Oil Industry Nature and Econ – what investors should know – Part3

The term “peak production” with reference to oil and gas implies that we have exhausted the Petroleum supply in world.  It’s taken thousands of years to create the oil & gas we are using.  Some day we will probably exhaust the world’s supply of oil & gas, but no one knows when that day will come.  We don’t know when the day will come, but I think we won’t know if we are there after only two or three years of increased drilling.  Based on my modeling effort and the previous drilling boom of the 70’s my guess was that we would find enough new production to start bringing the price down as early as 2012 – which would have been about 7 years from the start of the oil drilling rise.  But given that new fields may be in more remote areas that are harder to explore and  often require building infra-structure to get the oil and gas resources to market, I thought it might take a little longer than it had in the 1970’s so I added a couple of years to the old model.  So my guess was from early 2012 to before the end of 2014.  It took about seven years to get natural gas back into balance and bring the price down.  But the natural gas market is primarily the U.S., so it’s simpler to predict.  Oil is an International Market with a lot of politics involved.  What seems clear is our production capacity today is greater than the demand.  So where and when do we go from here?

A few key questions have gotten some publicity in the press relative to the following:

  • Demand growth from China:  Demand growth from China has been cited in most publications as the reason for the need for additional supply to cause the price to rise.   China is still growing, but at a lower rate, and so the question is will it comeback to where it was.
  • Is China going to regain its growth rate?:  Know one really knows the answer to this and I won’t pretend to.
  • Who will be the world “swing producer”?:  OPEC has not agreed to cut production this time, and the Saudi’s are saying they won’t.  I think the Saudi’s realized two things in the 1980s:  1)  Regardless of what OPEC officially agrees to, they might be only one to cut production, and to hold the price at too high a level will eventually be painful to them.  So it might be less painful for them to get it over sooner rather than later.  In 1974, I had an  A.D. Little study which looked at the OPEC countries government expenditures and income.  Their conclusion was that the Saudi’s were the only one that could make substantial cuts without serious budget cutbacks or deficits.  I’ve read a few recent comments that now 40 years later the Saudi’s don’t have the flexibility today that they had then.  But I think they still have the highest production and the lowest population, so has there been another study like the A,. D. Little done lately?  I don’t know.
  • With the decline in price why haven’t there been much reduction in production?:  This one is, I think, fairly obvious.  If the Saudi’s or some one like them doesn’t cut production based on political considerations, then the price has to get low enough to stop a significant amount of production.  Based on most U.S. production costs in the $20’s, the price would have to get below $30 per barrel.  The other way it might happen in the U.S. would be to cut out all drilling and have natural depletion take our production down.  If we have a lot of drillable prospects at $40 per barrel then the price would probably still need to get down to $30 for some period of time long enough for those projects to be canceled.  The one thing that probably won’t happen is that the Texas Railroad Commission and other state regulators are not likely to reintroduce production quotas again.
  • What about the political conflicts in the middle east?:  This is one thing that obviously make predictions iffy.  There is a lot of oil production capacity in the Middle East and North Africa, which has probably been significantly disrupted in recent years.  Is this going to get worse or better?  It could make a significant difference but who knows what might happen.

There is a lot of uncertainty here in terms of oil.  What about Natural Gas? It’s price has gone down hill recently to something below $2/mmbtu.  Natural Gas is much more a domestic market than oil, and the supply has probably been helped by associated gas which is produced with crude oil.  With a cut back in oil drilling this addition will likely decrease, and shale gas production depletion is faster than oil I’m told.  So my guess is that the price of gas is too low, and it should rise from the $1.90 where it closed yesterday.  My guess is that it will go back to the $3-4 level where it seemed to stabilize when it dropped from the $10 level.  We seemed to be getting enough drilling to keep the capacity up at that level.  But if demand grows faster because of the government’s encouragement to get the electric company’s off coal, it could go higher.  A price of $3-4 level, seems to spur the growth of the US. petro-chemical industry which I would like to see continue.

Natural Gas is a guess, but oil is more of a wild guess.  One thing I have some confidence in is that we’re not  going back to $100 per barrel anytime soon.  Drilling costs have come down and there are lots of idle rigs so rig rates should be lower. Because of these type cost rises and the time lags, the price always goes higher than it needs to bring on additional capacity.  My guess would be $40-50/barrel.  Without a lot of data, I would think at that price range, there will be enough new supply to offset depletion.  And we could be there for several years, without getting seriously out of balance again.  The wild card here I think is the  International situation.  Will the politics of the middle east continue to bring about production problems like they have the last few years.  Or will they get worse or improve.  I’m not as concerned with the Chinese growth rates unless they go extremes in one direction or the other.  Between 5% and 7-8% growth I don’t think it will make a lot of difference.

As for production companies, those with wells that were (are) economic in a price range of $40-50 should be in good shape. Wells drilled at those prices should be financially in good shape.  Completed wells whose economics were based on $60-70 per barrel will should likely provide a positive return, but maybe only 10% – not 20%.  Wells drilled based on $80-90/barrel may have some difficulty paying out all costs and the companies that borrowed a lot of money to drill those based on speculation of continued $100 oil may be in some trouble.

So my best guess for the next 5-10 years is getting back to, and having some stability at $40-50 for oil and $3+ for natural gas.

What do you think?

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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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