The Fuse

Stark Realities of the Global Underinvestment Risk

by Matt Piotrowski | September 22, 2015

With the lack of investment in today’s low-price environment, the industry will likely see a very tight oil market down the road.

As low oil prices drag on, oil industry underinvestment is quickly emerging as the most significant risk the sector is facing. With the lack of investment in long-term projects in today’s low-price environment, the industry will almost certainly see a very tight oil market down the road. How quickly the adjustment will take largely depends on global demand, but trillions of dollars’ worth of future projects are not economical in the current environment, and if history is any guide, underinvestment is followed by price spikes and extended periods of fundamental tightness that have serious consequences for the global economy and ensure oil price volatility for years to come.

Consultancy Wood Mackenzie (Woodmac) says some $1.5 trillion in investments is at risk for uncommitted conventional projects and that unconventional plays in North America, where most growth has taken place the past five years, is uneconomical with prices under $50 per barrel. For 2015-16, investment has dropped by $220 billion versus Woodmac’s expectations before last year’s price crash. The current weak oil price has hit everyone from the small U.S. shale producer to international oil companies in joint ventures: Ernst & Young said earlier this year that low prices have caused some $200 billion in megaprojects—which take about a decade to develop—to be either cancelled or deferred.

In order to move forward, there needs to be a significant drop in exploration and production costs, but they are sure to shoot back up once prices rebound. “Low oil prices over a number of years is likely needed to bring about profound, structural changes to industry costs,” Woodmac said. “This is unlikely—in our view oil prices will begin to recover from 2017, and there is a real risk that cost inflation pressures then return. Stronger collaboration between operators and service companies will be key in driving efficient practices. The winners therefore are likely to be operators with a strong pipeline of near-term projects close to sanction which are able to take advantage of the trough in costs through 2015-16.”

The consumer watchdog the International Energy Agency (IEA) has been warning of project delays and cancellations during the current low price environment, particularly in non-OPEC countries, where project costs are much higher. With a string of cancelled or deferred projects outside OPEC, the cartel regains market power heading into next decade and geopolitical supply disruptions become relevant again.

With a string of cancelled or deferred projects outside OPEC, the cartel regains market power heading into next decade and geopolitical supply disruptions become relevant again.

“If we see quite a substantial decline in upstream investment in conventional sources in non-OPEC countries, then the power to supply the marginal barrel will go back to the hands of the OPEC producers and they are also facing the extremely difficult unstable geopolitical situation,” IEA’s director for energy markets and security, Keisuke Sadamori, said earlier this month.

In North America, shale oil is particularly vulnerable to weak prices. Barclays noted in a recent report that oil companies will slash capital spending by some $12.6 billion to $18.9 billion in North American in 2016, which comes after a drop of more than $68 billion this year.

That U.S. companies have cut back so sharply comes as no surprise given that inexpensive debt has fueled growth in shale output. Now that prices have crashed, U.S. drillers are spending most of their cash flow to pay off debt instead of expanding activity. The U.S. Energy Information Administration said that in the second quarter, some 83 percent of domestic oil companies’ operating cash flow was used to pay off debt. That level was up from 58 percent in the second quarter of 2014 and about 44 percent in early 2012.

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In the Barclays’ global estimates, based upon a survey of 175 firms, oil companies have slashed their capital budgets by 20 percent this year to $521 billion, and plan to cut by another three to eight percent next year. This would mark the first time that spending drops for two years in a row since the mid-1980s.

Underinvestment = Tighter balances

From the mid-1980s to the early 2000s, the low price of oil discouraged exploration and development, causing spare capacity to thin to dangerously low levels.

Underinvestment has led to difficult adjustment periods in the past. From the mid-1980s to the early 2000s, the low price of oil discouraged exploration and development, causing spare capacity to thin to dangerously low levels, below 2 mbd, slightly more than 2 percent of total demand. This is about half of what the major forecasting agencies view as comfortable levels of spare capacity, at 4 percent of total demand. Dangerously low spare capacity was the main factor behind the 2008 price spike to $147. On the flip side, the high price from the mid-2000s until last year boosted supply-side investment, leading to the current glut of crude and weak oil price.

What fundamental outlook emerges for oil markets following an extended period of underinvestment depends largely upon demand growth, which is so far meeting expectations despite economic headwinds, particularly in Europe and China.

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If the IEA forecasts are realized, the adjustment toward a tighter market will occur at a rapid pace in 2016. Non-OPEC supply is expected to contract by almost .5 mbd, while global demand is set to rise by 1.4 mbd, a stark contrast from the past several years when supply growth outside OPEC met increases in demand. The tighter outlook next year would increase the call on OPEC crude by 1.6 mbd, already giving the cartel more strength in the market. But even if the market rebalances sooner rather than later, the projects that have already been cancelled will impact production well into the future, and many producers are likely to remain wary of another price drop, discouraging long-term investment in high cost projects. Given that capital expenditures are poised to continue to fall into 2016, fundamentals could be even tighter in 2017—and throughout the rest of the decade.