"Lower for Longer" - Again

The oil industry doesn’t want to hear these messages.

Two years ago the idea that global oil prices would be “lower for longer,” espoused by various energy company CEOs, was considered unrealistic by most in the industry. After all, it had just come off a multiyear span of $100 a barrel oil prices. Drilling was up. Oil output was soaring.  Profits were growing. Oil company stock prices were higher. Everyone was happy. 

            Or they were until Saudi Arabia and its fellow OPEC members decided to let the market determine oil prices. Ironically, OPEC’s decision was made on the morning of America’s Thanksgiving Day, a day when people give thanks for the bountiful harvests they are experiencing. But “lower for longer” – no way!

            For the industry, the shift from being thankful to being scared to death required barely 90 days. CEOs such as Bob Dudley of BP, Lance Ryan of ConocoPhillips and Paal Kibsgaard of service provider Schlumberger espoused the “lower-for-longer” view. They moved quickly to cut spending, lay off employees and batten down the hatches as they readied their companies for an extended period of low prices and significant financial and organizational pain. 

            Others remained confident that Saudi Arabia would eventually step up and save the industry from itself. That would enable American E&P companies to continue growing their production regardless of whether it was economic or not. Many oil executives could not imagine that, in less than two years, the industry would lose hundreds of thousands of jobs and billions of dollars in shareholder value while curtailing spending and often seeking court protection from creditors. 

Phoenix-Like Oil Prices

Starting this February, oil prices, just like the Phoenix of Greek mythology, began rising from the ashes. From $27 a barrel they marched steadily higher to $50, at which point they took a breather. The remarkable rise brought sunlight to dispel the black clouds overhanging the industry. People felt prices were on the road to $80. Returning to $100 a barrel was considered possible – it was just a matter of months. 

            Between February and September prices seesawed back and forth between $40 and $50 a barrel. As prices oscillated, so too did oil executives’ emotions. In mid-September, as oil prices retreated after failing to pierce the $50 barrier, the International Energy Agency issued one of its monthly reports announcing that “global oil demand growth is slowing at a faster pace than initially predicted.”

            While most industry eyes are focused on output and inventories, demand is a critical ingredient in balancing the global market and paving the way to higher prices. The IEA cut its projection for 2016 by 100,000 barrels to an increase of 1.2 million barrels a day, down from its prior estimate of 1.3 million. 

            For perspective, after experiencing year-over-year growth of 2.3 mmb/d in the third quarter of 2015, demand only grew by 1.3 mmb/d in 2015’s fourth quarter. That softness was erased in the first quarter of this year as demand growth rebounded to 1.6 mmb/d, buoying industry hopes for continued expansion. However, in the second quarter, growth fell to only 1.4 mmb/d and is now projected at only 1.2 mmb/d for the third quarter. 

            While many analysts, including the IEA, had targeted a balanced supply/demand scenario by the fourth quarter of 2016, or at least in the first half of 2017, those projections now appear optimistic. In fact, the IEA cut its forecast for 2017 growth by 200,000 b/d to an increase of 1.2 mmb/d. Resolution of the oil glut has been pushed further out.

            The lower IEA projections reflect the ongoing global economic weakness forecast by the IMF, whose reduced growth forecasts encompass the expected fallout from this summer’s U.K. vote to exit the European Union along with the continued terrorism and immigrant crises in Europe. Japan’s economy remains stuck in neutral despite the aggressive monetary easing operations of the Bank of Japan while economic data for the U.S. show its economy mired in a slow-growth mode. 

            The final nail in the coffin comes from China, where the economic miracle that has driven global growth for a number of years is sputtering. Chinese policy leaders are struggling to shift the economy’s emphasis from investment to consumption, and there are few signs this shift is helping speed up its economy. 

Whither CapEx?

Another sour-tasting message the IEA delivered to the oil business was its forecast that industry capital spending would fall in 2017 for the third consecutive year. After dropping by 25 percent in 2015, the IEA now estimates spending this year will fall by another 24 percent, up from its earlier estimate of 17 percent. The two-year decline has taken $300 billion out of the industry, leaving it with only an estimated $450 billion. The IEA’s message this month is that it expects oil industry capital spending to fall further in 2017, possibly below $400 billion, thereby cutting spending in half over three years. 

            As the IEA wrote in its report, “There are no signs that companies plan to increase their upstream capital spending in 2017.” It went on to state, “Many operators have revised downwards their 2016 capital spending guidance throughout the year and, as of September 2016, they plan to maintain 2017 investment at 2016 levels.” That is why the IEA believes companies could further cut their 2017 spending. 

            More optimistic, however, was the midyear exploration and development spending survey of investment banking firm Barclays. The energy analysts there see the possibility that E&P companies may actually boost their 2017 spending by three to eight percent, centering their projection on a five percent increase. Barclays, unlike the IEA, expects the 2016 decline will not be as great as its earlier survey projected. It now sees 2016 spending falling by only 22 percent, less than their prior estimate of 27 percent. 

            Despite a more optimistic spending outlook for 2017, however, when the Barclays’ analysts ran their company earnings forecasting models they concluded that overall estimates remained too high. The improved capital spending outlook will be offset by lower company earnings estimates, which will weigh on stock prices. 

            The message the industry was pleased to hear was that the capital spending reductions, which had translated into an all-time low in drilling activity, were taking a toll on global oil and gas reserve growth. According to oil consultant Wood Mackenzie, in 2015 the oil industry discovered the fewest reserves since 1947. So far this year the industry has drilled only 200 exploratory wells, less than a quarter of the number drilled in the least active year since 1960. 

            Wood Mackenzie suggests that these outcomes stem from the dramatic price collapse over the past two years and will haunt the industry – and likely the global economy – in five to ten years’ time as oil prices jump in response to limited output. That is certainly music to the ears of oilmen, but how many of them will still be in business ten years from now?

Social and Political Pressures

Not only is the oil and gas industry struggling to right its business model, it’s being pressed by social and political pressures to stifle the use of its products. The push for a greener energy world with increasing amounts of the planet’s power coming from renewable sources will further squeeze the fossil fuel industry. Hurdles remain for renewables to achieve the goal of ending fossil fuel use, but with every passing day there is progress in reducing power storage costs while improving electric grid performance. 

            Transportation still remains the preserve of fossil fuels, but the electrification of the world’s automobile fleet will increase, eroding the need for gasoline and diesel fuel. Additionally, many countries are mandating greater fuel-efficiency from internal combustion engines as they address their pollution challenges. Without a revolutionary breakthrough in battery storage technology, however, the pace at which renewables displace fossil fuels will likely not accelerate even though spending on renewables is ramping up. People don’t want to spending five days flying across the Pacific Ocean in a solar-powered plane, regardless of its minimal carbon emissions!

The Search for New Axioms

“Lower for longer” was not a message oil industry executives wanted to hear in January 2015. Hearing it again in September 2016 is no more welcome. Dealing with this emerging new reality requires that managers accept that what was past may not be prologue. Understanding that accepted axioms about how the world and industry work are no longer true is a challenge. Discovering the new axioms becomes critical. 

             The greatest challenge for oil industry executives today is determining just how much their businesses have changed and what that means in terms of new strategies. This requires an open mind because “out-of-the-box” thinking is necessary to uncover the new axioms. It’s especially critical during periods of historical reordering of an industry, such as the oil and gas business is currently going through. – MarEx