Citi vs. Chevron: The Oil Price Controversy

Here's a piece originally posted on Platts Barrel blog.

The direction of oil prices is once again a hot topic. In a recent Barron’s article, Ed Morse, Citigroup’s head of global commodity research, forecasts a collapse in global oil prices to $75 /b over the next three to five years. By contrast, Chevron has announced that it is budgeting with $110/b oil for 2017, with the company’s CEO John Watson stating, “There is a new reality in our business… $100/bbl is becoming the new $20/bbl in our business… costs have caught up to revenues for many classes of projects.” And for good measure, he adds, “If $100 is the new $20, consumers will pay more for oil.”

Thus, two diametrically opposed views of the future are emerging. The international oil companies (IOCs) have been unable to hold liquids production levels even in the face of soaring capital expenditures and rapidly increasing operating costs. Some, like ExxonMobil and Chevron, are budgeting with $110 oil in 2017 and are expecting that consumers will accept the cost increases necessary to permit the IOCs to sanction new projects.

By contrast, Citi sees cheap oil everywhere, implying either that Chevron and ExxonMobil do not have a solid handle on their cost outlook, or that the IOCs will see the oil side of their business quite literally gutted in the next three years. There is no middle ground here. At least one of these views is radically incorrect.

Citi’s view, which in many ways corresponds to that of BP and the International Energy Agency (IEA), is relatively straight-forward. They all see supply growing faster than demand. For example, the IEA sees supply increasing by 1.7 million b/d in 2014, well ahead of anticipated demand growth of 1.4 million b/d. And this pattern could persist into the future. According to the US Department of Energy (EIA), global oil consumption has grown by 1.3% annually on average over the last decade. Supply, augmented by the substitution of oil by natural gas, could grow faster. Citi, in particular, emphasizes the impact of natural gas substitution over the longer run.

Not all forecasters see supply outpacing demand, at least in the short run. For the 2014-2015 period, the US Department of Energy (EIA) sees consumption increasing by 1.3-1.5%, but supply up only 1.3% in 2014, suggesting continued strength in oil prices. But even this is predicated on OPEC reducing crude production by 500,000 b/d in the coming year to maintain market balance, something which BP also has anticipated.

Such restraint may prove elusive. With the recent surge in Iraqi production and the negotiations to restart Libyan exports, there is upside potential in OPEC supply. Discipline could depend heavily on the Saudis, if the EIA’s numbers are to be believed. Should Saudi goodwill prove lacking, there is a case to be made for Citi’s view.

Chevron’s approach, by contrast, builds on recent oil price history, rising operator costs, and perhaps the need to demonstrate to New York’s equity analysts positive free cash flow over the next several years. Chevron can take comfort in the notion that Citi’s forecasts have been well wide of the mark in the last three years. Citi has predicted prices as low as $65/b in just the last two years; but prices have remained remarkably stable above $105/b; indeed, price volatility is currently at historical lows. In the last three years, anyone betting that tomorrow’s oil price would be much the same as today’s has been vindicated. Thus, Chevron can look back on the last three years and declare that recent oil prices are likely to persist for the next three years. That is not a call on some theoretical basis, but rather one based on the historical track record.

Furthermore, the operators are beset by rapidly rising capital and operating costs. Capex per barrel has been rising by 11% per year, and some operators — Shell, for instance — have been seeing comparable increases in operating expenses. Thus, a traditional (demand-constrained) view of the market would argue that if costs are increasing, sooner or later these will be translated into selling prices. Cost increases are normally passed on to consumers, just as Chevron argues.

It would be comforting if consumers agreed, but in the last two years, oil prices have not risen to offset rising costs, suggesting that the oil companies cannot count on consumers to fully absorb rising exploration and production costs in the future. While Chevron’s price forecast is supportable, hopes placed on the consumer’s resiliency may well prove misplaced.

In short, we see two radically conflicting views of the future, both partially supported and contradicted by the data. Whom should we believe? Is all this just talk, or do the various camps have confidence in their predictions?

There are objective tests which will help us decide. We will know that Citi is serious when Ed Morse declares the IOCs — some of them no doubt important Citi banking clients — to be the walking dead. And we will know the IOCs are serious when they begin to buy oil futures. At present, 2017 Brent futures are trading at $95, even as Chevron and Exxon see oil prices for that year at $110. If they’re right, there’s more money — a lot more money — to be made in drilling for oil on the futures curve than at the bottom of the Gulf of Mexico.

But one way or the other, either Citi is wrong or Chevron is, and by a large margin.