Lazard Insights
The Evolving Global Oil Market Peter Hunsberger, Managing Director, Research Analyst Eugene Krishnan, Senior Vice President, Research Analyst
Summary • Oil prices have plummeted in recent months due to slowing global demand, increased North American supply, and changes in Saudi Arabia’s priorities. • US shale producers have contributed strongly to output on the back of technical innovation that has led to more efficiency and productivity. However, it is important to assess the breakeven costs of these producers, which differ across regions. • Despite current low prices, wells that are already in operation are unlikely to cease production unless prices decline significantly from present levels. • M ajor oil exporters, including OPEC nations and Russia, are the clear losers while consumers and large oil importers will benefit from low oil prices. In the long run, oil markets are self-correcting, as lower prices lead to declining supply.
Oil Prices Have Plummeted Oil prices declined sharply in recent months. As one may expect, there are multiple factors at work. In this paper, we discuss three key reasons for lower oil prices including: slowing growth in global demand, increasing supply, particularly in North America, and Saudi Arabia’s role in setting prices. Oil prices began the last decade near $20 per barrel (bbl) and then moved progressively higher until 2009, when the financial crisis occurred. Prices then plateaued near $110/bbl for the three years from 2011–2013 and remained near these levels through mid-2014. However, since June 2014 oil prices have plummeted, with prices declining about 40% from $115/bbl to approximately $70/bbl in early December (Exhibit 1). This sharp decline has reminded investors that despite the relative stability of the past three years, oil prices can be very volatile. Exhibit 1 Oil Prices Have Plunged Since June 2014 Brent Crude Oil ($/bbl) 150 100
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50 0
2000
2002
As of 1 December 2014 Source: Haver Analytics
2004
2006
2008
2010
2012
2014
2
It is important to realize that global oil demand (which currently stands at approximately 93 million barrels per day [mmb/d]) is a function of global economic growth.1 GDP growth has been weaker than expected, particularly in China and Europe, which has weighed on oil prices. However, it is important to note that demand remains robust: demand growth is weaker than expected but is still positive. After declining for more than twenty-five years, US oil production reached a trough in 2008, at approximately 5 mmb/d. Since then, oil production has boomed in the United States. In 2013, US oil production was nearly 8 mmb/d and today, the United States produces approximately 9 mmb/d (Exhibit 2), an astonishing 80% increase in a five-year period. Moreover, natural gas liquids (NGLs) add another 3 mmb/d of liquids production, bringing the total US oil and NGLs output to 12 mmb/d. To put this number into perspective, two of the historical giants in oil production, Russia and Saudi Arabia, produce 10.6 and 9.6 mmb/d, respectively.2 The increase in US oil production represents a major change following years of declines and is proving to be more disruptive to world oil markets than many had anticipated. Supply has also increased outside of North America, though by a lesser amount. Libyan output, which has been derailed for the last two years due to political unrest, has resumed in recent months, adding 800 to 900 thousand barrels per day of incremental supply to world oil markets. However, Libya continues to experience significant turmoil, and it is not clear whether production will pull back to 200 thousand barrels per day, a trough reached in May, or increase toward its normal level of 1.4 mmb/d in the coming months. Also adding to global supply is Brazil’s pre-salt oil production, which is oil found nearly 20,000 feet below the surface of the sea that requires drilling through a layer of salt that can be more than a mile thick.
US Shales Are a Game Changer for Oil One may wonder why US shale producers have been able to deliver so much production growth. First, shale formations have low geologic risk, as opposed to Brazil pre-salt oil production for example, and deep resource potential. Second, the growth in shale oil has been facilitated by two key technologies, horizontal drilling and multi-stage fracking. Costs continue to decline as the industry establishes best practices for drilling and completing wells, which is the process of making a well ready for production. Most “plays” (i.e., oil fields or prospects in the same geographic region) require an oil price roughly at $80/bbl to justify their costs. However, some shale plays are profitable at $70/ bbl or lower. Some key oil shale plays in the United States include the Bakken (in North Dakota), Eagle Ford and the Permian Basin (in Texas), and Niobrara (in Colorado). To illustrate some of the economics behind shale oil, Exhibit 3 shows the estimated oil prices needed to produce a 15% internal rate of return (IRR) across various oil shale plays. These estimates are based on the economics of drilling an incremental well on existing land positions. It is important to note that virtually all US plays produce a 15% IRR at prices below $80/bbl and the majority of plays can work at prices below $70/bbl. The marginal high-cost portion of global oil supply today, which still requires prices of $95–100/bbl or more to be profitable, is generally located outside the United States.
Exhibit 2 After a Twenty-Five-Year Decline, US Production Is Inflecting Higher (mmb/d)
Forecast
12 10 8 6 4 2
2000 2002 2004 2006 2008 2010
2012 2014E 2016E 2018E 2020E
As of 2013 Estimated or forecasted data are not a promise or guarantee of future results and are subject to change. Source: Credit Suisse, EIA
Exhibit 3 Many US Shale Plays Remain Attractive Near Existing Prices WTI Oil Breakeven Price at 15% IRR* Marcellus Shale—Super Rich Mississippian Lime Eagle Ford—Liquids Rich Marcellus Shale—SW Liquids Rich Niobrara—Wattenberg Utica—Liquids Rich Bone Spring (1st/2nd)—NM Yeso Uinta—Wasatch (V) Wolfcamp—Midland (Horizontal) Wolfberry Bone Spring (3rd)—W TX Bakken Shale/ Three Forks Sanish Uinta—Green River Granite Wash—Liquids Rich Horizontal Cana Woodford Shale Cotton Valley Horizontal Avalon Shale—NM Barnett Shale—Southern Liquids Rich
Eagle Ford Permian Bakken
0
30
60
90 ($/bbl)
* The oil breakeven price noted above includes all costs other than land. Estimated or forecasted data are not a promise or guarantee of future results and are subject to change. Source: Credit Suisse Estimates
Evaluating some of the specific plays more closely, we find that the Eagle Ford play has one of the lowest oil prices with a 15% IRR, only requiring a price close to $50/bbl. The Niobrara Wattenberg play also has a low breakeven price along with many of the Permian Basin shale plays such as the Bone Spring and Wolfcamp, which require oil prices near $60/bbl. In summary, most top-tier US oil shale plays are profitable near recent prices of $65–70/bbl. Therefore, wells currently in operation are unlikely to cease production unless prices decline significantly from current levels.
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The breakeven oil prices noted earlier, speak to the economics of drilling an incremental well and should not be confused with cash operating costs, which are much lower. We would not expect to see production shut down unless oil prices reached a level closer to $45/ bbl, where most oil operations would become unprofitable.
Technology Has Enabled Shale Oil Plays From a longer-term perspective, global exploration and production capital spending, displayed in Exhibit 4, increased significantly over the last fifteen years. However, the effectiveness of capital expenditures (capex) has varied by region. For example, global capex increased almost threefold over the last ten years, leading to a 15% increase in global oil production. By contrast, in the United States, capex has roughly doubled over the last five years, but US oil production growth has increased approximately 80%—a much more efficient use of capital. The last time we saw an oil price decline as significant as the current one was in 2008, when oil dropped from $140/bbl to $35/bbl for a short period. As a result, in 2009 global capex dropped 15% and US capex dropped 35%. Investments in technology by US producers have led to a significant increase in oil production per well, but perhaps more important, wells have become more productive each year. Before shale drilling was common, oil recovery per well was close to 150 thousand barrels per day; now it is closer to 500 thousand barrels per day (Exhibit 5). In our view, productivity improvements should continue as many US-based producers are increasing the intensity of drilling, with more horsepower, more sand, and longer wells. The combination of these factors means more perforations are made per well, thus increasing productivity. Producers continue to experiment calibrating the intensity of these variables. In addition to increasing output per well, new technologies have reduced the cost per well. The cost curve of US shale has been consistently falling, and we expect it to continue to decline because the
horizontal drilling and fracking of known reserves leads to a much higher drilling success rate. This means that US oil producers can use more manufacturing techniques to improve costs. The number of days to drill a well has also consistently declined largely due to more efficient rigs that can mobilize across wells faster, reducing this time from days to hours. Lastly, cost per well has also decreased as overhead costs can now be shared (Exhibit 6). A technique known as pad drilling has enabled these cost efficiencies. Whereas four years ago one might have only drilled one well per site, companies can now drill four to six wells
Exhibit 5 Continued Technical Innovation Has Resulted in Increased Productivity (Boe/d) 525 2014 2011
2013 2010
2012 2009
350
175
0 0
10
20
30
40
50
60
70 Month
As of August 2014 Source: HPDI
Exhibit 6 Drilling Costs Are Declining as Efficiency Improves Spud-to-spud days 48 32
Exhibit 4 Global E&P Capital Spending Has Increased Significantly
16 0
($B) 800 600
Outside North America Canada United States
2011Q3
($M) 15 10
400
2012Q1
2012Q3
2013Q1
2013Q3
Completion Costs Drilling Costs
5
200 0 1985
2011Q1
0 1989
1993
1997
2001
2005
2009
2013
2012Q1 2012Q2 2012Q3 2012Q4 2013Q1 2013Q2 2013Q3 2013Q4
As of March 2014
As of November 2014
Data for Bakken shale.
Source: Company data, Barclays Research
Source: Hess
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in different directions from the same well site, using rigs with greater mobility and sharing operating crews. We have not seen the success with shale replicated outside of the United States, largely because the infrastructure in terms of equipment, logistics, and expertise, have not been developed, or resources such as water are not as readily available. The United States is also somewhat unique in that property owners also hold the mineral rights to oil beneath their land. This gives the owner an incentive to drill in spite of potential risks related to environmental degradation, noise, and traffic that might arise as a consequence. These conditions will take time to develop elsewhere, therefore we believe shale oil production outside the United States will not be built out in the near term.
Have The Saudis Changed Their Stripes? Historically, Saudi Arabia, together with Gulf allies United Arab Emirates (UAE) and Kuwait, have acted as “swing producers,” much in the same way as the US Federal Reserve acts to adjust monetary supply and interest rates to stabilize markets. For most of 2000 through 2014, the Saudis increased oil production if prices were deemed to be too high. During periods of weaker oil prices, the Saudis would cut production to reduce supply. The market became used to Saudi Arabia moderating prices as Brent oil approached $120/bbl and defending prices as they neared $90–95/bbl. Oil markets were unsettled in early October when Saudi spokesmen indicated that Saudi Arabia may be comfortable with a period of oil prices under $90/bbl and perhaps as low as $80/bbl. Many believed these comments indicated that the Saudis had become less interested in defending prices and more concerned about maintaining market share—a seismic change in posture compared to the past ten to fifteen years. The recent OPEC meeting (27 November 2014), which had no accord on production or quota cuts, confirmed the change in strategy from Saudi Arabia. There are several possible reasons for this transformation. First and most obvious is that Saudi Arabia may want to slow or derail the growth in production from US shale producers. Although breakeven oil prices are likely near $70/bbl or lower for the top-tier US shale plays, we believe that lower oil prices will succeed in slowing shale production, as weaker cash flows force capex discipline and higher-cost plays are shelved. We also believe there are other reasons why Saudi Arabia may be satisfied with weaker oil prices. While painful for Saudi Arabia, current lower oil prices will prove much more difficult for other OPEC members, including regional rival Iran. Moreover, Saudi Arabia may believe that a period of weak oil prices is necessary to force other OPEC players, such as the UAE and Kuwait, to cut production. Finally, lower prices are also a material negative for Russia, which has geopolitical interests sometimes at odds with Saudi Arabia. For OPEC nations, oil prices are critical for balancing fiscal budgets. Importantly, only Qatar and Kuwait have budget breakeven points below $90/bbl. Saudi Arabia and UAE require an approximate price of $90–105/bbl, well above current prices. The challenge of balancing
budgets at lower oil prices is more difficult for high cost producers such as Venezuela, Iraq, Nigeria, and Iran. In this context, it is not hard to understand why OPEC price hawks such as Iran and Venezuela were unhappy with the outcome of the latest OPEC meeting. Current low oil prices represent a significant hardship for many OPEC producers and Russia—not just for US shale producers.
Conclusion: Implications of a Low Oil Price World We expect some significant fallout in response to the plunge in oil prices. First, it should be noted that commodity markets can overshoot, both on the upside (as in first half 2008 when oil hit $140/ bbl) and on the downside (as in second half 2008 when oil fell below $40/bbl). In the near term, absent a real production cut from OPEC and/or Russia, there is no clear backstop for oil prices. Importantly, markets are still well above cash production costs, the point at which oil producers shut down because they are unprofitable. We do not expect North American production will be reduced meaningfully unless prices move closer to $45/bbl. Nonetheless, lower prices will result in sharply lower cash flows, forcing greater capital discipline, as well as lower spending and drilling. Over the near-term, production growth will slow or even reverse. However, in the long run, supply and demand in oil markets is generally self-correcting. In a low oil price world, major oil importers like China, Europe, and Japan obviously benefit. Consumers are also winners as cheaper gasoline and home heating oil increase discretionary spending power. Additionally, retail and consumer companies should benefit from increased sales and from lower input costs (to a lesser degree), while chemical companies and industrial users also benefit. Oil exporters, including OPEC nations, Russia, Norway, and Canada are the biggest losers. High cost oil developments are now also at risk (e.g., oil sands, liquefied natural gas, Arctic oil, and higher cost unconventional plays). Additionally, oil producing companies will be hurt, especially oil-tilted producers with higher production costs. Finally, we expect oil services to be negatively impacted.
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Notes 1 Source: OECD Economic Outlook, Haver Analytics 2 Source: EIA
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