Oil price outlook: Lower for longer?

Following the 2014 Saudi policy shift, 2015 has seen oil prices below $ 60 per barrel. By mid 2015, the growth in non OPEC production (and in particular the growth in US shale production, the largest component of growth in the preceding years) had stopped. Throughout the world many projects that had not yet passed FID have been put on hold (and in addition a few projects that had passed FID, such as Shell’s Carmon Creek Canadian oil sands project). Upstream industry investment is down by approx $ 220 bn in 2015, compared to pre price drop estimates (WoodMac, September 2015). With December 2015 oil prices below $ 40 per barrel, the 2016 drop will almost certainly be higher, potentially by as much as $ 500 bn (Financial Times, December 2016 (subscription needed)). This will have a significant impact on production in 2020 and beyond but has a much smaller immediate effect. The short term impact has to come from a further reduction in US shale oil as well as a faster decline of the production of conventional assets (reduced infill drilling and workovers). Supply and demand are only expected to approach a balanced situation by late 2016.

fig 21

US shale oil. The figure below gives a forecast for shale oil production, as made in late 2014 by Rystad Energy. It illustrates the high sensitivity of shale oil production to oil price (rapid decline rates of existing production, short lead times for new production). Although I feel that lead times tend to be under estimated by many analists (significant time is needed to secure funding, hire or lay off rigs, fraccing crews after all) it is clear that shale oil is faster to respond to changes in oil price than the conventional oil industry. The actual 2015 U.S. shale oil production is quite close to this late 2014 forecast (for the oil price as it eventually materialised).

Throughout 2015 shale oil production has been quite resilient. No massive wave of company bankruptcies has taken place. A number of factors come into play:
– cheap funding continues, be it to a lesser extent. Bankruptcies and fire sales of assets are in no one’s interest. Hence there has been a tendency to be rather lenient regarding rollover of loans and reserves re determinations (Oil and Gas Journal, October 2015).
– a significant part of 2015 shale oil production been hedged (for approx 50 % of production of smaller companies, for prices anywhere in between $ 60 and $ 100).
– reduced drilling and fraccing costs, faster drilling (poor performing rigs being the first to be layed of).
– more focus on the best plays, sweet spots.
– land lease cost being sunk cost, there is often still an incentive to drill in order to minimise losses
– a gradual reduction of the number of drilled but uncompleted wells

It seems likely that 2016 will be a much more difficult year though. Continuation of funding will be more difficult and expensive. Hedging of 2016 production at attractive prices is much less prevalent. At some stage companies may run out of their inventory of drilled but uncompleted wells. Surviving without any drilling and fraccing of any new wells (“zombie companies“), just waiting for the oil price to recover, may at some stage be no longer sustainable. The December 2015 oil price drop below $ 40 per barrel does not bode well for 2016 prices and oil shale production.

Strong productivity gains have materialized over the last few years in the US shale oil industry. It is not always clear whether these gains have as yet reached a plateau. The Eagle Ford and Bakken plays seem to have done so; the Permian probably not. This is an industry which used to be booming and is now a sober bottom line business, in survival mode. Would prices drop much lower than it could go into hibernation.

fig 22

Other non Opec production. A revised supply forecast (late 2015) from McKinsey for 2025 production is given below (assuming a gradual return to an oil price of 65 – 85 USD). Compared to an early 2014 forecast 2025 production is reduced by approx 3.5 mln barrels/day (with a range of about 1.5 – 6.5 mln barrels/day.

A smaller supply growth from new projects is apparent across the board. The biggest reduction seems to be in new production from oil sands. Cost reductions for this play have so far been less pronounced compared to those of shale oil. Canadian oil sands continue to be hampered by export route restrictions, in particular after the November 2015 U.S. keystone rejection. Note that a greater decline in existing fields is compensated by a greater OPEC production (both under ROW crude).

fig 23

Oil cost curves

The precarious position of oil sands is also apparent in the simplified 2015 cost curve shown below. Compared to earlier generations of similar cost curves the production of shale oil has increased, whereas the break even price has decreased. 2010 cost curves still saw similar break even costs for shale oil and oil sands. It is striking that Exxon Mobil, the major with probably the best track record for capital discipline and project execution, is hardly active in oil sands, cautious and reluctant to go ahead with large deep water projects, but keeping up its investments in oil shale (in particular in the Permian Basin).

fig 24

 

The cost of incremental non OPEC oil production needed to keep up with demand will provide a floor for oil prices in the long term. Lower prices are definitely possible but only as long as needed to bring supply in line with demand (assuming that OPEC / Saudi Arabia remains committed to a long term policy of maximising revenue). In the same way, higher prices are possible only as long as supply has not yet significantly increased beyond demand. The ability of the shale oil industry to react quickly to falling or rising prices may reduce the length of periods of very low, or high prices, outside the band of “normal” prices. The “normal” price interval being defined as the cost of incremental non OPEC oil needed to keep up with demand, plus a limited addition for risk taking and profits. At current cost levels I would expect this “normal” price to be approx $ 60 – 90 per barrel.

Road Ahead

Within a single year, the low oil price has resulted in the arrest of shale oil production growth (reducing oil production in the short term by approx 2 mln barrels/day compared to pre oil drop forecasts) and an upstream investment reduction of approx $ 200 Bn for 2015 (resulting in reduction in oil supply forecast in 2025 of about 4 mln barrels/day).

The flow of FID’s for new major projects has been reduced dramatically. This not only reflects lower oil prices and uncertainty over how long the oil price stays low but also pressure from shareholders to cut costs and safeguard dividends. In general: in a more uncertain world (political, climate concerns, Saudi strategy changes) IOC’s may be more reluctant to go ahead with expensive long term projects (oils sands, deepwater). Shale oil has the advantage that is more nimble, easier stopped and started with individual projects of much lower costs. Maximising value (in what is increasingly seen as a sunset industry) has taken over from replacing reserves.

From a Saudi point of view they have made progress but as yet they have not reached their goals. In order to go back on their current policy I would expect that they would like to see:
1. Supply to have fallen below demand
2. Inventories to have reduced to – or at least to approach – average long term levels
3. Confidence that a sufficient number of projects have been cancelled / postponed so that future oil supply in the medium term is unlikely to exceed demand
It seems unlikely that this will happen in 2016 but we could start to see this some time 2017. Even then they are more likely to (at least initially) aim for a $ 60 – 90 bracket.

The recent Rystad Energy analysis  (based on a global database of fields and potential future assets) as shown in the figure below confirms that a continuation of current low oil prices beyond 2016/2017 is unlikely – given the resulting drop in non OPEC supply (and assuming no dramatic surprises on the demand side). It illustrates the significant time between investment cuts and the resulting lowering  of oil production.

fig 24extra

Medium term scenarios (2015 – 2020)

The low case
With a) Iraq and Iran internally stable and increasing production, challenging the Saudi dominant position in Opec, b) Long term sluggish demand growth due to lower than expected economic growth (even in a low oil price world) c) high CO2 pricing due to climate concerns and strong support for renewables, technological breakthroughs in e.g. batteries it is not inconceivable that oil remains in the $ 40 – 60 range for longer. In such a case Opec share will increase significantly, planting the seeds for significantly higher prices in the next cycle. The current low oil prices will boost demand and will reduce non OPEC supply but will not have a large bearing on Iraq and Iran supply. This is a major uncertainty for the medium term.

The base case
Upon sufficient reduction of current production and a sufficient lowering of future production forecasts Saudi Arabia decide that they have reached their goals; potentially by 2017 or 2018. Oil goes to a $ 60 – 90 range, enough to keep up non Opec production in the long term (with field declines being compensated by the best of US shale oil and deepwater). New oil sands projects and the highest cost mature provinces (North Sea) will continue to struggle.

The high case
Instead of staying within a more sustainable $ 60 – 90 USD range, oil prices overshoot again. Contributing factors to such a scenario could be Saudi Arabia switching to a policy maximising revenues in the short term, Iraq / Iran additional production that does not materialise and more extensive Middle East unrest and supply disruptions. Again, such a scenario is likely to result in significantly lower prices in a next cycle. The small current oil production spare capacity increases the probability of this scenario.

In short: oil prices will recover but timing and magnitude are uncertain.

To a first order this cycle is not different from previous cycles in the sense that it is all about supply and demand. But there are significant differences. In the current situation we have:
– a strong financial situation of the key OPEC player (Saudi Arabia)
– limited existing OPEC spare capacity (perhaps as low as 1 mb / day)
– cost of incremental non OPEC production (a likely floor for oil prices in the long term) of about 60 USD per barrel
– lower demand growth, as China gradually moves to a phase of lower economic growth and decreasing energy intensity.
– lower long term demand growth, due to climate concerns leading to CO2 pricing, increased efficiency, increased share of renewables in the power industry.
Lower demand may in the future result in longer periods of low and “normal” oil prices. A system change after which oil prices converge to the price of incremental low cost OPEC oil instead of converging to the price of incremental non OPEC oil seems very unlikely, however. It is not in the interest of OPEC for sure. It is not in the interest of the developed world either as it is likely to lead to a dramatic drop of oil company stock prices and it will severely hamper the transition to a lower carbon world.

Implications for producers.

The current low oil prices bring substantial distress for high cost producers. Especially OPEC high cost producers, often already in a difficult financial situation, and requiring oil prices close to 100 USD in order to balance budgets, are in dire straits. Countries like Venezuela may face periods of instability. However, even low cost OPEC producers may face issues. In the long term, even Saudi Arabia faces the problem that the oil price needed to balance the budget, at current expenses, is significantly higher than the $ 60 – 90 “normal” price range.

fig 25

IOC’s will face difficult times – basically because in the long term their business model has trouble adapting to changing times. A far cry from the situation in the 1950’s and 60’s when they were dominant in production, technical knowledge and financial strength. At present, IOC’s:
– have lost their edge in technical knowledge to smaller companies, service companies and, to a lesser degree, to NOC’s.
– have trouble replacing reserves given their lack of access to regions with low cost, easy to find oil.
– are gradually becoming gas producers rather than oil producers, given the much greater geographic spread of gas reserves. Gas is likely to be systematically less profitable.
– are not well suited (company culture, strengths) to profit from the US shale oil / gas boom.
– many of the big oil and gas discoveries in other parts of the world have been made by smaller niche exploration companies.

Their remaining strengths seem limited to their
– legacy assets
– financial strength (enabling them to take a long term view)
– ability to execute very large and complex projects

Profitability is to a significant extent based on oil fields and provinces that were developed many years ago and whose long term production is in decline. Their best strategy may be to accept a long term gradual decline of production and to be very disciplined in spending capital. In a world of uncertainties and limited demand growth (whether by limited economic growth, climate concerns and CO2 pricing or increased competition from low cost renewables) it may become more difficult to commit to very large and complex projects of long duration. By adopting such a stategy they can still remain very profitable for a long time.

Concluding remarks

The lower for longer mantra reflects the low price elasticity for oil as well as the greater than expected resilience of US shale oil. Shale oil can react quicker to changes in oil price than conventional production but it cannot take on the role of a swing producer in the way that Saudi Arabia has up to mid 2014. As for previous oil price drops it takes time to let the market do its work. It is all about supply and demand.

The arrest of the rapid increase of shale oil production has been established by mid 2015. The second milestone, demand catching up with supply on a global basis, is expected to be reached by late 2016. The last and final milestone, a significant reduction of oil storage levels and a gradual return to “normal” oil prices of $ 60 – 90 per barrel could follow some time 2017 or 2018.

Given the low existing current spare capacity and the significant reduction of supply in the medium and long term due to the current investment cuts there is a significant risk that the oil price will overshoot again on the high side prior to 2020.

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