Since the start of 2016, oil prices have swung between $27 and $42 per barrel, about a quarter of the 2008 peak crude oil price of $145. On February 16, oil ministers from Saudi Arabia, Russia, Qatar and Venezuela agreed to a tentative deal to freeze their production in an attempt to boost prices.
This was a characteristic move. For decades, this is how the oil business has worked. Producers carefully control production to try to match supply to demand. But there’s a lag between these decisions and their effects, creating the boom and bust cycles so typical in the business.
In reaction to this freeze, oil prices not surprisingly jumped five per cent. But the next day, they promptly fell back below $30. One week later, the oil minister of Iran, a country that had no intentions to join the freeze, and in fact still plans to double its oil production, called the freeze “a joke.”
Nobody really knows what oil prices will be in the future, but we think countries and companies should prepare for oil to hover around $50 per barrel for the foreseeable future. Historically, this wouldn’t be shocking at all. In fact, today’s oil prices that we think of as low are actually near the real average price of a barrel of oil for the last 150 years: $35 (2014 US dollar reference year).
What is surprising, though, is the fundamental shift we think is happening. The current low oil price environment is not an “oil bust” that will be followed by an “oil boom” in the near future. Instead, it looks as if we have entered a new norm of lower oil prices that will impact not just oil and gas producers but also every nation, company and person depending on it.
This new norm is the result of the oil business being disrupted.
In the past, it was assumed that conventional oil reserves would be developed by national oil companies and major oil and gas companies to supply virtually all of the world’s oil demand. And it would take them as long as 5 to 10 years to explore, develop and then bring production to market, after investing billions of dollars into new fields. These are some of the basic assumptions behind the model that has guided the oil and gas industry for decades.
But during the past decade, American shale oil and gas producers pioneered a new business model that shattered the incumbents’ approach. U.S.-based shale oil producers have improved their drilling and fracturing technology, and they can ramp up production in an appraised field in as few as six months at a small fraction of the capital investment required by their conventional rivals. As a result, shale oil has soared from about 10 per cent of total U.S. crude oil production to about 50 per cent. That has enabled the U.S. oil industry as a whole to produce roughly four million more barrels of crude oil every day than it did in 2008, closing the gap between U.S. oil production and the world’s other two top producing countries, Russia and Saudi Arabia. In January this year, the U.S. lifted the 40-year-old ban on exporting American oil, and the maiden shipments are finding their way to global markets, allowing U.S. oil producers to take advantage of markets that provide higher net-backs.
These “unconventional oil and gas producers” in the U.S. are acting as a quasi swing producer, the counterweight to traditional spare capacity held mostly by OPEC heavyweight Saudi Arabia. At the same time, several other countries such as China and Argentina are beginning to develop their shale oil and gas resources by adopting the technology and business model as well as building an investment and supply chain ecosystem that supports this development. Saudi Arabia, with its excess capacity, used to be a swing producer that could bring production on or offline to control market prices.
But now, that leverage is significantly reduced. If the price goes up, the disruptors can counteract the big producers’ decisions to cut production in a matter of months, rather than years.
That’s why the big producers’ decision to freeze production in February — completely predictable according to the old industry business model — was problematic. If traditional producers freeze production and allow prices to go up, shale disruptors will become competitive and simply rush in to fill the void and eat up their market share.
So what could a decade of lower oil prices mean?
New challenges for producers
Depending on how nations react, a lower per-barrel oil price could result in a new balance of power in the oil industry. We recently conducted a study to test the impact of sustained $50 oil on oil-producing countries.
The results showed that $50 oil puts some producing countries under considerable stress as they grapple with less oil revenue in their national budgets. Venezuela, Nigeria, Iraq, Iran, and Russia could be forced to address substantial budget deficits within the next five years.
Gulf Cooperation Council (GCC) producers such as Saudi Arabia, the United Arab Emirates, Kuwait and Qatar have amassed considerable wealth during the past decade through cash reserves and sovereign wealth funds. But even these countries could come under stress in the next decade if they continue to follow their status quo.
As a result, some of those better-off-but-still-threatened nations are gearing up to make a break from their past practices. The U.S. shale revolution will be difficult to replicate, but traditional oil producers such as Saudi Arabia are diversifying into shale-gas production and other forms of renewable energy so that they can diversify their energy mix and continue to export oil in spite of their soaring domestic demand for power.
Newcomers such as South Africa, China and Argentina are also getting ready to attempt to develop their reserves in a bid for energy independence. Argentina, which is furthest along, holds about 801 trillion cubic feet of shale gas and 27 billion barrels of technically recoverable “tight” oil reserves. China holds an estimated 1,115 trillion cubic feet of shale gas and 32 billion barrels of oil equivalent. By comparison, the U.S. has 622 trillion cubic feet of shale gas and 78 billion barrels of “tight” oil, according to the U.S. Energy Information Administration.
New gains for consumers
At the other end of the spectrum, net oil importing nations are benefiting from a significant boost to their fiscal strength and current account balance. India’s fiscal deficit has improved since the country saved nearly $70 billion on importing crude and other petroleum products in 2015. The government was able to reduce petroleum subsidies and increase its excise duty on petrol and diesel, and can now redeploy that $70 billion into productive efforts.
Energy-intensive industries ranging from farming to airlines are also profiting. Thanks largely to the decline in energy prices, the US airline industry is enjoying operating margins above 15 per cent, according to a recent economic analysis that our firm conducted. That’s a strong margin for any industry, but a particularly big deal for airlines that have struggled in years past to turn a profit at all.— HBR/GB