April 4, 2020 - Nom Geo
Oil prices are set to skyrocket later this year and here is why…
Under the pressure of delayed oil field projects and an expected bounce of demand in a post-COVID19 world, oil prices have only one way to go from here – and that is up!
Historically, the lowering of the price of crude oil resulted in increased consumption of gasoline and diesel and a fall in investments in new oilfield production. This ultimately led to a tightening of supply and a return to higher prices. Because of the impact that prices have on demand, most major oil companies would prefer an outlook that lies in between the high and low price poles. The advantage an oil major would have is that it has the capital and scale to benefit from both high and low price scenarios. However the most desirable equilibrium lies in the mid-price ranges of $60 to $90 per barrel. A low oil price has the effect of avoiding a flood of competing projects by smaller competitors, and because majors take a long term outlook, these periods of low prices afford them opportunities to snap up new acreage and fields as well as the all-important share-buybacks that accompany hard times. Conversely, very high oil prices result in capacity bottlenecks among engineering providers such as platform fabricators as well as placing a strain on mid-stream infrastructures that represent the all-important take-away capacity. These stresses are magnified by the elastic nature of demand which dampens consumption whenever prices are high and drives consumption in periods of low prices.
Large oil price fluctuations can also be magnified by time lag for the adjustment in supply capacity. In times of low price, cash strapped nationalized oil companies try to retain market share (a tendency which led to the formation of the OPEC price cartel). In times of soaring prices, new supply which can take years to build, is developed to capture the higher prices often risks missing the boat.
Most conventional oilfields are able to produce crude oil at well under $35 per barrel; In fact the average for Africa and the Middle East is likely to be closer to $10/ barrel. But despite low production costs, the key issue for nations in these regions is the over-reliance by most governments on oil money; as the profitability window shrinks, so too do their national revenues.
Large conventional oilfields take years (5 years at least) to develop and require huge upfront investments where cost-recovery necessitates the immediate start to production regardless of market prices. While operating and capital costs per barrel are often 20 to 50% that of shale, the imposition of exorbitant royalties along with political interference in underdeveloped producer nations often places them at higher risks.
Shale on the other hand is able to respond rapidly, usually in timeframes of half a year. In the USA and Canada these are uncoupled from government interference, which allows most shale operators to drill new wells in anticipation of the right moment to proceed to completion (hydraulic fracture) and then to production at the wellhead. This inventory of Drilled Uncompleted Wells (DUCs), mainly in Texas, Oklahoma, North Dakota and New Mexico can be likened to a loaded and cocked gun aimed at oil markets. Bringing DUCs on-stream is timed to coincide with desired market price and demand signals. Unlike their conventional counterparts, shale investments are incremental by nature and capital costs are rapidly recovered or written down. Wells range from $1m up to $10m in terms of upfront costs and often produce over 50% of their reserve in 3 to 5 years.
The risk profiles of different oil field projects translates into different calculations concerning the time-value of the upfront capital and this may be another factor that has driven up shale production in the US oil patch. In this regard, the ability to build up an inventory of DUC wells and the incremental nature of development can be counterbalanced against the higher cost to bring the crude to the wellhead. While large offshore oilfields can achieve breakeven under $30 per barrel, shale producers struggle to breakeven at less $45 per barrel, or even higher. As such, venture capital tends to flee the USA’s shale oil patch whenever oil prices fall lower than $50 per barrel.
The current low prices will be disastrous for many operators – but there will be an uptick in the mergers and acquisitions space in the USA, Canada, the UK and Norway.