Energy Consulting Group

Commentary on Declining Oil and Gas Prices

Early December 2014

Global Oil Markets

Oil prices have declined by more than 40% since peaking over this past summer.  The catalyst for this decline is twofold:

1)      Slowing Demand:  The global economy outside of North America appears to be slowing.  Especially, notable is the reported slowdown in China, which has long been a significant source of growth in oil demand.  As a result, the International Energy Agency (IEA) has reduced its estimates for demand growth for 2014 and 2015 from approximately 2.8 MMBOPD to about 1.5 MMBOPD.

2)      Robust OilSupply Growth:  As a result of this perceived slowdown, 2014 oil supply growth from North America is poised to outgrow 2014 demand growth significantly.  As a result, oil prices are being pressured, such that supply reductions are required to balance the market in the short term.  The agent of such intervention over the past four decades has been OPEC, and the large majority of market observers believed it would do so again as prices fell this fall.  However, OPEC’s leading member, the Kingdom of Saudi Arabia (KSA) decided not to pursue such intervention.  Three reasons are commonly referenced to explain their reluctance:

a.       Market share competition with non-OPEC sources of supply, which we take to be North American shale producers, especially in the USA.

b.      Geopolitical competition with Iran and Russia in places such as Syria.  Observers believe that KSA, because of its financial reserves, is better able to withstand lower oil prices than either of these rivals.  Indeed, Iran recently called KSA’s refusal to work within OPEC to help manage oil prices, “treacherous”.

c.       KSA is preparing the rest of OPEC, and perhaps even some non-OPEC exporters, for the possibility of joint cutbacks at some point over the next few months.

Of these three possible rationales, the competition for market share seems to be the main driver with the other reasons serving as, at best, secondary factors.  That being the case, our analysis indicates that oil prices will likely have to move below $60/bbl for 6-9 months before a significant slowdown in the growth of US oil production begins to occur.

Given the oil market imbalance, estimated by us and the IEA to be about 1.0 – 1.5 MMBOPD, prices are likely to continue to pull back unless one of four things happens, either individually or in combination.

1)       Demand growth - Reacceleration of demand growth back to between 1.3-1.5 MMBOPD per year or higher.  This seems a reasonable expectation given the extent of the oil price pullback, which should drive a significant, positive demand response.  Unfortunately, because of concerns over a slowing global economy, the market may not accept that such demand growth will occur before the middle of 2015.

2)      OPEC Intervention - OPEC does in the end decide to intervene, which may happen as soon as early 2015, if oil prices continue to slide. At an OPEC basket price (approximately equivalent to Brent pricing) of $40-$50/bbl, even the KSA may be forced to agree to production cutbacks.  This is due to many OPEC members being dependent upon $100/bbl or higher oil prices to fund government budgets, especially social program spending.  There is widespread agreement that the social stability of some OPEC and non-OPEC countries is dependent upon this social spending, making it a priority for the relevant governments.

3)      Market Forces-Low oil prices pressures non-OPEC producers to cut back on investment, reducing E&P activity and ultimately lowering growth in oil production.  At $50/bbl, we estimate that at least 40%-50% of shale drilling activity will be at risk over the next 6 – 9 months, with the potential for a bigger reduction if onshore USA operators and their bankers panic.  Some of the sharpness of this pullback will likely be dulled due to what we call “shock absorbers”, which are discussed in more detail below.

4)      Forced Reductions-Geopolitical upset in a major producer forces a significant volume of oil out of the market for an extended period.  The main mechanism in this scenario would be some type of social unrest that would lead to production reductions.  Recent examples include Libya, Syria, and Sudan.  Candidates, especially if there is a significant reduction in social program spending, include Russia, Venezuela, Nigeria, Algerian, Iran, Libya and Iraq.

North American Natural Gas

As of early December 2014, natural gas storage in the USA was about 10% below the historical 5 yr averages.  This is market significant and should be leading to gas prices in the upper $4.00/mmbtu range based on past relationships between storage and pricing.  However, the relatively low cost of supply, and the abundance of that supply, exemplified by the Marcellus/Utica regions are weighing on prices.  Still, if the winter turns out to be colder than average, or even just average, prices should rally into the $4.50 - $5.00 range.  This was illustrated by the arrival of the first Arctic vortex of the season in mid-November, which saw gas prices rise from about $3.70/mmbtu  to about $4.50 /mmbtu over the course of just a few days.  However, if the winter turns out to be relatively mild, prices could pull back into the mid-$3.00/mmbtu range.  And, even if the winter weather does push gas prices up to the $4.50/mmbtu or higher range, they are probably not sustainable for more than a few months given the abundance and productivity of shale gas opportunities.

A potential source of price support in the natural gas complex is that the oil price pull back will lower the price of NGL’s to the point of undermining the drilling economics in many wet gas areas.  This will potentially result in less new gas supply from these regions, potentially resulting in higher natural gas prices.  However, the subsequent  increased drilling in the high volume, dry gas parts of the Marcellus, Utica, Haynesville, Barnett, Fayetteville, Woodford, Piceance Basin, Green River Basin, etc. would likely prevent the price from rising too far, too fast,  and keep any  increase in the gas rig count to a relatively modest level.  Inadequate infrastructure, in plays like the Marcellus and the Utica, may exacerbate and extend the period of higher natural gas prices, but given the announced infrastructure build out plans it is not likely to be supportive over the medium to long term.

Forward Activity

As previously noted, we believe lower oil prices will push oil related drilling and development activity down from the late summer/early fall highs.  However, there are “shock absorbers” that should moderate the speed and depth of the pull back over the short-medium term.  These take several forms, and include: oil based hedges that allow operators to guarantee the price received for a set amount of production, obligations such as rig contracts, lease terms, and cheap, nearly guaranteed forms of JV financing.  Note:  these shock absorbers will gradually degrade over the course of the next year or so as hedges run off, JV financing is used up, rig contracts reach term, and lease obligations are fulfilled.

We expect the nadir of this latest oil price pull back to be in April or May of next spring, which are the shoulder months between the winter heating season and the summer driving season.  At this point, oil could dip to between $40-$50/bbl.  However, we expect it to rebound from that point into the second half of 2015, bolstered by declining activity/output growth in North America; nascent OPEC efforts to manage prices and a growing, above trend oil demand response.  However, we do not expect the prices to recover to the $100/bbl range.  Rather, prices will likely range between $60-$80/bbl due to sufficient oil from non-OPEC sources preventing a return to the higher price plateau.

Our conceptualization for this outcome is what happened when natural gas prices pulled back at the end of 2011.  At that time, natural gas prices declined by about 40% from approximately $4.50/mmbtu to about $2.70/mmbtu over about a six month period.  Over the course of the next year or so, the number of rigs drilling for natural gas declined from around 900 rigs to the low to mid 300’s.  Eventually, natural gas prices did move off the lows set in the spring of 2012, but did not return sustainably to the previous highs.  This despite dramatic falloffs in production from parts of the natural gas production complex, the most dramatic example of which is the Haynesville, which went from approx. 7.5 BCFD to 3.6 BCFD over a 3 yr period.  Offsetting such production declines is that the most prolific, economic parts of the shale plays, namely the Marcellus, Utica, and the Eagle Ford, which also happen to have large resource bases continued to grow.  In the end, those plays not only offset the declines elsewhere, but also met the above trend demand growth that occurred because of the lower prices.

Something similar could well happen on the oil side of the E&P industry, with the role of the Marcellus, being filled by plays in the Permian, parts of the Bakken, and parts of the Eagle Ford.  As in the gas example, we expect improving technology to assist this response.

High Price Outcome

As a final comment, there are plausible scenarios for a return to $100+/bbl.  In these scenarios, there is a supply disruption at a major exporter due to low oil prices causing either social unrest, or geopolitical conflict between nations.  Though there is a relatively small chance of this occurring in the case of each individual country, in the aggregate, the risk is not insignificant.