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A Perspective on Impact of Failure to Freeze Oil Production

22 April 2016
Texas Lawyer

A group of major global oil exporters who met on April 17 in Doja, the capital city of Qatar, failed to reach an agreement to cap oil production. The purpose of the meeting was to freeze the exporters' oil output at January levels in an effort to stabilize prices.

Texas Lawyer spoke to Thomas Moore, Houston-based energy partner at Mayer Brown, recently about the impact of the global oil exporters' failure to agree on an oil production freeze.

Texas Lawyer: What comments do you have about the failure of the world oil producers to reach an agreement pertaining to an oil production freeze at their recent April 17 meeting in Qatar? Can you briefly explain the reason that the group was unable to reach an agreement?

Moore: I always thought that the effect of a freeze would be more psychological than real.

TL: You have commented that moving forward the Saudis will probably continue to keep oil prices below the price at which high cost producers can successfully re-enter the market. Please explain what impact you think this will have on small and medium-size U.S. independent producers.

Moore: The Saudis' and other freeze proponents' underlying strategy is to stabilize prices just below the price that would induce U.S. shale producers to drill enough to maintain shale production at historical levels. What the freeze was intended to do (I believe) is to convince the world that as higher cost production declines because of curtailed drilling, the barrels would not immediately be replaced by increased production by lower cost producers like Iraq and Iran. However, I don't think that there is enough discipline in OPEC and the other major lower cost producers to make this happen in fact. The result is that the Saudis will continue their strategy of trying to keep prices below the price at which high cost producers maintain production, albeit at a lower price than they hoped to achieve with the freeze.

TL: Do you predict that the large number of bankruptcies involving small and medium-size U.S. independent oil and gas producers will continue during the rest of 2016?

Moore: The real impact of this will be felt in the U.S. by the small and medium sized independents, and I would expect a significant number of bankruptcy filings for the rest of the year, including filings by some larger, more established companies. The failure of the recent Doja meeting to reach an agreement to stabilize oil prices suggest that the downward pressure on pricing will continue. This gives the lending community little cause for optimism that the oil prices will get better, and therefore, no reason to continue their borrower forbearance. In the first two borrowing base redeterminations, the banks were willing to overlook the full current effect of low oil prices with the expectation (or rather the hope) that the decline would be relatively short-term and prices would rebound. It's now looking less and less likely that will be the case. Banks are being left with no alternative but to react to missed interest payments and financial covenant violations.. This will lead to accelerating bankruptcies and forced asset liquidation at depressed prices. One way of looking at it is that after Sunday, there may be no more straws at which to grasp!

TL: Looking ahead, do you predict that the world oil producers will try again sometime during 2016 or 2017 to agree on an oil production freeze? If not, why would they not try it again?

Moore: Low cost oil producers will try again to agree on an oil production freeze. In order for prices to stabilize, production will have to be squeezed out of the system. The Saudis want to squeeze out the high priced producers, such as the U.S. shale producers, and stabilize prices just below the level that allows the higher cost producers to maintain production. This will maximize their revenues from their existing market share and a production freeze is their chosen approach. I believe that the Saudis and other low cost producers will continue to test to see whether the Iranians and other potential outliers can be brought to see the wisdom of this approach. The failure in Doha should have caused a greater decrease in oil prices. However, at the same time as the Doha meeting failed, the oil workers in Kuwait went on strike and that caused a significant amount of their oil production to be taken off the market. But it was only a short term issue, and when the strike was settled four days later, prices immediately softened.

TL: Down the road, do you see any event or economic development that would drive up oil prices in the near future (during 2016)?

Moore: A cut in production or an increase in demand would drive up oil prices. For example, another serious bout of instability in the Middle East would result in an increase in oil prices because of concerns that the oil supply would be disrupted. Similarly, if the Chinese economy expanded more rapidly, demand would increase, which would affect prices. But that is not likely to happen in the near term.

Reprinted with permission from the April 22, 2016 edition of Texas Lawyer © 2016 ALM Properties, Inc. All rights reserved. Further duplication without permission is prohibited.

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