The option to wait

Oct. 5, 2015
While the oil and gas industry can trust currently cruel conditions of the oil market not to last forever, it must adapt to a fundamental change certain to reshape decision-making.

While the oil and gas industry can trust currently cruel conditions of the oil market not to last forever, it must adapt to a fundamental change certain to reshape decision-making.

Industry professionals have adopted the phrase "low for longer" to express disappointment that the price of crude oil didn't rebound quickly after its reduction by half since the middle of 2014. But some seem to think that means "low from now on." For at least two reasons, that interpretation is faulty.

The market adjusts

The future is never a simple extension of the present. Many mistakes begin with that assumption. The oil market always adjusts. It's adjusting now. Global demand growth will reach a 5-year high this year, according to the International Energy Agency, even with China's slowdown. And production has been falling month-over-month since midyear from the shale and other tight oil plays blamed for price-crushing surplus. That decline of roughly 500,000 b/d from the peak has been overwhelmed by a leap in total production from members of the Organization of Petroleum Exporting Countries of nearly 1.5 million b/d since early this year-mostly from Saudi Arabia and Iraq.

The other reason the oil price can't stay at current levels forever is that $50/bbl oil is unsustainable. A plunge to that level inaugurated an unprecedented industry contraction still painfully in progress. This week IEA Executive Director Fatih Birol pointed out to an Austrian newspaper that oil companies have slashed investment by one-fifth. "Never in the history of these companies has there been an annual reduction as strong as this year," he said. Although costs have fallen, cuts continue, as they will until the price rises to a tolerable level.

Pain isn't confined to oil companies. Saudi Arabia and other Persian Gulf producers can't produce oil and meet rising national expenses indefinitely with $50/bbl oil. The Saudi Arabian Monetary Authority (SAMA), the kingdom's central bank, is reported to have withdrawn as much as $70 billion from foreign holdings this year to cover the government's budget deficit. SAMA also is selling bonds. Saudi Arabia still has enormous financial reserves, of course. But it can hardly welcome this new reliance on them.

Some analysts think cost reductions and productivity gains in tight oil plays will sustain the surplus. While important, those improvements apply to less than 8% of global supply. If tight oil production managed to stabilize with the crude price no higher than $50/bbl-which seems unlikely-supply would fall in other, more-vulnerable categories.

Still, tight-oil production has importance beyond its share of the global total. It represents a new source of price-responsive supply-production that can be brought on stream nearly as fast as wells can be drilled and completed. In tight-oil plays, operators know where the hydrocarbons are; they don't have to find them.

Availability of non-OPEC supply promptly available at the first sign of price strength is new to the market. Supply management by OPEC worked as long as production everywhere else flowed at near-term capacity rates. Because that condition no longer applies, OPEC supply management is self-defeating. That's why the group abandoned the role last November.

Supply management has become the responsibility of individual producers. That burden falls most heavily on producers in the short-cycle tight-oil plays. They're marginal suppliers now. In place of exploratory risk they face a new hazard: oversupply and consequent price weakness resulting from herd-like response to any hint of price strength.

Incremental caution

A market no longer stabilized by coordinated supply management forces individual producers to respond to incremental demand, signaled by price elevation, with incremental caution. Producers can't collude, of course. They can, however, pay attention to what their competitors do-and, more importantly, study in advance what they can do. They can base production decisions on competitive assessments they never before would have bothered to conduct. And, when cost advantages appear to reside elsewhere, they can exercise the option to wait.

They'll have to.