Oil Price Blues
THE PROBLEM ISN'T TOO MUCH OIL. IT'S TOO MUCH MONEY.
(Article originally published in July/Aug 2017 edition.)
The recent World Petroleum Congress in Istanbul ended with an outpouring of negativism about the industry’s future. The negativism was characterized by the “lower forever oil price” outlook decreed by Dinesh Kumar Sarraf, Chairman of India’s state-run Oil & Natural Gas Corp.
He and others discussed the devastation caused by the collapse of oil prices in late 2014 and the subsequent lack of progress in restoring them. The market’s optimism earlier this year that the production-cut agreement among OPEC members and key non-OPEC producers would lift oil prices has been dashed by its failure to shrink global oil inventories during 2017’s first half.
While hand-wringing is normal when your future is undercut by events beyond you
r control, it doesn’t necessarily mean conditions will never improve. BP’s CEO, Robert Dudley, pointed that out when he told dinner guests that “It’s lower for longer, but not lower forever.” Many industry executives are desperate for oil prices to rise to levels offering sufficient margins for them to gain confidence about resuming exploration and development projects. That confidence may prove critical if the world is to secure sufficient hydrocarbon resources to meet future energy needs.
Dudley has a knack for distilling the industry’s challenges into catchy phrases. Early in the downturn he spoke of having to prepare his company for an oil price environment that was “lower for longer.” In comments at the Istanbul conference, he expanded on BP’s planning in response to his warning.
“We’re making our planning assumptions around a price of about $50 at the end of this year and about $50 to $55 over the next couple of years,” he said. Those prices are well below ranges forecast by others, but it forces BP to follow through on another Dudley article of faith: “What is more important than price assumptions is driving down our breakeven price each year and thus making our business more resilient for a range of prices.”
So what does the future hold? Forecasts are conflicting – either prices stay low, such as in BP’s view, or they are on the cusp of sharply rebounding, sending them back to $70 a barrel or higher by early 2018. Producers like the latter scenario more than Dudley’s view, and some forecasters are now starting to focus on the impact consecutive years of significant capital spending cuts may have on future oil supplies.
The International Energy Agency (IEA) warned earlier this spring about future global supplies failing short of demand. Over 2016-2022, the agency sees global oil demand growing by 7.3 million barrels a day with only six million barrels of additional supply available. That leaves the global oil market in 2022 facing the tightest spare production capacity in 14 years, suggesting increased price volatility ahead.
Dr. Fatih Birol, the IEA’s Executive Director, suggested that a potential relief valve may be the surging growth of U.S. shale oil output. But he cautioned that “Its size will depend on where prices go,” and therein lies the dilemma.
Other speakers embraced the view that oil prices would spike at some point in the next few years. A prominent Wall Street investment research firm recently lowered its oil price forecast as it declared that the future path for oil prices would reflect a U-shaped recovery by 2021. This forecast would certainly fit with Dudley’s prediction that oil prices will not stay “lower forever.”
Will the industry make the necessary investments to find and develop the resources needed to meet the projected rise in global oil demand? That depends on what profit opportunities it sees. Prospects for sharp oil price spikes tend to make producers conservative in their spending plans, and timing dictates returns. However, the pace of capital investment is only one aspect determining future supply. Technology and access to prospective acreage are other extremely important supply-determining factors.
The challenges facing the industry were summed up in two comments from BP’s Dudley: “The years of $100 oil will turn out to be an aberration. We used to make money at $40 oil; we used to make money at $25 oil.” If high oil prices won’t bail out producers from rising finding-and-development costs, then figuring out how to reduce breakeven prices is a must if the industry is to remain viable. That challenge goes hand-in-glove with Dudley’s admonition about how companies must operate: “We have to stay on a capital diet.”
If Dudley is right about how to successfully navigate the challenges facing the industry, it means capital spending will not rebound as sharply as many forecasters expect, or are counting on. Does that guarantee that the industry, and the world, will face another bout of $100+/barrel oil down the road? Not if Dudley’s philosophy proves sound.
Controlled spending forces a focus on the best prospects. But if insufficient and unfocused spending rules, the IEA’s view could prove correct. Where might additional capital come from to help avoid a worst-price scenario from happening? Private equity is the likely source, and it is already being cited as an impediment to oil price recovery.
TOO MUCH MONEY
In an interview on CNBC, the head of Goldman Sachs’ commodity research effort commented that it isn’t that there’s too much oil in the world, it’s that there’s too much money! He cited the recent billion-barrel oil discovery by a start-up explorer backed by a leading energy private equity firm. The firm teamed up with another private equity-backed company and a small publicly-traded oil producer in drilling the first discovery well offshore Mexico following the government’s opening its historically closed oil industry to private companies.
The Goldman Sachs commodity head also pointed to the large number of private equity-sponsored companies operating in U.S. shale basins that are being backed because of their ability to profit at low breakeven prices through lower overheads and the successful application of technologies for finding and developing new supplies. These low-cost producers contributed to the rebirth, and now the rebound, of U.S. shale oil output.
With seemingly unlimited capital backing these companies and other new start-ups, it’s likely shale output will continue growing and possibly surge if oil prices rise sharply as suggested in the IEA scenario. Could this eventually become the death knell for the oil business?
In Goldman’s view, the quick response in shale oil output to only modestly higher prices was the variable they failed to understand when making their previous higher price forecasts. In fact, their most recent forecast, which is still below prior projections, cited the possibility of U.S. oil prices falling back into the $30s a barrel range due to this shale industry response model.
Goldman’s price prognosis is well below others. Critics suggest its dismal view is shaped by the most recent drop in oil prices to the low $40s a barrel. After falling 20 percent since the beginning of the year, in early July oil prices rapidly rose nearly 11 percent, taking some of the sting out of the earlier decline, but then fell again. As expected, producers responded to the decline by not putting additional rigs to work.
SLOWING DEMAND GROWTH?
While the oil business won’t go away for decades – too much of the global economy is dependent on the energy harnessed from burning oil – it’s possible that future demand growth may be about to slow or possibly turn negative. The industry is coming under increased attack from environmental groups and governments pushing for a decarbonized world.
Electric vehicles and an emphasis on renewable energy will eventually curtail the growth in oil-based transportation fuels. Oil price volatility and concerns over carbon emissions will influence consumer tolerance for internal combustion engine vehicles as well, all of which creates an ideal scenario for governments to rally to the aid of consumers by restricting the use of ICE vehicles and subsidizing alternatives.
Increased oil supplies and low oil prices are the antidote to unfavorable consumer sentiment. Strict capital spending discipline could help stabilize oil prices by controlling supply growth. The huge pool of private equity on the sidelines seeking new energy investments remains a risk to this outlook.
Being an oil company CEO these days is tough work. Not only must you deal with the near-term emotions of the oil market, but you must also be clairvoyant about the industry’s long-term outlook, including divining future oil prices and the impact on demand from environmental and government actions. Embracing the current industry pessimism is unwarranted, as Dudley demonstrates. It ignores the industry’s history of successfully navigating challenging price environments by following long-term trends which, now flashing yellow, may soon be turning green. MarEx
The opinions expressed herein are the author's and not necessarily those of The Maritime Executive.