Crucial Insights During Unprecedented Period in OilBy Peter Appleby | Thu, 05/28/2020 - 09:00
Q: What are Rystad Energy’s expectations for global oil supply and Mexico’s position in the OPEC+ agreement following the oil price collapse?
A: Demand is crawling back after a crushing quarantine regime and producers are starting to shut-in material volumes, Rystad Energy believes the abyss is behind us and no longer on the horizon. As the supply-demand picture gets slightly less apocalyptic, the storage panic retreats, or at the very least, gets pushed down the road into late summer.
“Demand is better than it was last month” will be a mantra of 2020. As COVID-19 measures are loosened, oil demand (total liquids) will continue on an upward, albeit sluggish, trend in 2020. From the 72MMb/d low in April, demand could inch back to 95MMb/d by December 2020. Our bottom-up field analysis estimates that about 7.8MMb/d of oil production will be removed from the market between April and June. The lion’s share of 6.6MMb/d will come from OPEC+ cuts and another 1.2MMb/d of declines from non-OPEC+ (with downside risk to supply) as we now count 2.85MMb/d of field shut-ins from non-OPEC+ producers like the US and Canada. US operators have already announced crude production shut-ins of at least 1.2MMb/d in May-June. This will help.
But the physical market is not completely “out of the woods” when it comes to supply-demand. We see 13.7MMb/d implied liquids (crude, condensate, NGLs, others) stock builds in May 2020, with some downside risk to that estimate. Although significantly down from the all-time-high 26.7MMb/d implied builds in April 2020, the market will need to absorb crude into storage both onshore and at sea. Rystad Energy estimates the world currently has less than 600 million barrels of remaining working crude storage capacity. This may sound like a lot, but local storage hubs could still easily hit bottlenecks before global capacity is exhausted.
Long-term oil demand does not get back on its structural track until 2023. The current oil price rut will have lasting scars on the long-term supply outlook. The most resilient region is OPEC Middle East, but an upward price swing will quickly bring back shale/tight oil wells, which have a much shorter sanction to first oil timeline.
For the Mexico-specific situation, we would suggest that if our forecasts hold true, then Mexico is fairly well-sheltered from the unprecedented downturn because of its sovereign oil hedge. This has protected Mexico from every downturn over the last 20 years, though at a cost. Mexico emerged as the unlikely point of contention during OPEC+ negotiations, which resulted in the country agreeing to cut only 100Mb/d in May and June. This was 300Mb/d less than what was initially required. This cut is best understood in the context of national oil revenues, which are protected by the huge hedge. The exact hedge structure is unknown, being classified as a state secret, but most estimates suggest a potential hedging gain of around US$6 billion in 2020 given the current prices. In addition, the AMLO government strongly supports the revival of the state’s upstream and refining industries, which have finally achieved operational momentum after multiyear declines.
Considering the natural decline of Mexico’s maturing fields, does the 100Mb/d today represent much? Rystad Energy has used transparent well-by-well data from CNH to visualize the country’s latest upstream activity production and trends concerning the country’s base production decline. We conclude that if wells being drilled come online on schedule and no new wells are planned, Mexico would need to effectively reduce output by only 50Mb/d in May and June to adhere to the OPEC+ agreements, either through partial shut-ins or flow restrictions on less economic production. In the short-term, Mexico seems to have pulled out a nice win for themselves with the production cut, and in the long term with the massive hedge. The sovereign hedge is something we have seen other countries express interest in, including China. The market will recognize the benefit of these Asian-style put options for other nations as well.
The sovereign hedge may become more attractive because volatility is increasing in oil markets globally. We have observed the tightening of the peak-to-peak and trough-to-trough cycles of the oil markets, which, traditionally around seven years, is now about four years. This is due to a number of factors, but a major reason is the responsiveness of US shale production to price fluctuations, in terms of being able to shut in or turn on production. From a pure supply and demand analysis, there are no longer the long lead times to bring supply online that there were when oil was in the deepwater age. As this volatility increases, there is more appetite for hedge positions even if this incurs more cost.
Q: How does Rystad Energy foresee the impact of operators reducing budgets for Mexican developments?
A: In a broad context, Mexico’s vulnerability is in delays to different projects because of the recent downturn and slashed budgets. The main risk here will be Final Investments Decisions (FID) from discovery projects. Delays could also be seen in construction activities for both PEMEX and IOCs. Specifically, Eni’s Amoca development could be delayed because of the FPSO construction, which MODEC was meant to deliver in early 2021, and which could now slip by several quarters. While BHP has begun its FEED studies for Trion, the FID that was expected for 2023 could now hit 2024.
Another specific example of how operators are suffering here is with Talos Energy and their Zama discovery. This will continue to be affected as there has been no progress to date on the PEMEX unitization, which is essential for the FID, originally scheduled for 2020. That looks likely to slip to at least 2021. The Zama development is indicative of bigger problems in Mexico.
The one part of the industry in Mexico that is insulated from these budget reductions is the offshore exploration space. This is due to the nature of the contracts that were signed during the bid rounds. During the six offshore exploration license rounds, 55 blocks were awarded with a collective 63 commitment wells in the blocks. Shell alone has 13 gross exploration wells committed. These wells still look like they will be drilled in part due to the sunk costs associated with the signature bonuses, which was a combined US$356 million paid to the Mexican government in the exploration round signature bonuses. This must be tempered by the fact that companies may try and invoke a force majeure to extend the timings originally scheduled for these different commitment wells.
In general, we believe that Mexico is in a better position than some other countries and specifically other asset classes like US shale, which is already feeling the market’s reaction.
Q: How could operators’ CAPEX reductions impact their green initiatives in Mexico and around the world?
A: In general, when there are lower energy costs there is less incentive for investment into renewables. This holds true for both the developing world and countries including the US, which benefits greatly from cheap energy prices, and takes the impetus away from pushing for a global energy transition. The inverse is also true: when oil prices are high, necessity becomes the mother of all invention and there is a much bigger push for alternative energies.
Many companies that have expressed carbon neutral aims are subsidizing different renewables projects. The competition for dollars must be considered within these organizations. When that money becomes tight, money is invested in projects with the highest ROI or IRR. In lean times, it becomes difficult to justify projects that do not bring in great return. The consequences may be that majors continue to voice a desire to be in the renewables space, and invest in that space when and where they can, but the focus will certainly remain on the investments that make shareholders happy.
Q: Considering recent market events and the government’s energy policies, how attractive is Mexico in comparison to other markets in the region?
A: The overall attractiveness of Mexico for IOCs is going to depend on the commitment wells in the offshore space, particularly in the Perdido Fold Belt, which are supposed to be drilled in 2020-2021. Outside of Zama, the discoveries that have happened have been modest in size although the size of Repsol’s newest discoveries may change that trend. Zama has been indicative of many of the issues that IOCs have faced in Mexico, including working with PEMEX as a partner and the question of whether PEMEX has the institutional maturity required for an open market, which was a much-discussed topic when Mexico’s oil and gas market was liberalized. But this is a situation IOCs have been through many times before, with Petrobras a perfect example of a company that was in a monopolistic position before learning how to partner with international operators.
However, the problems of a difficult NOC or an onerous government are forgotten by IOCs if the size of the prize is big enough. If we begin to see major discoveries in Mexico, then attractiveness rises dramatically. At the moment, organic investment opportunities are being shut down because there are no new bid rounds. There are opportunities through JVs with companies that have existing acreage and, depending on exploration results, this could become a more popular option. However, countries including Brazil – and the standout regional opportunity, Guyana – are now competing for dollars.
There needs to be a change in government thinking in Mexico. The government has so far shown no signs of changing course on its nationalist energy policies. President López Obrador is still very PEMEX-centric in his thinking. The government has also shown no signs of abating on its Dos Bocas refinery plans despite mounting cost estimates. Rystad Energy is hearing numbers like US$12 billion to US$13 billion for the construction, rather than the original US$8 billion. The rationale behind that is still opaque to any outside observer and, from a purely economic standpoint, the project seems unlikely to be viable. This is taking place in the context of Mexico’s six refineries operating at under 40 percent capacity and creates a lot of questions about how the project can be justified. Other questions around the president’s 2.6MMb/d production goal are equally puzzling. The company’s debt situation adds further difficulty, though it is by no means inescapable. But the country must understand that oil has a finite value. If there is still oil in the ground in 2060, it may be worth nothing. Mexico is at a turning point, and we hope that it does not miss out on what could potentially be the last big wave of oil and gas investment.
Rystad Energy is an independent energy consulting service and business intelligence data firm offering global databases, strategy advisory and research products for E&P and oil service companies, investors, investment banks and governments.