With Brent crude prices falling below $50, widespread trader views of continuing oversupply and massive cut-backs in the oil and gas industry, Shell has begun drilling in one of the world’s highest cost locations, endeavouring to tap the huge reserves of the offshore Arctic!
So what’s going on?
We all know, but often choose to forget, that the oil industry is an extremely cyclical business, the continuing victim of regional wars, global geopolitics and macroeconomics.
After nearly 20 years of subdued prices, oil convincing broke through $50 in the second quarter of 2005, surging to exceed $140 in summer 2008 before collapsing again to $40 during the global financial crisis.
This was followed by a long period at some $100 before the beginning of the US shale oil boom which sent the global market into a state of oversupply collapsing prices and this remains the case.
From 2008 to date, US production has grown by 90%, by an astounding 7.5 million b/d!
The real impact of low oil prices has been to force US shale producers to dramatically increase their efficiency. In effect, Saudi’s growth in production has strengthened its number one competitor.
US rig counts may have collapsed but production, despite slowing, has not and we expect it to average 14.5 mb/d in 2015. The US remains the world’s largest producer and stand-off between Sheiks and Shale continues.
Looking ahead, it is evident that Saudi, whose oil production hit a new record of 10.6 mb/d in July, holds the key to future oil prices. Crude oil accounts for 76% of Saudi exports and despite its huge foreign reserves the Saudi economy needs $106 oil – it is reported it used $65bn of reserves to fund spending and that 2015 could see a deficit of $130bn.
And Saudi is not alone; many of the OPEC producers also need $100+ oil.
In short, the numbers do not add up for Saudi. Assuming production costs of $15/bl, at today’s $50 prices the margin is $35. To return to the income equivalent of $100 oil would mean more than doubling production to more than 25 million b/d and that logistically is not realistic. So for Saudi, prices must ultimately rise.
Note that a few days ago Opec Secretary General Abdalla Salem El-Badri said they do not expect prices to fall any lower as demand picks up in 2016 and continues to grow through the end of the decade – a view we share.
So do the IEA. In its July report they state oil demand is set to grow 1.4 mb/d in 2015. But they note non-Opec production growth is slowing; from 2.4 mb/d in 2014, to perhaps 1.0 mb/d in 2015 before grinding to a halt in 2016.
Low oil prices are however bringing one benefit, a long overdue downward pressure on industry costs. Between 2000 and 2013 oil prices increased by 283% and industry expenditure by 281%, however, oil & gas production grew by a mere 24%! Projects are now being taken back to the drawing board and significant cost reductions achieved.
And what of Iran? Yes, there are huge reserves, but after years of neglect it is going to take time to bring them back onstream and the $185bn proposed spend on oil and gas projects will open a major new market for the international oilfield equipment and services industries.
So in this situation why is Shell drilling offshore Arctic? Oil and gas production is a long term investment often involving projects that will pay back over 10 to 30 years.
It is not based on the minute-by-minute actions of those trading paper oil.
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