The drop in oil prices has prompted some industry observers to compare what we are witnessing in the market to the previous downturn of 1986 to 2000. We, however, see a big difference between these two time periods. When we look at the previous upcycle in 1978, the price rose drastically as supply was cut in an increasing demand environment.
This led to the investment in new technologies of the time such as deep water drilling and increased exploration in areas such as the North Sea. About eight years later, the increased supply combined with a demand drop resulting from high oil prices led to a price collapse in 1986. At this point in time, there was a spare capacity (a capacity available but not used) of 10mn barrels per day, equating to around 25% of total production. Even if OPEC did cut production it took a long time to absorb this spare capacity, explaining why the downturn lasted from 1986 through to 2000.
The period from 2000 to 2008 ushered a renaissance in the oil industry, with a price hike from just under $30 per barrel to $140. The resurgence in revenue helped drive growth in both the industry as well as the regions which supplied this oil. In this context, the sudden drop in prices necessitates bold industry moves and looking to the past for direction can be a tempting option for most. There are, however, some fundamental differences between the current situation and that of the past, which make it unlikely that we will continue to see sustained low oil prices in the medium to long-term.
The spare capacity today is much lower at an estimated 2mn barrels per day or 5% of total production, as compared to the 25% of 1986, so the market is not characterized by a massive over-capacity. However, bear sentiment, along with low oil prices, has halted investment activities in the oil industry over the past 18 months, impacting production in the short term in the US and in the medium to long term everywhere else.
The question on everyone’s mind is how fast the shale industry in the US can ramp up and act as swing producer if demand growth outstrips supply capacity. There is one school of thought that shale exploration in the US will quash global demand, but this must be challenged. The financing of shale will be much more difficult in the future due to the estimated $1.6tn of debt that has been use to fuel shale production. This overleveraging has led to several US companies filing for bankruptcy. Hence the next wave of shale drilling will cost far more to finance as banks will be more reluctant to lend.
Additionally, oilfield services companies have already made drastic cuts to their head-counts and operations, so when demand picks up they will look to benefit from the increased price before increasing capacity, slowing production growth and increasing cost of developing shale oil.
Another crucial difference from the previous downturn cycle is that we already see demand increasing, so there is not a long-term structural demand drop. India is a key driver of increased global demand for oil, overtaking the Chinese growth in demand. In 2015 alone, India’s oil demand grew by 300,000 barrels a day, as living standards improved and more people bought cars. This is double the average rate of the country’s fuel consumption in the previous decade and amounted to 4mn barrels of oil in 2015.
The ingredients for a medium-to-long-term rebound in oil price are in place – an increase in global demand and a reduced supply resulting from the investment cuts producers have had to implement during the past years of low oil price. As demand increases there will be a point where there is tension in the market, leading to increased volatility.
All these factors considered, it is likely we will see oil prices climb again and they may even spike in the medium-term.
So what does all this mean for oil producers in the Middle East? We argue that NOCs should apply the same modern management techniques as shale producers in order to reduce costs. These techniques have been applied in the past by the automotive industry, where manufactures collaborate with suppliers to drive innovation. Through increasing such cooperation within the oil and gas industry, we could reduce the costs of oil companies by 30-35%. At the same time, NOCs must keep investing in maintaining capacity, as those with spare capacity will be in the strongest position when prices rise again.
