Price, as everyone knows, represents a signal to buyers and sellers about conditions in the oil market. It's information that guides behavior.
At the start of the second quarter of 2015, the signal is stronger than usual. The market, in fact, is pounding on the figurative door, bellowing at oil producers, Pull back! For crying out loud, pull back!
Producers indeed are pulling back.
Cutting investment
As noted in Oil & Gas Journal's Capital Budgets Update last week, they have cut investment plans by about 30% for exploration and production in North America and worldwide (OGJ, Apr. 6, 2015, p. 28). In the US and Canada alone, according to OGJ estimates, spending this year on all industry operations will be down $147 billion. For exploration and production only, the countries' combined spending decline is $117 billion.
Many companies that recruited vigorously last year now are laying off workers. Most are cutting travel. They're pressing vendors for price concessions. They're promising to tighten further if prices continue to fall.
The process is messy.
In earlier surpluses, members of the Organization of Petroleum Exporting Countries would agree to lower the collective quota and hope their colleagues actually cut production enough to make a difference. The adjustment seldom hewed to plan, but the sense that management was being exerted-a numerical target was in place, after all-at least mitigated panic among traders.
The strategy, such as it was, worked as long as OPEC nonmembers, already producing at capacity, couldn't respond promptly to a price rebound with new supply. In the young era of unconventional resources, that condition doesn't apply. OPEC members know shale producers can boost output as fast as they can drill wells. For savvy OPEC members, price management means foresworn market share, and they want none of that.
Adjustment to the current surplus, therefore, is scarcely strategic and mostly reactive. There is no comforting production target. Producers respond individually, cutting operations and costs, and hope things improve.
The crude price will rise when aggregate contraction lowers supply meaningfully relative to consumption-and not before then.
So which project categories suffer most in this painful business?
Intuition says high-cost projects are most vulnerable: frontier exploration, integrated LNG, enhanced oil recovery, unconventional resources, deep water, and so on. But a project's durability also depends greatly on its owner's financial health.
And an important distinction has emerged between projects relatively easy to suspend and those in which capital has been sunk. An operator forced to make a choice might idle an onshore drilling program and leave an oil sands development in the steaming cycle at work despite the latter's higher overall cost.
In a Mar. 26 report, a Gaffney, Cline & Associates analyst divided project categories usefully according to internal rate of return (IRR), the discount rate that yields zero net present value. IRR accounts for variation in the timing of cash flows changes among different project types.
The analyst, Regional Director Ricardo Barreto, estimated IRRs for unconventional, conventional, shallow-water, and deepwater projects under three crude prices: $90/bbl before the crash, $70/bbl after the crash, and $50/bbl after the crash.
At $90/bbl, conventional was tops in IRR at 47%, followed by unconventional at 44%, then shallow water at 33%, and deep water at 21%. Conventional of course leads the other price scenarios, while deep water stays at the bottom.
Reactivity to price
Unconventional and shallow water, however, swap places between the higher and lower post-crash price scenarios. At $70/bbl, unconventional has an IRR estimated at 29% vs. shallow water at 24%. But at $50/bbl, the unconventional category's IRR slumps to 3%, while shallow water's falls to just 11%.
This strong reactivity of unconventional activity to prices below $70/bbl is manifest in plunging rig counts in US and Canadian tight-oil plays.
And it's embedded in another signal thundering from that door-pounding market: Fifty dollars a barrel is too low! For crying out loud, it's too low!
