Wednesday, May 17, 2017

The Struggle Behind Oil’s Ups And Downs

We likely won’t see $100 a barrel again. The industry has been recalibrated to a lower price level.


By Daniel Yergin
The Wall Street Journal
May 17, 2017

A great struggle is unfolding in the world oil market. On one side are forces pushing to rebalance supply and demand; on the other, those pulling to recalibrate the business so that it operates at lower cost. That tension explains why the price keeps jumping toward $60 a barrel and then falling back near $40.

Oil prices collapsed at the end of 2014 because supply and demand had gotten out of whack. That year global supply grew 2.5 times as fast as demand. The shale revolution in the U.S. was a prime cause of the imbalance; American supply grew by 1.4 million barrels a day in 2014—60% of the entire increase.

The expectation was widespread in 2014 that Saudi Arabia would cut its oil output to keep prices up. But Riyadh tried that in the 1980s, only to see its own market share shrink dramatically. “We will not make the same mistake again,” then-Saudi oil minister Ali Naimi said two years ago. In particular, the Saudis made clear there would be no deal to cut output without participation by nonmembers of the Organization of the Petroleum Exporting Countries—especially Russia, the world’s largest oil producer.

By the fall of 2016, lower prices had pushed supply down and stimulated demand, moving the two closer to balance. U.S. oil production had fallen by a million barrels a day. Around the world, spending on exploration and production for 2015-19 is 50% lower than what had been expected in 2014, before the price collapse. At the same time, demand grew in 2016 at almost double the 2014 rate.

Last December, oil-exporting countries took the action that had been beyond reach in 2014: They agreed to cut production. “Oil revenues are . . . the main reason,” Saudi Deputy Crown Prince Mohammed bin Salman said earlier this month on a Saudi-owned TV station. Even Russia, whose rainy-day sovereign-wealth funds were depleting rapidly, signed on. It also brought 10 other non-OPEC countries to the table.

With the market heading back into balance, this expanded group concluded that total cutbacks of just under 1.8 million barrels a day would be sufficient to wear down the excessively large inventories overhanging the market. OPEC countries demonstrated remarkable compliance with quotas, in sharp contrast to previous efforts. By March, prices had rebounded 75% from their 2016 lows.

But since then, prices have fallen. Rebalancing is now colliding with the other force—recalibration of costs to a lower level of oil prices. This massive adjustment is reshaping the way the global oil industry works.

It first became evident in the U.S. The collapse in revenues, along with heavy debt burdens, led to multiple bankruptcies and the expectation that prices would be “lower for longer.” Shale producers had no choice but to slash costs if they wanted to survive. In the process, they became more efficient, focused and innovative. A new well that might have cost $14 million in 2014 now costs $7 million. The gain in efficiency is so great that a dollar invested in U.S. shale today will produce about 2.5 times as much oil as a dollar invested in 2014, according to IHS Markit .

In 2014, many thought a drop in price to $70 a barrel from $100 would shut down U.S. production. It didn’t. Today, new shale oil wells can be profitable at $40 to $50 a barrel, and some companies claim even lower. That makes possible a new surge in U.S. production—as much as 900,000 additional barrels a day over the course of this year. By next year, the U.S. is likely to hit the highest level of oil production in its entire history.

This cost recalibration is happening everywhere, as a new analysis by IHS Markit shows. Canada’s oil sands have always been among the highest-cost, yet some new projects can produce near $50 a barrel. In Russia, costs have come down more than 50%. Even deep waters offshore can now produce at less than $50. In March the CEO of the Norwegian company Statoil told the CERAWeek conference that owing to a wholesale redesign, a project in the North Sea that had originally required $75 a barrel to be economical now needs just $27 a barrel.

This recalibration will push up supply more than had been anticipated, at least in the next few years. But there’s a big question. How much of the cost saving is the result of innovation, efficiency and new ways of doing things? And how much is the result of dramatic cutbacks in spending, leading to head-count reductions and idle rigs and other equipment? What happens when the markets for people, equipment, and services tighten?

As activity goes up, so will oil-field costs. That’s already evident in today’s hottest area for drilling—the Permian Basin in West Texas and New Mexico. Companies large and small, along with private-equity investors, are piling in. They’ve realized that shale technologies may make the Permian, in terms of recovery, the second-largest oil field in the world.

The effects are already visible. As drilling increases, tightness and bottlenecks are starting to become apparent in terms of manpower, supplies and equipment. Costs in the Permian could increase by 15% to 20% this year, whereas they will remain flat in most of the rest of the industry.

As oil producers get back to business all over the world, some of the big cost savings will be given back, which will support rebalancing—so oil prices will rise. But the entire business has been recalibrated to a lower price level. An industry that had become accustomed a few years ago to $100 oil now regards that as an aberration that will not recur absent an international crisis or a major disruption. The lessons about costs since the price collapse are not going to go away. They are too powerful to forget, and too painful.


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