What Direction Are Crude Oil Prices Headed Next?

The Exploration and Production industry producing crude oil and natural gas must be unique and the least understood of all the commodity industries.  Crude was selling a few months ago at over $100/Bbl and natural gas was once about $10/mmbtu. Now gas is around $3/mmbtu and crude has been down to the low $40’s before  bouncing back to either side of $50/Bbl.  Where are prices headed next and where might they stabilize?  Despite conflicting theories, no one really knows the answer to that question.  But what I would like to do in this post is to add some perspective to what the major factors are.  I don’t think these are well understood by the  investment community and as an investor, I think we should understand the factors involved.

1) Crude oil is a commodity with a world-wide market.  But unlike most other commodities, it isn’t manufactured in a plant – it’s produced from an unseen “reservoir”.  Manufacturing plants useful life may be 20 or 30 years or more.  Their production capacity is the same all of their productive life.  Oil wells may have a life of 20 or 30 years or more, but their production capacity will deplete over that period of time so that at the end of their useful life they may produce only a small fraction of their original capacity.  How fast they deplete is determined by reservoir characteristics which are mostly out of the control of the owning company.  So depletion rates vary, but they all deplete.

2.)  For manufactured products, new plants can be built in a fairly short period – maybe a year or two.  For new production from a new producing area there are several stages involved: The exploration phase involves  geological and geophysical studies.  Then there is lease acquisition time and costs.  Exploratory drilling finds more information about what is below ground and finally develop drilling and production.  Costs for drilling and development vary substantially depending on several factors including location (onshore or offshore, etc.) On-shore horizontal wells could run maybe 8-10 time the cost of conventional wells.  The time for drilling development wells in an existing known location can be relatively short, but for a new, unexplored area, the time could be 7-10 years from the first expenditures to the start of significant production.  The availability of rigs, people and equipment is also a factor in time to production.

3.) For a manufacturing plant, the majority of the production costs are in the ongoing process, not in the initial building costs.  Oil production is front-end loaded.  The majority of the cost are incurred in finding the reservoir, drilling and completing the well.  On-going production costs also vary significantly, and are dependent on the characteristics and location of the reservoir.  But once the well is completed and on production, the ongoing cost are usually relatively small.  For example, the CEO of an energy company speaking at a meeting recently, said that on-going production costs of new horizontal wells are mostly in the neighbor hood of $20-$25 per barrel.  For those wells, the price of oil would have to get below $25/ Bbl before there would be any economic incentive to cut production.

4.)Economic attractiveness of potential drilling prospects can also vary significantly, depending on the expected reservoir characteristics and the expected production rates and crude quality.  The CEO cited above said that his company would still have economically attractive drilling prospects at $40 and $50 per barrel.  But of course, there would be some that would need higher prices to make them attractive.

5.)  10 or 12 years ago the weekly active rig count was running about 400 rigs in the U.S.  Not enough activity to replace the production depletion rate from existing wells and keep up with demand increases.  When prices started up and companies began to increase drilling, there weren’t enough rigs, geologists, engineers, or field and service people to meet the growing demand.  Costs had to go up.  The active rig count went up to about 1,800 (looking for oil and natural gas both),  but has now started down. As the drilling rate goes down, one would expect that some of the costs would also come down.  This of course changes the economics of  the projects.

6.)  On the demand side there is also a reaction to higher oil prices.  In the short-run,  the demand curve is very inelastic.  (e.g. if I am driving 15 or 20 miles from home to work, I’m going to continue that, even if the price of gas doubles.  But when I get ready to buy my next car, I may give more weight to the gas mileage.)  The same goes for most manufacturing operations, the higher energy prices may not shut me down immediately, but I may start considering spending money to increase energy efficiency.  In the 1970’s, it took about 8-10 years to see significant reduction in demand brought on by increases in efficiency.  At $100/Bbl, there should be some economic incentive to spend some money to decrease energy demand, but it will likely take some time for that to be noticeable. Some of that spending may be holding demand growth back at this point. The other demand factor is obviously, how fast world economies are growing.  Lately, they haven’t been growing very fast.

So what does all this mean?

Well there are a couple of obvious things that one could say with certainty.  We now seem to have more oil production capacity than there is demand.  1) The price of oil went higher than was needed to increase production, and as the price goes down, there will be cuts in exploration and drilling.  This will come about for two reasons:  a) some of the drilling prospects needed the higher prices to be attractive and b) lower prices will put pressure on earnings and cash flow, which will cause company’s to cut expenses for exploration and drilling.  and 2) there will not likely be a lot production cuts because of lower crude prices until the price gets below on-going production costs, and we’re not there yet.

On the demand side, the key factors are:  a) How much is being spent to reduce energy usage that hasn’t shown up yet?  and b) will the world economies come back to pre-recession growth rates and how quick will that happen?

But the bigger, most significant questions are on the supply side.  These factors include: a) How fast will the existing production deplete without additional drilling?  b) How much drilling is needed to offset production declines? and what price will be needed to provide incentive for that?  c) In the “gear down” there will likely be some continued increase in production for a period of time because projects with significant dollars already spent (“sunk cost”) will likely be completed even if the current crude price would not be enough to justify them in total.  c) We know a lot about what has happened to the U.S. with the shale plays, but what about the rest of the world?  There have been significant discoveries reported in different locations (such as Brazil) – where do they stand?  And there are political upheavals in some of the major producing areas of the world – such as the middle east and Russia.  What will happen to production levels from these areas?

My guess is that in the short run, the price will go below where the long-term equilibrium price  needs to be to provide enough drilling to offset depletion and cover demand increases.  Where that “equilibrium level” is a guess at this point.  Natural gas is not a world-wide commodity, but in the U.S. we seem to be doing OK with gas prices at about 40% of its peak and drilling rates at about one-third of higher numbers. Comparable numbers for oil would be about $50 and U.S. drilling rates at about 800 to 900 total active rigs (about half of what we had a year ago. The Saudi’s, who I think may have as good a handle on this, have said publicly  that they think the long-term price should be around $60.  That’s not far from where we are now.  But I think with some continued increases in production, and absent a major disruption in the Middle East, that it could go back to the early $40’s and maybe into the $30’s before it comes back.  The timing is also uncertain, but if  we have to depend on depletion to bring current production rates back into balance, it will likely take more than a  year. If the price goes low enough to have some production shut in, it may take less time.  But my guess is that it could easily be 18 months to 2 years before we stabilize.  When the price comes back up, I would not bet against the Saudi’s idea that longer run stability could happen around $60.



About tjc13

BE - Chem Engineering, Vanderbilt Univ, MBA, University of Tulsa - Worked for an energy and chemical company for many years and then started a management consulting business working for both for-profit and not-for-profit organizations.
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