January 19, 2018

Troubled Water Over Oil

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I’m sure you are aware that the oil price has fallen from over $100 per barrel to less than $50 since the middle of last year. This is bad news for some and good news for others.

But what has caused this dramatic and, it appears, unforeseen drop in the price of oil? You’ll find lots of discussion of this in the financial papers of course (see this Economist leader, registration required), but I prefer to look at things simply in supply and demand terms.

On the demand side we have slowing growth in China, deflation in the Eurozone and possible troubles with the new Greek government. There is also the fact that we are becoming more efficient at using refined fuels. This is likely to be a continuous process.

But it’s the supply side that has changed fundamentally. What we are seeing at the moment is effectively a staring competition between the US and Saudi Arabia. Shale gas production has expanded massively in the US over the last five years turning it from a net importer to a net exporter of hydrocarbons. Shale gas requires different processes and different drilling techniques to conventional resources, but has a very short life cycle. This means that the marginal cost of production can fall quickly as new innovations enter the supply chain, and while some producers might find the new $45 oil environment a difficult one, others will not. It looks like US shale is here to stay. Saudi Arabia, the world’s largest producer, has said that it will not reduce production even if prices hit $20.

So what is next for the oil and gas industry? Just this week Afren, a small AIM-listed exploration and production company, saw its shares fall by more than 70% in one day on the news that it might not be able to meet its debt obligations. The company looks ripe for takeover and a wave of consolidation in the industry might follow, similar to that seen at the end of the last century. Anyone who has been making cash flow forecasts based on oil at $100 will find that their numbers just don’t add up any more.

The good news for them is that the oil price is notoriously volatile. The cobweb model of supply and demand dynamics can help predict what might happen in the future. Lower prices now will result in lower investment in future production making future prices higher than they otherwise would be. These higher prices will stimulate investment, making future supply higher than it otherwise would be, which will cet. par. result in lower prices again. It’s a never-ending cycle. Don’t forget that oil prices were around $10 for most of the 1990s…

 

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