Investigating the implications of low oil prices
Rhiannon Garth Jones talks to Neil Atkinson about the International Energy Agency’s latest annual report on the price of oil and considers the implications for future investment.
It has been hard to miss the dramatic decline in oil prices since June 2014 – from more than US$100 a barrel for Brent crude to around US$41 at the time of press, briefly dipping as low as US$26.21 in January. Almost US$150bln in the value of oil and gas company bonds has been lost over that period. At this point, there is some consensus among industry analysts about the causes of that collapse, but nobody seems confident about what the future will look like. The International Energy Agency’s (IEA) Medium Term Oil Output report, released on 22 February, stated in its introduction that ‘attempting to understand how the oil market will look during the next five years is today a task of enormous complexity’.
It added, ‘Some certainties that have guided our past outlooks are now not so certain at all – that oil prices falling to 12-year lows will lead to a strong demand growth spurt, that oil prices falling to 12-year lows will lead to a mass shut-in of so-called high cost oil production, and not least that oil prices falling to 12-year lows will force the largest group of producing countries to cut output to stabilise oil prices.’
So far, none of those ‘certainties’ have proved to be true – the world (and, particularly, China’s) economy have not required more oil, American light tight oil (shale gas) companies, presumed to be high-cost producers, have dramatically cut their costs, while Russia and OPEC-members, led by Saudi Arabia, have refused to cut their respective outputs. That has led to the IEA cautiously suggesting that we could be ‘in a new era of lower oil prices’.
The new reality
Neil Atkinson, editor of the report and the Head of Oil Industry and Markets at the IEA, described the American shale industry focus on cost and procedures as laser-like, noting that production only slipped below the year-earlier level for the first time in December 2015 and that, while the number of US drilling rigs dropped from more than 1,500 at peak to 440 earlier this year, oil production has not fallen nearly as quickly as the rig-count would suggest. He observed, ‘Instead, the shale industry drew on its experience during the rush to improve well performance, with initial production rates up to 23% higher than in 2015. Best practices, more efficient rigs and a severe squeeze on service and material spending have continued to reduce well costs, with companies reporting savings of 25% to 30%.’
The IEA expects a 50% reduction in shale oil well completions this year from 2015, but Atkinson believes the flexibility and cost-consciousness of shale operators leaves the industry ready to shift back into high gear relatively soon when higher prices allow. ‘Only fundamental changes in technology or process can lower unit costs for good. Despite continued technological improvements, our World Energy Outlook New Policies Scenario sees production costs rising in real terms to 2040 as oil producers develop ever more technically challenging (and generally smaller) reservoirs.
‘But when prices do recover, producers might see a more certain return on investment, and sooner, if they focus on additional recovery from existing fields or smaller-scale modular development of new discoveries, rather than pursuing vast, expensive megaprojects.’
While the low prices are forcing producers to trim their expenditures and focus on more efficient processes, they are also causing a decline in capital investment. In 2015, the IEA saw a 24% drop in global capex, and this year it expects a further decline of 17% – the first back-to-back annual declines since 1986. Atkinson says that, ‘The cutbacks are mainly concentrated in high-cost projects in countries such as Canada, Brazil and Russia. However, the cuts are not limited to capex – operating expenditure is being cut even in lower-cost areas such as the Middle East. Such are the budgetary pressures affecting their economies that oil industry cutbacks are necessary to fund politically important social expenditure.’
This retrenchment, Atkinson believes, will lead to slower oil supply growth around the world. The report anticipates global oil demand growing by an average of 1.2mb/d to 2021. To satisfy this growing appetite, he forecasts, ‘Investment must be made both to sustain existing oil production and to provide the necessary new capacity. If the investment cutbacks continue for even longer than we currently anticipate there is a risk that oil prices will rise sharply upwards, threatening economic growth.’
A renewable future?
When asked what the impact of the 2015 United Nations Climate Change Conference’s (COP21) commitment to further reduce carbon emissions might have on capital investment, Atkinson acknowledged that ‘the transformation inherent in the commitment agreed at COP21 represents a profound challenge to a fossil-fuel dominated energy system. For one, our World Energy Outlook’s 450 Scenario, which posits policies for limiting greenhouse gas emissions, shows that oil prices will, in all probability, be lower. Upstream megaprojects will very likely face considerably higher risks, while the sector will find it harder to attract new skilled professionals.’
However, he makes clear that ‘a secure and least-cost shift to a low-carbon future via a demand and emissions trajectory, like the 450 Scenario, still requires continued large-scale investment in oil and gas’. Even if demand for oil declines sharply and that for gas increases only moderately during the transition, investment will still be needed to compensate for the two-thirds decline in output from current fields, a far more rapid decline that anything the IEA has seen (or considers foreseeable) on the demand side.
Finally, he noted that a particular hazard for oil and gas companies could lie in inconsistent climate-change policies, which would lead to substantially more market disruption, price volatility and a higher risk of stranded investments for the industry. There appear to be few certainties in the current oil and gas industry except that things could remain unpredictable for some time to come.
To read more about the 450 Scenarios or further IEA reports, please visit bit.ly/1UlEXFR