The slippery slopes of oil prices

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As oil prices plummeted – reaching the lowest levels in over 10 years in January 2016 and causing mayhem in worldwide markets – the view on the future oil price development has become gloomier than ever. Most forecasts set prices at lower than 60 USD per barrel even by 2018, and not ruling out lows of around 20 USD per barrel in between.

What the market coverage on oil development fails to address is whether there is something fundamentally different at stake: what if we are indeed seeing the emergence of a “buffered” market?Looking up “buffer” in a dictionary, the Merriam-Webster defines it as a means used as a cushion against the shock of fluctuations in business or financial activity. And a cushion to break the fall is exactly what is needed in the rollercoaster ride that is oil pricing today. We believe in a buffer in the form of light tight oil (LTO) production from shales in North America.

In a recent perspective, QVARTZ puts forward the thesis that US unconventional oil development, in particular LTO production, will behave as a buffer and practically cap oil prices within a corridor of USD 30 to 70 per barrel for the next 10 years.

What would be the required characteristics of an LTO buffer? In our view, it would have to garner a few critical characteristics: volume & scope, flexibility & adaptability as well as resilience. The volume and scope of light tight oil production has time and again proven to exceed analysts’ expectations. With LTO production growing at 40% CAGR in the last few years, and break-even prices declining at a steep pace (within the 30-70 USD per barrel corridor and declining), current levels of volumes and costs support the thesis of an LTO buffer.

In addition, driven by the current low price environment, operators have significantly improved efficiency, and their focus on higher well productivities has led to a relatively stable overall LTO production in the face of the oil price crash – with rig counts at less than 30% compared to that of a couple of years back.

Moreover, a unique constellation of onshore operators, service companies and venture capital combined with their entrepreneurial business acumen, has given the industry significant flexibility and adaptability. This has enabled the industry to quickly build up, mobilise and relocate, scaling down supply chains, infrastructure and labour as needed – leading to a similar output behaviour in terms of production levels.

The abovementioned elements give the US LTO industry a large measure of resilience to navigate the storm and emerge from the current price climate – stronger, leaner and even more relevant, determining the industry dynamics for years to come. This resilience has been seen once before, through the cycle of natural gas shale production: from a spur of activity when prices were high to a rapid mobilisation towards liquid-rich plays a few years later.

“The volume and scope of light tight oil production has time and again proven to exceed analysts’ expectations”.

What then, would the implications of an LTO buffer be? Well, expensive unconventional oil sources such as oil sands, harsh environments like the Arctic, ultra-deepwater and deepwater will continue to suffer from pulled investments. This is already affecting investment plans in for example Canada, GOM, Brazil, Mexico, West Africa and the North Sea. Decommissioning in mature, expensive offshore regions will accelerate (the North Sea, selected Southeast Asia and GOM).

Meanwhile, closing down the production of expensive fields will be a must, and valuations of companies will suffer significant corrections in the next couple of years as assets in their portfolio get revalued to the new normal. Could anything shift the corridor limits outside of the USD 30-70 per barrel brand? Yes, but it is highly unlikely. It would require decisive concerted action from OPEC and non-OPEC producers or a major demand upsurge. We believe that the future of oil holds a buffer made up of light tight oil, and that this US unconventional will flip oil price fundamentals on their head.

WHAT IS LIGHT TIGHT OIL?

Light tight oil is produced from shales (which are the “kitchen” where all hydrocarbons were cooked from organic deposits when exposed to high temperatures and pressure through the geologic ages). In order to produce oil from shales, alternative techniques like horizontal drilling and fracking are required (while for conventional oil fields, drilling simpler, vertical wells without additional stimulation is sufficient to produce the oil). This adds to the cost of development, but the industry, through factory mode, has developed through a steep learning curve how to produce these difficult-to-extract resources in an economical manner.