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.