Why Oil Could Be Higher for Longer

Last week Wood Mackenzie released a report estimating that oil and gas companies will spend $1TN less on finding and developing new reserves through 2020 than was expected to be the case before the 2014-16 oil price collapse. 2016 reductions in capex have been estimated at $300-400BN, but this is the first credible figure we’ve seen over a longer period of time. It’s likely to be followed by substantial changes in the crude oil market that will benefit U.S. shale producers.

To see why this is the case, consider how the risk profile of a conventional new crude oil project has shifted. Whether it’s offshore, or Canadian tar sands, these plays require substantial upfront capital investment with a payoff over many years. If it’ll take you five years or more to extract and sell enough crude oil to earn an acceptable IRR, you are simply long crude oil. Exploration and production companies (E&P) routinely hedge only for a couple of years out, because that’s all that the liquidity of the futures market will reasonably allow. For example, Pioneer Natural Resources (PXD) shows 85% of this year’s crude production hedged but only 55% of next year’s. This is fairly typical.

The price collapse of last year, combined with the growth in U.S. shale extraction and enormous cut in capex, reveals the following calculus: evaluating a new conventional project requires assessing some probability of another price collapse to $30/BBL or lower during the life of the project. Prior large drops in oil, such as in 2007-8 or 2000 coincided with a recession and were the result of a drop in economic activity. While softening global growth bore some responsibility for the most recent drop, it was largely caused by supply increasing faster than demand.

So now imagine the difference in risk assessment facing an E&P company contemplating an investment in a new shale project versus a conventional one. Shale extraction is characterized by large numbers of individual wells completed relatively quickly with high and sharply declining production. Data from the Energy Information Agency shows that the cost of drilling a single well in any of the five most prolific U.S. shale regions has fallen to $6-7MM. Much has been written about declining production costs, which is why U.S. crude oil production only dropped from 9.5MMBD to around 8.5MMBD even while the rig count fell by 75% 2015-16. That increased efficiency includes better use of drilling rigs, so they’re not needed for as long to drill a well. The corresponding fall in costs has also shortened the time to break-even for shale drilling.

By contrast, in Canada the enormous upfront investment required in a tar sands project meant that production has continued to ramp up seemingly impervious to the price of oil. Steam-Assisted Gravity Drainage (SAGD) involves sinking pipes into the bitumen to heat it up for extraction. Shutting down production risks the pipes freezing, causing potential damage to the facility. So Canadian operators have continued production even at prices that fail to cover their operating costs because of the risk to their huge capital investment.

The consequence of a price collapse in the future looks entirely different to these two operators. The U.S. shale operator is nimble and can rely on hedging production because high initial production rates mean more oil is produced sooner. But the shale operator also knows he can respond to lower crude prices by stopping drilling. He has a short response time.

The tar sands operator has to make a long term forecast on crude oil that cannot be hedged. He has no way to mitigate his exposure to prices years out, and his scenario analysis now has to incorporate some possibility of a repeat of 2014-16. Moreover, the existence of shale oil production raises the risk of a future temporary collapse, precisely because the E&P companies whose collective activity might cause it can so easily respond and protect themselves.

The swing producer is not the lowest cost producer, but rather the producer whose time to break-even is shortest. The risk of a future big drop in oil is why $1TN in capex has been cut. The market has changed, and it favors the nimble producer who can exploit temporarily high prices and then drop back when prices do. We may have a permanently higher crude oil price over the long run, precisely because the risk of ruin dissuades the big projects whose supply would lower prices. Canada may never see another new tar sands project. The outlook for U.S. shale, with its constantly improving technology, falling break-evens and short time required to recover capital invested, looks very bright indeed.

Print Friendly, PDF & Email

Important Disclosures

The information provided is for informational purposes only and investors should determine for themselves whether a particular service, security or product is suitable for their investment needs. The information contained herein is not complete, may not be current, is subject to change, and is subject to, and qualified in its entirety by, the more complete disclosures, risk factors and other terms that are contained in the disclosure, prospectus, and offering. Certain information herein has been obtained from third party sources and, although believed to be reliable, has not been independently verified and its accuracy or completeness cannot be guaranteed. No representation is made with respect to the accuracy,  completeness or timeliness of this information. Nothing provided on this site constitutes tax advice. Individuals should seek the advice of their own tax advisor for specific information regarding tax consequences of investments.  Investments in securities entail risk and are not suitable for all investors. This site is not a recommendation nor an offer to sell (or solicitation of an offer to buy) securities in the United States or in any other jurisdiction.

References to indexes and benchmarks are hypothetical illustrations of aggregate returns and do not reflect the performance of any actual investment. Investors cannot invest in an index and do not reflect the deduction of the advisor’s fees or other trading expenses. There can be no assurance that current investments will be profitable. Actual realized returns will depend on, among other factors, the value of assets and market conditions at the time of disposition, any related transaction costs, and the timing of the purchase. Indexes and benchmarks may not directly correlate or only partially relate to portfolios managed by SL Advisors as they have different underlying investments and may use different strategies or have different objectives than portfolios managed by SL Advisors (e.g. The Alerian index is a group MLP securities in the oil and gas industries. Portfolios may not include the same investments that are included in the Alerian Index. The S & P Index does not directly relate to investment strategies managed by SL Advisers.)

This site may contain forward-looking statements relating to the objectives, opportunities, and the future performance of the U.S. market generally. Forward-looking statements may be identified by the use of such words as; “believe,” “expect,” “anticipate,” “should,” “planned,” “estimated,” “potential” and other similar terms. Examples of forward-looking statements include, but are not limited to, estimates with respect to financial condition, results of operations, and success or lack of success of any particular investment strategy. All are subject to various factors, including, but not limited to general and local economic conditions, changing levels of competition within certain industries and markets, changes in interest rates, changes in legislation or regulation, and other economic, competitive, governmental, regulatory and technological factors affecting a portfolio’s operations that could cause actual results to differ materially from projected results. Such statements are forward-looking in nature and involves a number of known and unknown risks, uncertainties and other factors, and accordingly, actual results may differ materially from those reflected or contemplated in such forward-looking statements. Prospective investors are cautioned not to place undue reliance on any forward-looking statements or examples. None of SL Advisors LLC or any of its affiliates or principals nor any other individual or entity assumes any obligation to update any forward-looking statements as a result of new information, subsequent events or any other circumstances. All statements made herein speak only as of the date that they were made. r

Certain hyperlinks or referenced websites on the Site, if any, are for your convenience and forward you to third parties’ websites, which generally are recognized by their top level domain name. Any descriptions of, references to, or links to other products, publications or services does not constitute an endorsement, authorization, sponsorship by or affiliation with SL Advisors LLC with respect to any linked site or its sponsor, unless expressly stated by SL Advisors LLC. Any such information, products or sites have not necessarily been reviewed by SL Advisors LLC and are provided or maintained by third parties over whom SL Advisors LLC exercise no control. SL Advisors LLC expressly disclaim any responsibility for the content, the accuracy of the information, and/or quality of products or services provided by or advertised on these third-party sites.

All investment strategies have the potential for profit or loss. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be suitable or profitable for a client’s investment portfolio.

Past performance of the American Energy Independence Index is not indicative of future returns.

Print Friendly, PDF & Email
1 reply
  1. Mike Moran
    Mike Moran says:

    Agree with your comment. If writing for a different audience you would likely say the volatility in the price of oil has increased the risk associated with cap ex regardless of price making long lead time projects much less attractive on a risk adjusted basis. While you focus on oil sands, the more meaningful source impacted by this new reality is offshore, which produces a significant amount of the world’s oil, and which has decline rates of around 15% a year (while the tar sands have an almost zero decline rate). Generally offshore production increased in 2015 despite the price decline because the projects must be planned far in advance. While offshore production may increase in 2016, it will likely start declining in 2017 and that decline will continue for several years.

    Reply

Leave a Reply

Want to join the discussion?
Feel free to contribute!

Leave a Reply

Your email address will not be published. Required fields are marked *

This site uses Akismet to reduce spam. Learn how your comment data is processed.