Though oil and gas prices closed on a high note in 2016, there are few assurances that the market will see a continuation of that momentum throughout 2017. Though US natural gas and power have been disconnected from oil prices for the last several years, prices for many of the other energy and non-energy commodities are influenced by the price of oil and will generally rise and fall in near concert. As such, any discussion of what might be expected relative to the energy markets in 2017 should start with oil.
After 2 years of languishing oil prices, OPEC announced at the end of November 2016 that they had reached agreement with other OPEC members (and several non-members countries) to cut crude production by as much as 1.8 million barrels per day, for a period of at least six months beginning January 1, 2017. Buoyed by the announcement that countries such as Russia, Iran and Mexico had joined with OPEC to limit output, the markets reacted positively and pushed prices into the mid-$50’s, their highest levels since July of 2015.
However, given the potential for this fragile alliance to fall apart, production could again rise and volatility increase. Even without obvious cheating by the parties to the agreement, the market will undoubtedly remain hypervigilant and will quickly react to rumors of possible cheating, or political posturing, by any of the partners to this agreement.
Despite the potential fragility of the agreement, should this group of otherwise adversarial parties stick to the agreed limits, some experts believe that oil could reach as high as $70/bbl, well above what many analysts believe to be the break over point for producers to return in force to drilling for new supplies in the shale fields of the US.
Like oil, US natural gas has had an up and down year in 2016. With prices seemingly stuck in the $2 - $2.50 mmbtu range for much of the first half of the year, they did break out in June and began a gradual rise, ultimately reaching $3.70 by year’s end (in large part due to an early season arctic blast in December). While short-term natural gas prices and volatilities are largely driven by weather related burn, the longer term supply and demand balance will ultimately determine the direction of prices.
Though the US has been in an over-supplied condition for the last several years with the massive influx of new production from shale fields such as the Marcellus, the almost continual decline in prices beginning in 2013 has slowly brought new production increases to an end. However, investments in new export infrastructure during the same period, such as pipelines to Mexico and LNG liquefaction terminals, have helped increase market demand, draw down storage inventories and helped to essentially rebalance the US market.
According to the EIA, US natural gas exports via pipeline to Mexico hit 4.2 BCFD in August 2016. These exports are expected to continue to rise as more pipeline capacity is built from South Texas across the border. With exiting capacity of 7.3 BCFD and new capacity additions coming online in 2017, total export capacity into Mexico will sit at nearly 11 BCFD by the end of the year. Additionally, LNG exports from Sabine Pass in Louisiana are expected to average almost 1.5 BCFD for the year.
While the immediate future does look good for improved natural gas prices, there is little doubt that with increasing prices, volatility will also increase. Further, should prices reach $4 or even the upper $3 range for a sustained period of time (several months at least), many producers will undoubtedly increase their capital budgets and return rigs to the field, once again leading to a sustained growth in production – and the potential for an over-supplied market in the not too distant future.
Forecasting future production growth is difficult as there are no set levels at which oil and gas producers can or will react to higher prices. While technology advances have reduced drilling and completion costs for new wells over the last several years - reducing the breakeven price for new production - there are simply too many variables at play to accurately predict at what price the production of oil and gas will begin to rise. Though many of the largest producers have sufficient cash flows to fund incremental projects if market conditions improve, smaller producers tend to be highly leveraged and may have difficulty finding financing for new development, even in a rising market.
Additionally, there are questions about how quickly the oil and gas producers can bring on new production as much of the equipment and personnel needed for drilling, fracing and completion activities has been sidelined for almost 2 years. Though some rigs and production equipment are available in a “warm stacked” state and can be redeployed on relatively short notice, others have been “cold stacked” and could take months longer to deploy back to the fields. That being said, equipment availability probably won’t be the choke point to bringing on new production – the issue will likely be finding skilled personnel to staff the rigs, trucks and fracing units that have been idle. With the industry shedding somewhere between 200,000 to 350,000 jobs since peak employment in 2014, luring critical skills back to what is a boom or bust industry could prove problematic. If the assets, both equipment and manpower, are not available despite rising prices for oil and gas, delays in bringing on new production to meet increased demand could lead to sharply higher prices and periods of much higher price volatility.
As gas goes, so goes power
With natural gas reaching parity with coal as a fuel source for power generation in the US in 2016, gas prices have become the single greatest influence on wholesale power prices in the US (or globally?). Though regional imbalances do exist, particularly in areas with high levels of renewable energy sources, wholesale power prices will continue to be highly correlated to natural gas. If natural gas prices do increase sharply in response to increased demand brought about by economic growth and increasing exports, wholesale power prices will undoubtedly rise as well. That being said, if gas prices spike for an extended period, we could see fuel switching back to coal for some of the baseload capacity that gas had taken away in the last couple of years.
What will the new administration bring?
With Donald Trump having only recently assumed office, it’s difficult to know the impacts his presidency will have in the areas of economic growth, financial and environmental regulation, and global trade in energy products. Nonetheless, Mr. Trump’s campaign platform focused heavily on several key areas of concern for energy producers and traders, including reducing the burden of compliance with financial and environmental regulations and improving economic growth - both potential positives for increasing energy demand and reducing costs. Bolstering expectations of reduced regulations, Mr. Trump, in only the second week of his presidency, issued a directive aimed at rolling back or revising portions of the Dodd-Frank regulations covering bank fiduciary rules. His directive also empowered the Secretary of the Treasury to restructure other (and as of now undetermined) provisions of the Dodd-Frank regulations to ensure they are in-line with the administration’s goals to improve competitiveness of US businesses in the global markets. Nonetheless, it still unclear at this time if any future changes to Dodd-Frank will impact energy and derivatives trading.
Many of his cabinet-level Secretary picks, including former Texas Governor Rick Perry for the DOE, Oklahoma Attorney General Scott Pruitt for EPA and Montana Rep Ryan Zinke for Interior Secretary, have yet to be confirmed at the time of this writing. However, each have previously been very vocal critics of Obama administration regulations that have negatively impacted the energy industry - particularly those rules that sought to curb CO2 emissions or limit the development of oil and gas resources. Further, Mr. Trump’s often stated desire to reduce US trade deficits may also influence future energy policy as US energy exports of LNG, LPG, natural gas, crude products and (as of 2016) crude oil are growing and can be viewed as a net positive in reducing trade imbalances. However, since assuming office, some of Mr. Trump’s foreign policy pronouncements have resulted in rising tensions with many key US trading partners, including Mexico and China, raising the specter of potential tariffs or other trade barriers that could impact exports of US energy commodities to these nations in the near future.
Lots of questions to be answered
While the energy prices appear to be well positioned to move higher in 2017, there are many unsettled questions and unknowns facing the markets - At what price will producers bring on additional supplies of oil and gas, in what quantities and how quickly can they do it? Will the Saudi-brokered OPEC agreement hold and for how long? Will the Asia-Pacific economies, and particularly China, regain momentum, increasing demand for energy commodities? Will President Trump’s campaign rhetoric translate into action in 2017, including loosening federal regulations that have impacted energy producers and traders? How will the US economy perform under the new administration – will economic activity and energy demand increase beyond that of the sluggish growth seen for much of the last decade? And finally, will tensions with key trading partners reduce US exports of natural gas and other energy products?
While it is difficult to predict and quantify the impact of these myriad factors, either individually or in whole, the implication is that 2017 is clearly going to be a year of uncertainly and increasing price volatility. For those that have the appropriate trading systems and processes in place to quickly assimilate data and identify opportunity, increasing volatility will be a welcome change from the languishing energy prices of the last couple of years. For those that have limited their investments in ETRM related technologies over the last couple of years, it is still not too late to take a look at your systems and processes, and ensure that they are ready to deal with the inevitable, but as of yet unmeasurable, changes that will impact the energy markets in 2017.
For details on how Capco, Energy Solutions can help your organization achieve and maintain readiness for the 2017 market, please contact us at firstname.lastname@example.org
Lance McAnelly is the Managing Partner for the Capco Energy Solutions business. An established business leader with significant energy industry experience, Lance provides team leadership to deliver and promote client-focused, value-added solutions that result in organizational growth and improved efficiencies. With both national and international experience, he has successfully managed and delivered more than 200 person-years of service to his clients.
The content and opinions posted on this blog and any corresponding comments are the personal opinions of the original authors, not those of Capco.