A glimmer of light in the tunnel

IT'S HARD to remember when energy market conditions have seemed so unsettled. Currently, oil prices have been hovering generally in the $40 to $50 per barrel range, but no one is certain when prices will move and in what direction. Most industry people I talk with are optimistic, but it would be an exaggeration to say they are bullish. Outside the industry, some tout energy investments as good value but others are uncomfortable with the cyclicality of the petroleum business and the risk factors around commodity prices.

For this month's column, I thought it might be worthwhile to share some comments from several key sources about the current state of the oil and gas industry and where they think it is headed in 2017 and beyond.

OIL MARKET OVERSUPPLY INTO 2017

McKinsey Energy Insights, the data and analytics firm that provides insight to the global energy industry, forecasts that it will take more than six months for the oil markets to fully rebalance. MEI modeled four scenarios - fast recovery, slow recovery, under-investment, and supply abundance - and the latest trends point towards a slow market recovery. The MEI analysts believe the market will take another six months for oversupply to disappear and another six to 12 months to burn excess inventories. In the long run, continuous cost compression efforts could reduce average marginal costs to $65 to $75 (US dollars) per barrel.

James Eddy, head of MEI, said, "The market is recovering, but this may be slower than previously expected. We expect demand growth to decelerate as a result of slowing economic development and structural shifts in the transport sector. On the supply side, in addition to OPEC Gulf crude production, we see unconventionals and offshore resources playing an important role in replacing the 34 million barrels per day decline in conventional basins through 2030."

The research notes that there is a short-term risk that OPEC Gulf members have the capacity to add more than three to four million barrels per day of incremental production by 2019. This could potentially stifle oil prices into 2018 or 2019.

POSSIBLE IMPACT OF OPEC ANNOUNCEMENT

OPEC has reportedly agreed to cut oil production to 32.5 to 33.0 million barrels per day next year from its August level of 33.2 MMbbl/day. The surprise agreement in late September immediately boosted oil prices by about 5%. Although many analysts are skeptical of OPEC's ability to make this agreement work, some believe it is an indication that Saudi Arabia is softening its stance on protecting market share.

Stifel noted that if OPEC does maintain production near this target that US supplies could rebound more quickly than anticipated. Stifel analysts said they believe the US appears poised to regain market share due to improved well economics, supported by lower costs and greater productivity, coupled with stronger balance sheets. Some companies are even contemplating double-digit oil production growth next year based on $50 oil prices.

Andy Brogan, partner and global oil & gas transaction advisory services leader at EY, offered his perspective on the apparent OPEC agreement. "It's not a straight line from this announcement to permanently raised oil prices," he said. "There are a number of intermediate steps and remaining uncertainties which need to be worked through first." Among them:

• The agreement must be converted into actual cuts in production. Historically, implementation has been a problem for OPEC members.
• The production cuts have to start a sustained draw from inventories.
• OPEC producers (at the very least) need to show some lag in responding to any tightening in the market.

"All of this will be happening in the context of a global demand picture which appears for the moment to be fairly soft," said Brogan.

Operators are unlikely to change their tactics anytime soon, says EY. Having driven cost and cash flow discipline into their organizations, they will want to hold on to some of the gains they have adopted in the past 18 months or so. Also, they want to see hard evidence that OPEC means what it says and that prices respond accordingly.

Brogan thinks that unconventional players will react before those in the conventional space mainly because of the large number of drilled but uncompleted wells. Expect a lot of attention to be focused on this over the next few months, he adds.

Brogan concluded that, "The industry seemed to be at its most pessimistic around February/March. Since then, there has been a gradual, if slight, improvement. The OPEC announcement will underpin the sense that the worst is behind us, even if the future is still highly uncertain."

ADJUSTING TO NEW EXPLORATION ECONOMICS

New research from Wood Mackenzie indicates that the industry is set to emerge from the current price slump leaner, more efficient, and more profitable. Dr. Andrew Latham, VP of exploration research at the UK-based firm, says that the majors have changed the way they approach exploration, leading to improved returns, even at lower prices.

Latham says, "The new economics of exploration mean that rather than pursuing high-cost, high-risk, exploration strategies - elephant hunting in the Arctic, for example - the majors have become more conscious of costs. Smaller budgets have required them to choose only their best prospects for drilling, including more wells close to existing fields. The industry now has in prospect a different - and potentially more profitable - future."