6th May 2015
As we have been reminded in the most dramatic fashion in the last nine months, the petroleum industry is cyclical, unpredictable and capable of rapid, value-destroying downturns. While these kinds of events tend to have their own harbingers and seemingly unique characters, similarities can be observed and comparing past events to the current situation may offer some useful insights. Two historic events seem particularly useful as analogues: the price crash of 2008 and, more distantly, the price drop and related events beginning in the mid-1980s. Looking back to these earlier events and comparing them with the current situation can be both informative and useful, as we endeavour to answer the question of whether we are experiencing a downturn very much like other downturns, or whether this is something new altogether.
The oil markets in the early 1980s were being influenced by two major factors:-
Softening demand in the OECD countries; and
Growing sources of supply in places like the North Sea and the North Slope of Alaska.
As we are seeing today, producers in the early 1980s expected OPEC, and Saudi Arabia in particular, to use their market power to bring order to the markets. OPEC’s strategy was in the first instance to protect prices, rather than market share. Saudi Arabia’s production decreased from approximately 10 million barrels per day (MMbpd) in the 1980/1981 timeframe to 2.3 MMbpd in mid-1985. Despite this extraordinary commitment by Saudi Arabia, the strategy failed. The strategy failed because most other producers were unwilling to match Saudi Arabia’s commitment. In late-1985, Saudi Arabia shifted direction and adopted a market share-focused strategy. To do this, Saudi Arabia increased production and implemented other commercial strategies to protect its market share. It had an immediate impact and between December 1985 and July 1986 oil prices dropped by more than 50% to below US$10 per barrel. Projects in high cost areas that had been buoyant in the relatively benign price environment to that point became uneconomic and investment into these new areas slowed. Oil and gas companies turned away from high-cost developments and focused upon low cost conventional opportunities in the international arena. The oil market found a new level and prices were not to recover on a sustained basis for another 15 years.
On the broader economic front, sustained lower prices supported improved economic growth and, with it, the demand for oil, particularly in the US where imports increased from approximately 3.1 MMbpd in 1985 to just over 9.1 MMbpd by 2000. With its low production costs, Saudi Arabia was able to increase its share of the US market dramatically. This “efficient producer” strategy pursued by Saudi Arabia and some of its OPEC partners was unforgiving but effective.
Let us now move to 2008 and the World financial crisis and accompanying oil price crash. The collapse of Lehman Brothers was the first in a rapid series of unsettling events that many thought might lead to the failure of the global banking system. The fear and uncertainty were palpable and the prospect of a long recession or even depression reducing the demand for oil caused a dramatic fall in oil prices. Leading economies and their respective central banks intervened and relatively quickly it became apparent that the worst would not occur. The underlying supply / demand balance in the oil markets was not materially upset and oil prices began to recover.
What can we learn from these two different kinds of events? Where the oil prices are driven down by an over-supply into the market, the ‘recovery’ in oil prices may take time to manifest itself. The root causes of the over-supply must be addressed and this typically involves eliminating or reducing the activity of the high cost producers. This is painful and it takes time as we can see from the 1985 event, where prices remained relatively low for an extended period.
In contrast, where oil prices are driven down not because of over-supply into the market but because of a widespread concern about the future of major economies, the recovery can be rapid if those concerns are addressed. The 2008 event is a good example of such a quick recovery.
So what of the current price collapse? Oil prices fell from heights of over US$100/bbl in mid-2014 to below US$50/bbl in less than 6 months. Should we look to the 2008 model as the analogue and expect that the market will rebound back relatively quickly, or is the current situation more akin to the downturn that began in 1985 and therefore we should expect an extended period of relatively low oil prices?
On the face of it, the similarities between 2014/15 and the events of 1985/86 are striking:-
The demand for oil is softening, but instead of decelerating demand in OECD countries we see that demand growth in China and other emerging economies has been slowing, while at the same time energy intensity in the mature Western economies gradually reduces.
There is also an oversupply situation with exceptional contributions from non-OPEC producers, but instead of rising North Sea production we have seen the dramatic emergence of North American unconventional production.
As was the case in the early 1980s, we see a discordant OPEC with Saudi Arabia and the Gulf States aggressively protecting market share by once again adopting an “efficient producer strategy”.
On top of everything, fractious geopolitics is playing an important part, with continued instability in the Middle East region and the growing potential for conflict in the Ukraine and Eastern Europe creating heightened uncertainty.
What does the future hold? When you look around the market there are at least as many views of the future forward price as there are analysts considering it.
Broadly speaking, however, they fall into two groups, one of which expects a rapid recovery or restoration, and the other which believes the oil market is undergoing fundamental or revolutionary change. Before examining these different perspectives, a few words about the threshold question: what constitutes a recovery? At GCA, the ‘informal’ narrative has tended towards the view that a sustained $70 - $80 price level would constitute a recovery although that is by no means a universally held view. It may be that recovery is a ‘state of mind’ more than an objective set of facts. Prices will have recovered only when oil and gas companies and other players have finally coalesced around a general view that the market has re-balanced and projects can be planned and executed with reasonable confidence.
The Restoration Perspective – Prices will Recover Quickly
This perspective is informed by a belief that the “efficient producer strategy” being pursued by Saudi Arabia and others will be successful again but more quickly this time. North American unconventional and other high cost producers will be unable to maintain intensive drilling programs and other necessary activities and production will rapidly decline. Many producers that are focused on high cost developments will be eliminated. Other producers will have to drastically reduce investment programs. As a result, the supply–demand balance will be restored and oil prices will recover.
The Revolutionary Perspective – Fundamental Change means Slow or No Recovery
The revolutionary perspective sees fundamental changes in the geo-politics of oil production. OPEC is fractured and is unable to act as a coherent force. Many OPEC and non-OPEC producers would like Saudi Arabia and others to pursue a strategy to protect prices through substantial production cutbacks. But Saudi Arabia and the Gulf States understand very well that most other OPEC producers and major non-OPEC producers do not have the luxury of cutting back production. These producers have the dilemma of needing high prices and maximum production to balance their budgets. Saudi Arabia and its allies will continue to look first to their interests and pursue an ‘efficient producer’ market share strategy. In this environment, the law of the jungle will dominate, with large resource, low cost producers wielding the ‘big stick’.
The revolutionary perspective also sees technology underpinning fundamental change. The rapid development and application of technology in the North American unconventional context and in deepwater developments worldwide will continue. Low prices will not stifle innovation but encourage it. Costs will be pushed down and productivity increased as producers find a way to succeed in the low price environment.
Another consideration is that significant new quantities may be released to the market from different sources. First, many important projects around the world have momentum insofar as they have already made a large part of the necessary investments and have entered, or are expected to enter, production. This would include deepwater projects in the Gulf of Mexico and to some extent in Brazil’s pre-salt, Canadian heavy oil (tar sands), as well as large scale projects in Kazakhstan and Azerbaijan. Second, the difficulties faced by a number of major producers that have been constrained in recent years, such as Iran and Libya, may be resolved releasing additional volumes onto the market. Of course, at the same time production from other sources will decline in the normal course or as a result of the more difficult economic environment for oil and gas projects. The net effect of these different factors is difficult to judge but additional volumes coming onto the market may materially impact the supply curve and keep pressure on oil prices.
Finally, the overall supply-demand balance may continue to be impacted by major economies continuing to reduce their energy intensity, and by gas, renewables and nuclear becoming an increasingly important part of their energy mix.
Taking all of these factors into consideration, the revolutionary perspective sees oil prices remaining at low to moderate levels for the long term.
What does GCA think? Predicting oil prices is a hopeless endeavour at the best of times, and now, with so many powerful forces pulling in different directions, it is particularly difficult. However, experience suggests that when prices are driven down by over-supply in a fractured, complex geo-political environment, a sustained recovery may take years, not months to materialize.
Notwithstanding the prospect of an extended period of low prices, GCA believes there are reasons to be optimistic. Understanding and adapting to uncertainty is what the oil and gas industry does very well. So, how do we find a way to move forward and prosper in this new environment? Ultimately for most companies, this is about change and adaptation. We believe key areas of focus are:-
Getting more out of assets, not simply though cost cutting but by the use of expertise and knowledge to improve performance, including by investing more on understanding reservoirs and being prepared to apply best technologies and recovery practices to optimize production.
Rebalancing portfolios to better match financial resources with developmental and cash generation requirements, including by exploiting the low price environment to acquire assets and companies that fit and disposing of assets that no longer meet strategic objectives.
Evolving government policies to encourage companies to create value, jobs, and tax revenues, including by changing fiscal terms to encourage investment and risk taking and by promoting collaborative behavior where a ‘me first’ approach has been a barrier (i.e. shared infrastructure).
We have been here before and survived. These types of events do not happen every day and represent not just a challenge but an opportunity, too. For those seeking to transform and grow their businesses, will there be a better time? Make the most of it.
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