“As 2015 comes to a close, I am struck by what a unique year this was in the always-fascinating and dynamic world of oil and gas. 2014 was a year marked by a price shock that rapidly brought us from our “new normal” (or so we thought) of $90-$100/barrel to prices around $60/barrel by the end of the year,” says John England, US Oil & Gas leader, Deloitte LLP in the latest 2016 Oil and Gas industry Outlook.
In 2015, oil prices continued to trend lower, getting down to the $40-50/barrel range since mid-summer and dipping below $40/barrel in December. In less than a year, upstream oil and gas companies faced 50 percent drop in revenues.
The industry responded by experiencing the five stages of grief:
- Denial: “This is just a blip and won’t last long” (this view died by March)
- Anger: “It’s OPEC’s fault” (for producing as much as they can…a lot like US producers)
- Bargaining: “If only we had invested for returns, not growth, for the past five years”
- Depression: “Cash flows continue to diminish, and balance sheets continue to weaken”
- Acceptance: “I guess we’d better prepare to ride this out for as long as it takes” (current view of most players)
For the most part, 2015 saw the exploration and production sector of the industry pull out the 1980’s playbook for a severe price decline:
- Cut capital expenditures and defer major capital projects
- Cut operating expenditures and headcount
- Push suppliers for better pricing
- Hope for better prices
“The first three have been quite effective at reducing costs and preserving cash. The fourth one is still in progress, and although I often hear “hope is not a strategy,” it sure beats “no hope,” at least when it comes to morale,” adds John England.
We do see some positive development that should get us to a better place from a pricing perspective:
- Demand: US demand is responding to lower oil prices in the usual let’s-go-buy-a-new-car, or better yet, a-massive-SUV kind of way. As auto sales go up, expect to see increased US demand. More broadly, Asian demand, beyond just China is showing strong growth. China itself, despite the stock market jitters of the summer, remains a huge source of global demand and China’s move to allow two children per family, rather than one, promises to double the numbers of drivers (and thus, fuel buyers) at some point in the future. (Let’s just say I used very rough math on this prediction).
- Decline: Why is decline in the hope section? Because natural reservoir production decline, which has historically been four to five percent globally, means that even without demand growth, the oil and gas industry must produce another four million barrels per day every year just to keep up with current demand. This naturally puts upward pressure on pricing.
- Production: As noted above, total US production finally started to decline and that trend is expected to continue in 2016. More broadly, billions of dollars of investments have been deferred due to the low price environment, which translates to millions of barrels that will not be produced in the years to come. This sets the stage for a price rally.
- A leaner, stronger industry: More than anything else in business, I believe in the power of free markets. Just as I believe the high prices of natural gas were a critical impetus for the development of the shale gas revolution, I believe today’s low crude prices are forcing an equally powerful innovation in the way oil is being developed and produced. Price forces innovation and I believe we are still in the early stages of what can be achieved in terms of reducing unit costs of oil production and ultimately increasing unit margin and achieving higher return on capital employed. The endgame is an oil and gas industry that will be stronger, leaner, and built to last.