Oil price and its effect

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Oil Platforms undergoing maintenance are docked in the port of Santa Cruz de Tenerife on June 6, 2014. The Spanish government gave oil giant Repsol the green light to explore for oil and gas off the coast of the Canary Islands, a move that environmental groups described as ‘unjustifiable’.

Oil Industry

In the late 1980s, some people in the oil industry were said to have bumper stickers reading, “God give me one more boom and I promise not to mess it up.”  (When the price was over $100, I joked about people investing in bumper stickers.)  With the recent recovery in oil prices to $50 a barrel, and soaring investment in the Permian, voices can be heard warning that shale producers are threatening to ‘mess it up’ again, while others warn that the decline in upstream investment will lead to tight markets in 3-5 years.   In fact, this theme originated in the post World War II era with British petroleum economist Paul Frankel who described the industry as prone to cycles of over- and under-investment.  (My mentor, Morry Adelman, disagreed, stating that over-investment seemed the norm.)

Insufficient price

During my four decade career, complaints from various sectors of the industry regarding insufficient price levels have been near constant.  Tanker owners, drilling service companies, and oil producers have argued that higher prices were needed to justify investment, or else shortages would occur within a few years.  Some have gone so far as to argue that customers should offer higher prices to enable them to be healthy enough to invest for the expected boom years.  Unsurprisingly, when costs soar, none are willing to offer discounts to their customers.
As the figure below shows, global drilling has declined since the price fell.  But the drop in upstream investment is temporary and should not cause a significant market tightening.  When company revenue crashes, they have a rapid reduction in capital expenditures, but as they get their balance sheets in order, a bounce back occurs.  Last year, Wood Mackenzie estimated a reduction of as much as a trillion dollars of investment over five years, about 30-40%, but much of that will be offset by cuts in rig services. And Douglas Westwood has projected deepwater spending this year will be roughly at 2013 levels.

 

There is a fine line between irrational exuberance and wishful thinking, but from bankrupt shale producers to struggling companies like Chesapeake Energy, the cost of believing bad price forecasts was clear.  Many assumed large debts in order to invest in resources they expected to provide a strong payout in future years, which required those prices to remain high.  Aubrey McClendon even argued that shale gas was high-cost and thus necessitated high natural gas prices, a misunderstanding of the relation between costs and prices that cost him and his company.
He was hardly alone.  When oil prices were $100 a barrel, a chorus insisted that the easy oil was “gone” and the high breakeven cost necessitated that prices not decrease below that level for any length of time.  One CEO even suggested in 2012 I was an idiot for thinking that the long-term price was likely to be $50-60 per barrel.
Most oil company executives, if asked, will explain that naturally prices have to rise in the long-term and the vast majority of forecasters would agree.  For example, the U.S. Department of Energy predicts prices rising to $91/barrel by 2025 and $141 by 2040 while the International Energy Agency sees them going to $80 by 2020 and rising gradually thereafter.