Oil: the Search of a New Equilibrium Continues – Goldman Sachs

In short, Goldman sees oil market equilibrium back around 2016, since the main adjustment course will come from capital. Warns of « high yield defaults potentially beginning if prices were maintained at $40/bbl ». Sees US supply growth slowing to 400k b/d yoy in 4Q15.

BUT, as GS puts it: « To keep all capital sidelined and curtail investment in shale until the market has rebalanced, we believe prices need to stay lower for longer. » That’s a warning.

Now sees marginal cost  at $65/bbl for WTI and $80/bbl for Brent.

From GS’s note dated January, 11:

« E&Ps can conserve cash as impressively as they can spend it

The search for a new equilibrium continues. Unlike in the past when the rebalancing took place primarily in the ‘physical’ and ‘paper’ markets, in the current environment, the ‘capital’ markets are playing the dominant role. This new source of adjustment is generating not only a high level of disorientation, but also the need to reassess the paradigm.

Faster ‘time to build’ makes capital the margin of adjustment

Previous paradigms were plagued with one simple problem: capital was slow to move due to the long time lag between capex and production. Capital investments are now a new margin of adjustment – a direct result of the collapsed time lag shale has created between when capital is spent and when production rises, as well as producers’ ability, through very high decline rates, to quickly throttle back production when spending slows. With capital driving the adjustment process, the market has more levers to balance the market – credit, equity and cash flow.

The need for sidelined capital may force a U-shaped recovery

The credit, equity and oil price mix today is likely appropriate to achieve the slowdown in supply growth needed to balance the global oil market by 2016. Overall capex in the US E&P sector is down 25% – a further decline from 12% in mid-December – and drilling has dropped more quickly than in previous bear markets. But the short-cycle nature of capital investments in shale requires that such pressure remain in place long enough to also sideline the large amount of low cost capital available today. Because shale can rebound quickly once capital investments return, we now believe WTI needs to trade near $40/bbl for most of 1H15 to keep capital sidelined.

The one-year ahead one-year swap is a market anchor

Excess storage and tanker capacity suggests the market can run a surplus for a very long time, preventing storage blowouts and a collapse in cash prices. This leaves cash prices as a simple storage arbitrage to the forwards. As producers hedge 9-12 months out, new capital primarily focuses on the 12-24 month strip, making this the new market anchor that enables the capital markets to balance the future physical markets. To keep capital sidelined, this strip needs to remain well below our revised ‘new normal’ WTI estimate for the marginal cost of production of $65/bbl. »

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