Why $100 Oil Won't Be Coming Back for a Long TimeBradley Olson
Get ready for an L-shaped oil recovery.
A growing consensus is emerging from the likes of BP Plc, the International Energy Agency, shale wildcatters and even the Saudis that a near-term recovery to $100-a-barrel crude isn’t in the cards. Instead, expect a range of $50 to $60 for at least the next few years.
When oil prices plunged sharply in 2008, they rebounded almost as quickly. Several months ago, industry and government touted the same U or V-shaped recovery this time out. On closer examination, a new factor in the marketplace -- shale oil -- has changed their minds.
“This is the new normal,” Dennis Cassidy, co-leader of the oil and natural gas practice for consulting company AlixPartners, said in an interview. His group sees an L-shaped chart that could extend for three to five years.
Unlike other petroleum formations, the nature of shale -- with multiple inexpensive, short-lived wells -- means producers can stop and start drilling on a dime. On the one hand, this allows them to quickly cut costs in a downturn; on the other, every time prices tick up, so will their output -- renewing downward pressure on prices.
While an offshore well usually costs about $100 million to drill, and takes as long as 10 years and billions more to begin producing from a new field, a shale well requires only several million dollars and a few weeks to coax out oil and gas.
“When the price of oil recovers, most shale formations will be aggressively exploited,” said Leonardo Maugeri, a former Eni SpA vice president and now a researcher at Harvard University’s Belfer Center for Science & International Affairs. Based on his appreciation of shale’s special qualities, he predicted the current glut in 2012.
No central authority tells shale drillers, who have been described as the new “swing producers,” what to do. Unlike the Organization of Petroleum Exporting Countries, the effect they’ll have in holding down prices comes from a set of independent decisions influenced by the need to deliver shareholder returns.
The expectation that U.S. producers will boost drilling as soon as prices improve is why oil executives, including BP Chief Executive Officer Bob Dudley, are saying they don’t see $100 a barrel returning for a “long time.”
Chesapeake Energy Corp. and Oneok Partners LP are among companies basing their budgets on an assumption that oil will stick to about $50 to $55 a barrel this year, with $65 the ceiling for next year.
The current oil market is an echo of the 2012 natural gas crash, in which shale producers inadvertently created a glut that hasn’t yet been resolved. In that instance, even after prices fell to the lowest level in more than a decade, gas output continued to grow, according to data from the U.S. Energy Information Administration.
That reflected the industry’s ability to adapt to lower prices by improving productivity and reducing expenses, said Bloomberg Intelligence analysts Vincent Piazza and Gurpal Dosanjh in a report this month. Market observers who see historically higher costs as proof of an eventual decline in oil should “appreciate the industry’s experience in cost cutting,” they wrote.
After sinking to a low near $44 a barrel in January, crude prices have hovered around $50 in recent weeks, rising and falling a few dollars on the latest comments from OPEC members or government reports on drilling activity, production and inventories. U.S. crude rose less than 1 percent to $49.92 at 8:58 a.m. in New York.
This is not the first ever L-shaped recovery. Talisman Energy Inc. CEO Hal Kvisle compared the current downturn to the late 1980s and early 1990s, noting that oil prices spiked briefly during the first Gulf War and then stayed around $20 a barrel through most of the rest of the decade as global production peaked from Alaska to Russia to Saudi Arabia.
A similar range of between $70 and $75 could occur now for many years, Kvisle told reporters Feb. 18.
“We’ve probably established the bottom of the range now, and we’ll see prices generally trend upwards, but I don’t think things are going to go upward in a dramatic fashion,” he said.
Just 10 years ago, surging demand in developing countries and increasingly difficult-to-get oil resources combined to push up crude prices on fears of running short. After briefly plunging below $40 during the 2008 recession, prices have traded mostly above $80 a barrel, and often above $100 for the past five years.
Those higher prices helped pay for the technology and innovation needed to develop U.S. shale fields and Canadian oil sands, leading to a North American production boom that’s now created an oversupply of oil as growth in global demand faltered on a weakening economic prospects in Europe and China.
During boom and bust cycles since the early 1970s, a powerful OPEC, the cartel of oil-producing countries led by Saudi Arabia, coordinated output among its 12 members to raise and lower world crude prices. This time, it has refused to act to prop up prices, insisting that it’s up to U.S. shale producers to make the cuts needed to rebalance the market.
That was a startling change from several decades ago, when the majority of the world’s oil produced outside of OPEC countries came from projects such as offshore developments in the U.K.’s North Sea, requiring vast investments in new technology and pipelines to wring crude from hard-to-reach deposits.
Production from shale-rock formations makes up about half of total U.S. output, which also includes offshore projects in the Gulf of Mexico and wells drilled in past decades. Unlike the giant gushers behind previous oil growth, the shale boom was driven by thousands of new wells that could be drilled quickly and relatively cheaply, but faded fast after an initial burst of production.
The steep falloff in well output that was perceived as shale’s key weakness is proving to be an advantage in the downturn. With fewer new wells drilled to make up for declines, production will tail off faster than when the world relied on traditional wells.
“Shale has attributes that make it nimble. It is proving very responsive to prices,” said Jim Krane, an energy fellow at Rice University’s Baker Institute for Public Policy in Houston. “There are low barriers to entry, but also low barriers to exit. Other, conventional producers cannot do this.”
The flexibility to increase or slow output quickly has now made shale companies -- whose 4.3 million barrels a day represents about 5 percent of global output -- the world’s “swing producers,” according to Bloomberg Intelligence and the IEA.
It was a role they took on reluctantly -- and then ferociously as prices plunged late last year. U.S. oil companies slashed more than $50 billion from their spending and laid off tens of thousands of workers as prices continued a freefall and investors began to flee. The market value of U.S. shale companies has fallen by more than $200 billion since June, according to data compiled by Bloomberg.
“We’re not interested in growing oil, when oil is at the bottom of the cycle,” William Thomas, Chairman and CEO of EOG Resources Inc., the biggest U.S. producer focused on shale, said at a Credit Suisse Group AG energy conference Feb. 25. “We’re deferring growth until future years and prices gets better.”
Stalled growth is not a story investors like to hear, so shale companies are walking a fine line between holding down costs and reassuring shareholders that they can turn the spigot back on as soon as prices recover. In comments Feb. 19 about fourth-quarter profits, Thomas talked about cutting drilling in half and also emphasized, “We will be ready to respond swiftly when oil prices improve and resume our leadership in high return oil growth.”
One way producers are preparing for the rebound is by leaving hundreds of wells half-finished. Companies already had learned to complete wells in a matter of days, compared to the weeks it took a few years ago. So the pre-drilled wells will be completed and turned even faster when prices rise.
EOG, Continental Resources Inc. and Concho Resources Inc. are among those leaving wells uncompleted, meaning they’re poised to produce quickly when the price is right. U.S. producers’ improving skills at operating profitably with oil between $50 and $60 will also support higher production and pressure prices lower.
Continental, one of the earliest and most prolific producers in North Dakota’s Bakken shale formation, can weather low crude prices “forever,” Chairman and CEO Harold Hamm said Jan. 29 in an interview. EOG said this month that, thanks to improved technology and cost reductions, it can make more money with oil at $65 a barrel than it did three years ago when oil was $95.
“I don’t think anybody is thinking it’s going to go back to $95, but $65 would be great for EOG,” Thomas said at the Feb. 25 conference. “That would be fine with us and then hopefully we’ll get to that point.”
Most producers, like Devon Energy Corp., are moving rigs to the most prolific areas, or even going back to old wells to re-frack them and produce at a quarter of the previous price.
“The knowledge curve and the technology curve of shale are improving every six months,” said Harvard’s Maugeri. “This correlates to big improvements in cost and productivity” that will allow most producers to keep drilling through the downturn.
Even as drilling rigs declined by a third since October, there’s been less than a 15 percent reduction in the growth of new output, showing how improved efficiencies will continue to prop up production rates, according to Drillinginfo Inc., an Austin, Texas-based oil and gas analytics firm.
Costs meanwhile continue to fall as companies such as Halliburton Co. that provide drilling and other oilfield services cut their prices by 20 percent to 30 percent to retain business, said Drillinginfo CEO Allen Gilmer.
“This whole episode has really highlighted the robustness of unconventional producers in the U.S., who can ramp up and ramp down,” he said in an interview. “If the point was to test the shale players, it probably has not worked out as assumed.”
All the additional supply waiting in the wings creates more volatility and uncertainty. Global prices should average $56 a barrel this year, with ups and downs making a “shark’s teeth” pattern based on headlines of the day, Paul Sankey, a Wolfe Research analyst, said in a Feb. 13 note to investors.
Steady at $70
Some producers are still counting on oil rebounding above $60 by the end of the year, and then to continue rising. Continental’s Hamm said he would not use hedging contracts to lock in oil prices at $70 a barrel because he thinks the price will go higher.
Ed Morse, Citigroup Inc.’s head of commodities research, who forecast that oil prices would fall before last year’s collapse, has said oil will probably hover around $70 for years. Morse doesn’t see the market staying as flat as an L-shape, though he suggested in a Feb. 9 note to investors that the global oil benchmark won’t exceed $75 by the end of 2016.
The self-correcting nature of low prices and shale may take years to resolve. The market will have to wait for supply reductions elsewhere, such as in Russia or Venezuela, or for global demand to strengthen enough to absorb extra output.
“We’re going to have a couple of years of this sloppy, $40-$60ish oil,” said David Foley, the head of energy deals for private equity giant Blackstone Group LP. A major geopolitical event could raise prices, he said, but “other than that, you just have to wait” for the gap between supply and demand to narrow again.