On several occasions, including in the winter Oil & Gas Report, I have pointed out that the financing of new oil projects must be economic based on conservative assumptions and not based on hopeful future projections. This past week in Houston, Saudi Arabia oil minister Ali al-Naimi made the point very clear:
“Cutting low cost production to subsidize higher cost supplies only delays an inevitable reckoning.”
“The producers of these high-cost barrels must find a way to lower their costs, borrow cash or liquidate,”
“Inefficient, uneconomic producers will have to get out… This is tough to say, but it’s a fact.”
“It sounds hard, and unfortunately it is, but it is a more efficient way to rebalance markets,”
“If we can get all the major producers not to add additional barrels, then this high inventory that we have now will probably decline in due time… It’s going to take time. It’s not like cutting production. That is not going to happen.”
“There is no sense in wasting our time seeking production cuts; they will not happen… What will happen is we will all as major producers find it easy to freeze production, let demand rise and let some inefficient supplies decline, and eventually the market will balance.”
If there is any doubt that Saudi Arabia and their Gulf Cooperation Council allies aren’t going to keep producing at their current paces, then those doubters simply aren’t paying attention. The idea that the lowest cost producers would cut production now that oil demand is flattening and high cost producers were taking market share simply makes no sense. It is the highest cost producers that need to move out. That is not manipulation, that is a normal market. For those who want a free market, here it is.
Immediately after that meeting, Whiting Petroleum cut capital spending 80%, Continental Resources 66% and Chesapeake Energy 69%. Those come shortly after other announced capex cuts of 20% to 60% for 2016 at Anadarko, Conoco, Apache, Devon, Marathon, Exxon, Chevron and a raft of others. This all of course after the massive cuts in 2015.
Who are the “high cost” producers?
In general there are three high cost producers to consider:
- Oil Sands
- Ultra Deepwater including Arctic
- Shale
Shale is taking a pummeling now because they are the most flexible and can cut production fastest leading to near term cuts in production. Oil sands and ultra deepwater are less flexible. They have cut capex now and in coming years, however, depletion will not cut production for a few years until depleted supplies are not replaced.
Once oil supply and demand is back in balance, we will finally see shale come back into higher production. Why shale and not oil sands or ultra deep water? Logistically, oil sands or ultra deep water takes a lot more money and scale. Also, and more importantly, because the production is relatively even and thus takes a long time for payback, financing might not be there. In an uncertain long-term for oil due to the advent of Electric Vehicles, financing for oil sands and ultra-deepwater projects will be tight as lenders will want to know they won’t invest in a project that doesn’t produce profits for long enough to payback.
The first shale production will be the completion of uncompleted wells. There are about a thousand more DUCs than usual right now, possibly a bit more, that can be completed within about 90 days once it is desired. I’d anticipate that to happen as soon as oil crosses $50/barrel. Once oil stabilizes over $60/barrel that is when we’ll see more capex for new drilling, probably not until spring 2017 at the earliest and possibly not until 2018 or 2019 as companies continue to repair their balance sheets. During the next several years, some of the surviving companies will become very free cash flow positive as oil prices rise (we will want to buy shares sooner than that).
Here’s why oil price will rise
I have read arguments that oil will stay cheap forever. I think that is naive to the point of being laughable, especially since it comes from a lot of folks who used to claim that oil would be expensive forever. Forever isn’t forever in economics, it’s only as long as a cycle, unless there is permanent change.
While I have been a year early on my rebound forecasts, mainly due to greedy executives who failed to make the necessary adjustments, it doesn’t take away from the fact that oil demand will be in the 90-110mbd range for another decade or so. With higher cost producers capped to a large degree, that means that oil prices will increase as unreplaced depletion occurs.
It really is that simple of an equation. Demand will increase a bit and supply will decrease a bit over the next few years. The equilibrium will hit in the next year or two. From that point on, until real demand destruction for oil occurs in the middle to late 2020s, the price of oil will be very firm as OPEC raises prices back to over $80/barrel.
In addition, because there will be much less spare capacity due to far less investment in oil sands and ultra-deepwater, we are likely to see the return of the risk premium as reserves come down. I would not be surprised to see oil prices near $120/barrel by the middle 2020s if we avoid a global economic meltdown (not a sure thing given the precarious nature of demographics and debt). Prices in that range will stimulate EV adoption.
When permanent demand destruction for oil finally really hits, then we will see a more permanent change to the oil markets, but we are well over a decade away from that. How that plays out is hard to define as we don’t know what the adoption rate of EVs will be. My guess is that EV adoption is slower than bulls promote. Why? Price. The bottom line is most people will still buy their cars based on price and cost to operate. For literally hundreds of millions of people, that means a lot of used gasoline cars for a long time which means that oil ain’t dead yet (even if some of us want it to be).
Kirk
