Oil economics: a peak under the hood

In our previous post, we looked at the current imbalance between supply and demand.  We concluded that this imbalance was clearly due to an excess supply.  We concluded that, barring (likely) geopolitical turmoil, it would take two to three years for crude oil markets to stabilize.

But how will this take place? Which oil sources will be affected the most and see their production curtailed first?  How will producers decide to cut or not to cut output?  Many of the answers can be found in basic oil economics, accounting and finance; in particular, in the difference between profits and cash flows.

Shale oil is the sector which has grown the most, and the one which has been the first to retreat.  There are three reasons for that:

1.     Its upfront (capex[1]) costs are relatively low; as a result the lead time to production is short which represents low entry barriers for small, entrepreneurial and innovative companies.  The result has been a boom in production; it has also made it easier for producers to step back;

2.     Second, as shale well production typically falls 50% to 70% within the first  12 months, shale producers must continually invest in new drilling to at least maintain  production levels, the result being chronic free cash flow deficit;

3.     Thanks to rock bottom interest rates and the popularity of shale, producers had no problem avoiding equity dilution by financing these deficits with ever mounting debt.

But when credit markets tighten and oil prices plunge, shale producers face both deeper cash flow deficits and scarce credit.  They have no choice but to pare down capex and current operations. This retrenchment, combined with the naturally steeply falling production curves, explains why shale oil has been the sector most affected.

At the other extreme, Canadian oil sands producers have very different economics:  their business calls for very high upfront investments and very long lead times to production.  Afterwards, their operating costs are average but they do not need to invest much besides maintenance.  In the current environment, their cash operating costs are close to breakeven while the depreciation of their investments will push them into accounting losses.  Oil sands operators are like copper miners: once they have completed at least 70% of the investment for a new project, and unless long term oil/metal prices are expected to stay very low, they are committed to completing the project, and taking their losses for a while.  Of all the oil producers, they have the least flexibility to cut back on current production.

All other oil sectors fall somewhere between these two extremes.  Most of the non-OPEC and non-shale new production has come from sources which call for high levels of upfront investment.  As producers in these areas are strapped for cash and pull back on new investments, future production will suffer as there will be no quick fix for expensive, long lead time projects.

Accounting will also impact future production in another way.  Most oil producers must adjust the value of their oil reserves to the economic reality.  Typically, they are obliged to verify that the book value of their proven reserves doesn’t exceed the present value of their future cash flows[2].  This test is carried out quarterly, based on the monthly average market oil prices for the previous 12 months[3].  The steep drop in prices since last summer - and the likelihood that they will continue for at least two years - will force massive asset and equity write-downs and inhibit producers from raising additional capital financing.

Finally it is often forgotten that industry costs are just as dynamic as their prices, making it difficult to rebalance supply and demand.

When a cycle of rising oil prices gets under way, it attracts more money to the industry and encourages companies to boost their production.  This reverberates through the supply chain of goods and services: demand for new crews, drilling services and equipment boosts their costs and raises the producers’ breakeven points. 

Conversely, when oil prices fall, the relationship works in reverse: headcounts are reduced, third party contracts are renegotiated and weaker demand for inputs lowers their costs; the breakeven of oil producers goes down and production cuts are delayed as cash margins remain in positive territory.

Again, in a such a scenario producers may show accounting losses, but if they lower their costs to a level that lets them eke out positive cash flows, they will maintain their output as the cash is needed to service debt and stay above water.

This phenomenon was clearly illustrated by the ability of shale producers to defy predictions and survive oil prices well below what was thought to be their breakeven points. 

The result is that the adjustment to falling oil prices is not linear but more akin to a series of waterfalls, where not much happens until a sudden drop follows a shallow decline, followed by another gentle decline and another sharp fall.

When this dynamic plays through the whole industry, and when geopolitical risks are layered on top, one better understands why oil is such a volatile commodity.

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[1]  Capital expenditures.

[2]  Usually, net future cash flows are discounted back to the present at a rate of 10%.

[3]   Should the oil be committed to be sold under multi year contracts, the price imbedded in these contracts would be used.

Crude oil blues

While hard commodities are going through very tough times, crude oil has grabbed most of the headlines, and no wonder: its derivative, gasoline, is an essential product that billions of human beings consume every day.  Oil is also associated with the most volatile areas of the world which are making the headlines of newspapers and TV evening news.

Crude prices have fallen from over $100 per barrel in the summer of 2014 to under $30 today.  Some experts foresee $20 and even $10 before any rebound takes place.  Are they right?  A better question is whether such collapse is cyclical or secular.  Crude oil is a global commodity, largely driven by supply and demand.

Two charts are most instructive in this regard.  The first one shows the quarterly global demand for oil from 1Q 1996 to 3Q 2015:

Source: Bloomberg.

What is striking is how linear and steady the rise in global demand has been over the last 20 years.  Yes, the Great Recession of 2008-2009 cut demand by some 3 million bpd, but that drop was erased in less than 2 years.

Despite a short but a massive global recession, global demand for oil has grown fairly consistently at a rate of 1.5% p.a.  The supposed crumbling of the Chinese economy is not apparent over the 2010-2015 period; indeed, Chinese demand for gasoline grew by 12% in 2015 over 2014[1].  It is also interesting to note that the demand for oil kept rising steadily from 2002 to 2007 and from 2009 to 3Q 2014 despite prices soaring from $19 to $91 and from $36 to $94 respectively.

Put it another way, global demand for oil is fairly price inelastic over the medium and long-term; despite claims that fossil fuels are on their way out, there is little evidence that demand is falling, and I doubt that this will happen for the next few decades.

The second chart shows US oil production over the 1983-2015 period.  It does much to explain why prices have suddenly dropped.   Or why OPEC, and Saudi Arabia in particular, have decided to no longer play the role of market moderator. 

Source: Bloomberg.

After peaking at 9 million bpd in 1986, US production steadily decreased to 5 million bpd in 2008.  However, thanks to the development of shale extraction, it skyrocketed to 9.6 mm bpd in June 2015 before falling to 9.2 mm bpd by year end.  From the end of 2011 to the middle of 2015, shale oil production grew at an astounding annual rate of about 1 million bpd!

With oil at $100 shale was a terrific business.  At $40, it is a losing proposition for most.  Already, US shale production has dropped by 400,000 bpd since June of 2015.  Estimates of another 600,000 bpd cut this year are reasonable, for a cumulative 1 million bpd.

When might global oil markets get back into balance and prices rise to a range of $50-$70 which would permit the commercial exploitation of most sources of crude except for the more expensive shale and oil sands?

If we assume that the sudden oversupply of shale oil caused the current imbalance, then the secular annual increase in global demand of 1.5% (or about 1.4 mm bpd today) should take 3 years to close the gap, everything else being equal[2].  This would get us to the end of 2018.

But it is unreasonable to assume no extraneous factors, especially in today’s world.

First, as we indicated earlier, US shale production is likely to fall further, probably by another 600,000 bpd this year.  This decrease will probably be compensated in large part by increased Iranian exports of 300,000 to 500,000 bpd.

Towards the end of projection period, drastic cuts of close to 40% in investments made so far by the oil industry are bound to result in flat, not rising, production.  Among the world leaders, Petrobras for one has already massively scaled back its growth and may be forced to do more.

Geopolitical factors may cause more significant swings in global supply: Venezuela is teetering on the edge of economic chaos; Libya is in even worse shape. The second largest OPEC producer with 4.4 mm bpd, Iraq is in a state of war with IS.  And then there is the rising tension between Iran and Saudi Arabia where the principal actors don’t want a war but do want to test each other.  Russia is strapped financially and barred from access to the best of western petroleum technology.

Between cuts in US shale, increases in Iranian exports and difficulties faced by OPEC and non-OPEC producers, it is not unreasonable to envisage a net reduction in global supply of 800,000 bpd to 1 mm bpd over the next three years.

Finally, there is the reality that at least 5 mm bpd of new production must be ramped up every year to make up for natural field depletion.  That costs money.  A lot of money.

I don’t know what the oil prices will be this year or the next.  However, I think that, barring major geopolitical accidents or a recession,  the global oil market should get back close to equilibrium by early 2018 through a combination of lower production and higher demand.  Financial markets should anticipate that by six months or so.

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[1]  RBC Capital Markets.

[2]  At present, the US shale production is about 4.2 million bpd.  4.2/1.4=3 years.