingly widespread,” Bill Herbert, a senior Piper Jaffray researcher, said in March. “We’re digging ourselves a very deep hole.”

The very small increase in the oil rig count in the U.S. over the past few weeks is not nearly enough to reverse the decline, especially since the oil price rally may have stalled for now. Goldman Sachs predicts that oil prices will remain below $50 per barrel through the summer, barring another major supply disruption. “We view the price recovery as fragile,” Goldman wrote in a recent research note. “Absent further sharp rises in disruptions, the market is likely to remain close to balance in June as Canadian production restarts and production elsewhere remains resilient. As a result, we continue to expect that prices between $45 a barrel and $50 a barrel in coming months are still required to bring the market into a deficit in the second half,” the investment bank added.

By Nick Cunningham of Oilprice.com

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