As the oil industry stumbles into 2016, everyone is asking the same questions:
- Why did oil and natural gas prices fall so far and so fast in 2015?
- Did anyone see the collapse coming? Did anyone forecast it?
- Were OPEC or non-OPEC countries or groups to blame? Were individuals?
- How long will current conditions last? Will prices recover?
- Could prices go lower from here? Is there a floor?
- What will happen to my oil and gas investments? Could I lose all my money?
- What factors would have to change for prices to rise?
- What’s the long-term outlook for the industry? Is this the time to be selling petroleum interests, standing pat or loading up?
Of course, no one has answers to all the questions, but in this article we will present the facts as we know them and share thoughts about where the future may take us from here.
The most likely explanation of the recent drop in prices was that oil traders suddenly recognized that the world is awash in oil and is likely to remain so for several years. Cited are full-to-overflowing storage tanks in Cushing, Oklahoma, and oil loaded tanker ships idling on oceans and docked in harbors throughout the world, just waiting to offload millions of barrels to refineries and power plants. Price-bears note that oilfields in Iraq were back to producing almost 4.5 million (MM) barrels of oil per day (“bopd”) in November of 2015, and that Iran has resumed production and announced intentions to increase to 3MM bopd in the near future when sanctions are lifted. On a statistical basis, global inventories built by 2.0 MM bopd in the second and third quarters of 2015. These are the largest inventory builds since the fourth quarter of 2008. The EIA forecast that global inventory builds started to decline in the fourth quarter of 2015 to 1.4 MM bopd and will average only 0.6 MM bopd in 2016.
The possibility of a continuing worldwide oil glut is a concern to producers. In previous times, when oil markets became sated, OPEC, led by oil behemoth Saudi Arabia, acted as the world’s swing producer, cutting back production in order to maintain price stability. This time Saudi is showing no indications of slowing production anytime soon, and in fact is working to produce more. They are attempting to regain their market share at the expense of high cost producers, including US shale drillers. US production appears to have peaked in May of 2015 at 9.4 MM bopd.
Everyone is waiting for the other guy to flinch on production. Until someone does, the price of oil is likely to remain low. Although the Saudi production cost is less than $10 per barrel, social welfare programs take the all-in cost to $100 per barrel. The Saudis are beginning to utilize their cash reserves and have even discussed monetizing a part of Saudi Aramco through a public offering.
A second factor influencing prices is investor perception of future supply and demand. Because there are limited substitutes for oil, a relatively small perceived or actual shortage/surplus in the worldwide balance of supply and demand can cause wide price swings. A relatively small quantity of surplus barrels in the system is interpreted by the public as unlimited supply, and prices fall. A few barrels temporarily unavailable for immediate needs can create panic. Markets react as if the world will soon run out of oil, and prices soar. The tail wags the dog: the price of a few barrels can establish the price of millions. The pendulum can and does swing rapidly and widely in both directions.
Little more than a year ago, US producers were on a roll. Wells were being proposed and drilled in record time, production was increasing, and the US was reducing its unfavorable balance of payments gap. In November 2014, oil closed at $91.16. As US storage capacity disappeared and OPEC stood firm on production quotas, prices fell: to $53.27 in December 2014, and further to $34.66 in December 2015, a collapse of 62% in only 13 months.
Oil-bears recognize that US oil producers, through horizontal drilling and multi-stage hydraulic fracturing, have unlocked the secrets of obtaining oil and natural gas from the world’s bountiful shale reservoirs. The bears believe now that the genie is out of the bottle, the world’s oil producers will acquire and utilize them, and oil will no longer be a scarce commodity.
A third factor that may lead to disastrous consequences for many companies is the extensive use of borrowed capital. The disadvantage of America’s high-tech shale-play is its high cost. Competition for prospective oil and gas leases has been frenetic. Drilling and completion expenses are high. In their rush to exploit leases before they expire and to “prove up” as much of their potential reserves as possible, aggressive companies have been drilling as fast as they can, typically borrowing as much as banks and private investors would allow.
Collateral to secure the loans has often been producing assets, hedged by futures contracts purchased to assure deliveries at specified prices. Over time, higher price contracts have been expiring and new contracts are at much lower prices. The result is that many bank loans are now in non-performance status and are likely to be called for repayment in 2016. By some estimates, as many as one-half of existing E&P companies, especially the newer, highly leveraged shale drillers, will be out of business by the end of the year.
Prices may be further weakened by increased usage of renewable energy. But despite the growth over the last few years, wind and solar account for only 2 ½% of US energy supply. Further production and efficiency increases are expected, but most authorities do not believe renewables can or will substantially replace oil and natural gas based transportation fuels within the next decade or so.
Facts for the oil-bulls’ case can be equally persuasive as for the bears’. Oil and natural gas are commodities, and at the fundamental core, prices are ultimately determined by supply and demand. Energy is essential to the economies and well-being of all countries. The more energy one has, or can get and use, the stronger, healthier and more viable is its economy. The US, with only 6% of the world’s population, uses almost 22% of the world’s annual energy production, but is able to generate 22% of world’s nominal economic output. We are an immensely successful nation specifically because we have great natural resources, and have learned to use them effectively.
The world requires about 94 MM bopd. Annual demand is increasing about 1.1%, or 1 MM bopd. Worldwide spare capacity is now only about 2 MM bopd above daily production, down from about 8 MM bopd only a decade ago. The International Energy Agency (IEA) projects that by 2020 the world will need another 6 million bopd, outstripping the spare capacity of OPEC. In other words, demand has been increasing while spare capacity has been decreasing. The decreased margin of safety increases price volatility.
With world population continuing to increase, and with the citizenry of developing countries demanding more goods, services, and access to better transportation, the question is whether enough oil and natural gas will continue to be available to meet future demand. Exxon estimates that global population will grow from 7 billion in 2010 to 9 billion by 2040. Even if the per person consumption of energy stayed the same, energy demand would increase by 28%.
US production of shale oil is currently 4 MM bopd. Unlike production from conventional sandstones and limestone reservoirs, which typically have longer lives and slower decline rates, production from shale reservoirs have steep decline rates (up to 90% in the first year) and shorter lives. The result is that production from shale oil fields must be increased or maintained by continued, active drilling programs. If wells are not being drilled, production declines rapidly.
When oil prices began their decline in November 2014, drillers began taking rigs out of service and laying off employees. From a high of 1,931 working rigs in November of 2014, the number has plummeted to fewer than 700. US shale oil production has already declined by more than 500,000 bopd. Projections are that it will have declined by 1 MM bopd by mid-2016. In other words, without drilling as many or more wells than were drilled in 2014, US production will continue to decline rapidly.
Of course, the real wild card in the supply/demand picture is the possibility of turbulent disruptions in any of the world’s major oil producing areas, particularly in the Middle East or the Former Soviet Union. The loss of sustained production in one or another of those hot spots would immediately and dramatically drive prices skyward. The effects of such disruptions are to no country’s best interest, but it is not out of the realm of speculation.
For the present, we at Five States believe that opportunities to acquire quality producing properties may soon be among the best in our careers. A recent article in the Dallas Morning News cited a prediction that half the oil companies now in business would declare bankruptcy and/or go out of business in 2016. Many of their assets and producing properties will be sold at prices much below their value at year-end 2014.
With strong financials and a substantial amount of cash on hand, Five States is well positioned to respond to the opportunities of 2016. We will endeavor to make prudent investments, and to keep our clients and investors informed of our results throughout the year.