A Map to the Oil Price Roller-Coaster

Posted on February 10, 2015

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What’s in store for oil prices?

Here’s the basic tug-of-war of forces that will shape the trajectory of oil prices over the next two or three years.

Oil prices have plummeted because production has risen sharply in recent years, particularly because of the American shale oil boom which has made the US a net exporter of oil. This is coupled with a drop in demand because of a stalling global economy with major trouble-spots including Europe and China.  This is often portrayed in the West as some kind of price-sabotage play by Saudi Arabia, but actually it’s the result of a production contest between them and the US. The Saudis hold the stronger hand because their oil is far higher-quality and cheaper to produce. North American shale oil and bitumen are low-grade, high-cost resources that are very vulnerable to price swings.

That’s the straightforward part.

But how do producers respond to this scenario?

First, they are under increasing pressure to squeeze as much revenue as they can out of their existing facilities.  Current production is maintained with sunk capital – so even if low prices mean they are selling at a loss, it’s a far smaller loss than not selling oil at all.  For jurisdictions like Russia or Malaysia, where so much state revenue depends on oil, this logic operates on a macro scale – the lower the revenue per barrel, the more barrels you need to release into to the contracting market, and the more downward pressure you put on the commodity.

Initially, low prices actually increase pressure to maintain or increase production.  That means that in the short term, low prices create a vicious circle that keeps production from dropping and delays a correction in the imbalance between supply and demand.

Second, the energy corporations are curtailing new capital investment.  The logic of squeezing production and revenue out of sunk and committed capital does not apply to new capital. Low prices and falling share prices are draining the producers’ financial resources and straining their ability to raise capital for new projects.  The cost per barrel of new rigs and facilities increases inexorably (as lower-cost plays get played out) so tight money,  rising capital cost and low prices combine to put a powerful damper on investment.

The International Energy Agency sees much the same dynamic: “Producers will . . . be incentivized [sic] to maximize output in a bid to recoup investment costs. . . New projects, on the other hand, are unlikely to be sanctioned and will likely be delayed.”  Current US statistics show a decline in the number of wells but an increase in total oil production.

Eventually production will fall as existing facilities get tapped out and are not being replaced with new ones at the rate one sees when the market is healthy, and at that point glutted reserves will start to dwindle and prices will approach a more stable and sustainable level, probably returning to the long-term upward trend but not likely a strong rebound.  If the European economy continues to tank, if China’s economy continues to slow, if the American recovery is a short-term phenomenon, then demand will stay soft and so will oil prices for quite a while.

Capital will remain tight in the oil sector for a time. Bankers have a long memory and will not be enthusiastic about advancing money to energy companies until the financial shocks of all this price volatility have receded.

In terms of our parochial interests here in British Columbia, the squeeze I have described refers to the same energy companies that are the only candidates for the development of a Liquefied Natural Gas export industry, and the soft global energy markets I have described are the places where they would need to feel assured they can turn a sustained profit out of LNG ventures, which require enormous capital outlays.

In other words, don’t hold your breath.

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