Bauer Executive Professor Chris Ross Offers Insight
The best way to predict the future of oil and gas is to look to its past, according to Chris Ross, an executive professor of finance at Bauer College of Business and a longtime consultant to the industry.
Ross outlined his thoughts at the first of the year for the Forbes website, detailing the ways the energy industry’s historical boom and bust cycles, based on supply and demand, provide a platform for making informed judgments about what to expect going forward.
In the January 5 article, Ross looked in detail at the price collapse of 1986, and events that took place over a subsequent “slow grind” that endured until oil prices began ramping up in 2002. He likewise examined deregulation, technology innovations and other factors influencing supplies of natural gas, which ultimately had a price collapse in 2009.
Ross came to a conclusion — which he still holds to — that history won’t repeat itself, exactly, despite lessons learned from those previous cycles. This time around, the long grind for oil prices may be closer to five years, rather than 15, he says.
Ross points to considerable turmoil in the Middle East and Africa that is keeping oil supplies down.
Additionally, he wrote in the Forbes piece, “OPEC’s agreement to reduce production with apparent support from Russia will be tested by inducing expansion of U.S. shale production. But the need for cash to meet social commitments is likely to reduce funding available for capital spending by the national oil companies and will lead to lower production, regardless of the OPEC quotas.”
And while demand grew for natural gas as it displaced coal under the previous administration, “Natural gas will have to compete with coal more on price than on cleanliness,” Ross said, given that the Obama administration’s Clean Power Plan is widely expected to be eliminated.
“Expect natural gas volumes to grow but prices to remain capped by coal through the mid-2020s,” he wrote.
“All things being equal,” Ross said, price increases in both the oil and natural gas sectors are likely to materialize by 2019.
“My strategy recommendation was really to remain conservative financially and drill within cash limits for upstream and I still think that’s appropriate. Several companies are, in my opinion, getting a little past their headlights, accelerating activity in advance of a great deal of confidence that oil prices will be high.
“Going forward we can say if the industry in total shows undue exuberance they will cause oil prices to come back down again.”
By Julie Bonnin
Here, Ross offers a detailed revised forecast.
Oil prices have been depressed since 2014 by growth in production from U.S. shale plays, and consequent rising global oil inventories. The IEA Oil Market Report (OMR) has been tracking elements of supply, demand and inventory levels monthly and is beginning to see light at the end of the tunnel (Figure 1). The pace of inventory building declined in 2016 and the most recent OMR estimates a significant draw down over the second quarter of 2017 as restrained production from OPEC and Russia have held supplies below demand. If this estimate is confirmed with hard data, the trend would over time remove a heavy shadow from the oil market.
Building on the OMR data, further reasons for cautious optimism regarding higher oil prices are emerging. OMR is projecting global oil demand to grow by more than 1 million barrels per day in 2017; if this growth rate continues, demand by 2020 would be about 7 million bpd higher than in 2015, and would stretch oil supplies to their limit and would challenge the sustainability of the current 2020 Brent Crude Oil futures price of around $55 per barrel (Figure 2).
Many existing oil fields are mature and production is in decline: If Brent prices remain around $55 per barrel there will be limited new investment to slow a decline of about 5 million bpd between 2015 and 2020.
At a price of $55 per barrel, higher drilling activity could be expected to increase U.S. light tight oil (LTO) production to about 3 million bpd higher in 2020 than in 2015, but given the drastic reductions in capital investment in 2015 and 2016, global deep water production and other smaller contributors would add only about 2 million bpd. Together, they should roughly match the decline in mature field production.
If this scenario were realized, the call on OPEC crude oil to meet all global oil demand growth will rise from 30 million bpd in 2015 to 37 million bpd in 2020, and OPEC crude oil market share would rise above pre-2015 levels. OPEC could reverse its production restraint in 2018 and oil prices would rise above $55 per barrel to stimulate further growth in LTO drilling and production required to meet demand growth. Higher oil prices would also increase cash flow in the integrated major oil companies, allowing resumption of investment in deep water prospects, but increased production from these new projects would not be realized until after 2020.
The oil market over the next few years will likely continue to be volatile as participants try to balance growth in demand with growth in supplies. Price volatility will be fueled by uncertainty and conflicting news stories on numerous market drivers:
- Can technology advances reduce the decline rate in mature fields economically at a $55 per barrel price point?
- How price elastic is U.S. LTO supply? Will drilling and fracking equipment and crews be mobilized fast enough to provide the required growth? When will the weight of declining existing wells exceed producers’ ability to bring on new production from new wells?
- Will OPEC and Russia choose to focus on restoring market share or achieving higher prices?
- Will production shut in by internal strife in multiple countries (Libya, Syria, South Sudan, Venezuela, Nigeria) be restored?
- How much of recent demand growth reflects China’s build-up of strategic oil reserves rather than increasing consumption of petroleum products?
- Will harsh U.S. rhetoric on trade restrictions translate into policies that lower global economic growth?
- Will a roll-back of burdensome regulations and tax reform in the U.S. result in higher global economic growth?
- At what price level will there be a demand response due to reduced driving and lower economic growth?
- At what price point will activity in deep water field discovery and development accelerate?
Looking back to the past again, global oil consumption grew by 5.4 million bpd between the oil price collapse of 1986 and the year 1991; OPEC (mainly Saudi Arabia) increased production by the same amount, restoring their production to 1982 levels and continued raising production in the 1990s, dampening any chances of price recovery. This time, OPEC has voluntarily reduced production by around 1.5 million bpd from its peak crude oil production in late 2016 and has limited spare capacity to raise production beyond that peak. There remains considerable uncertainty on oil prices through 2018 and oil-focused companies would be well advised to maintain expenditures within cash flow from operations, but to watch closely the drivers listed above and develop options to accelerate activity.
U.S. natural gas markets will be amply supplied through 2020, and U.S. LNG exports will continue to contribute to an over-supplied international market. In 2016, the market was balanced through increased deployment of floating regasification units to make short term, relatively low price sales to countries with lower credit than traditional Asian and European customers. Independent LNG project developers are finding it difficult to negotiate long term contracts with creditworthy customers and consequently are encountering difficulties in financing their permitted multi-billion dollar projects. A shift from bust to boom in LNG prices could result after 2020 and gas producers should consider making deals with developers and LNG customers that will facilitate financing of the most advanced projects to assure “security of demand” for their production.
The scenario described above would be quite encouraging for the oil and gas, oilfield services, midstream and downstream sectors with multiple opportunities for profitable growth if they can maintain capital discipline and control over costs.
By Chris Ross