Defending Market Share: A Dilemma for OPEC or for Shale Oil?

 

Dr. Salman Ghouri[1] & Umama Ghouri[2]

The sustained higher oil prices provided an excellent breeding place for a technology that has been around for many decades – hydraulic fracturing to nurture and prosper. As a result, US shale oil production increased from 1.24 million barrels daily (MMBD) in 2007 to over 4.72 MMBD at the end of 2014. The sustained higher oil prices provided wind falls to major oil producers but at the same time severely affected the global economies, particularly oil importing countries. For oil producing countries more revenues means more resources for the development of their economies and therefore generally ignore its implications for the global supply and demand. The sustained higher oil prices not only destructed the demand side but it also created a glut in oil market – eventually collapsing oil prices.  

Economic development – more reliance on cash cows!

Most of the OPEC members require continuous massive cash flows because they are in the process of economic development. When oil prices are high there are no issues however when oil prices are suddenly in free fall this poses a real challenge. Challenges for OPEC members in 2015 are even more difficult then they were in the past as they are fighting three conflicting fronts: meeting ever increasing cash flow requirements; defending their market share in a low oil price environment; and dealing with the competition of the US booming shale oil industry. In the past, OPEC has been pursuing a policy of stabilizing the market by increasing/decreasing production quota but at the same time defending its market share. For example, strategy in 2015 is different than during 1980s when OPEC increased its production to regain its lost market share due to significant increase in Norway and UK oil production, resulting in collapsing oil prices in 1986. Whilst in 2008, OPEC twice cut its production in an effort to arrest the free fall of oil prices. During recent meetings OPEC has been maintaining a production quota of 30 MMBD as oil prices remained above $100/BBL and even when oil prices plunged below $60/BBL. For example, during the 166^th meeting held on Nov 27, 2014 and the 167^th on June 5, 2015, OPEC members unanimously agreed that the global oil market is well supplied, inventories are higher than the previous five years average and therefore they would stick with 30 MMBD production quotas. The next meeting will be held on Dec 4, 2015. With this announcement the element of uncertainty is reduced and one can see the determination and commitment of OPEC members to defend their market share even at the cost of lower oil prices. OPEC probably would not be interested in further increasing its production like in 1980s or cutting its production for a revival of oil prices (2008). The problem is that OPEC is now in a Catch-22 situation. On the one hand OPEC members need more revenues to meet their ever increasing government budgetary requirements but lower oil prices prevent that from happening. On the other hand if OPEC cuts its production in an effort to revive oil prices it is threatened by loosing market share to US shale oil. At oil prices of, for example, $65/BBL (Brent May 2015) OPEC members would be needing substantial higher oil prices to balance their budget (see Table-1). Only Kuwait and Qatar would be in a position to meet their cash flow requirements.  The other members would have to produce more or withdraw from sovereign funds in order to balance budget.

Table-1: OPEC production based on quota and oil prices to balance budget*

 

Countries	Production Quota (%)	Oil Price $/BBL to balance budget
Algeria	3.6	111
Angola	5.3	98
Ecuador	1.7	117
Iran	8.8	93
Iraq	12	71
Kuwait	9	47
Libya	1.7	215
Nigeria	6.3	119
Qatar	2.2	59
Saudi Arabia	33	103
UAE	9.2	73
Venezuela	7.9	121

*The respective shares of the group’s supply are based on April levels. The estimates for the price per barrel each member needs to balance its budget are from the International Monetary Fund unless stated otherwise.

Source: Saudi Oil Strategy Seen Prevailing in Vienna: OPEC Reality Check

 

More challenges for OPEC

So far so good. OPEC is successfully maintaining its production quota of 30 MMBD (though there is news that they are producing more) that allows it to maintain its market share, and also deter the rising US shale oil production threat. The real challenge however, for OPEC, is how to deal with Russian increasing oil supplies. Russia hit hard by sanctions, requires more revenues to aid its crippling economy – by increasing its oil production.  According to Bloomberg in May 2015, it extracted 10.7 MMBD, compared with Saudi Arabia’s 10.2 MMBD. It was the first time Russia took the global lead since 2010. In addition to Russian oil supplies, another challenge for OPEC is how to deal within its own group. That is, what will happen when economic sanctions on Iran are lifted? A number of countries/companies are already lining up in Iran to seize this investment opportunity. Experts estimate it will take a year or so before Iranian oil production of over one MMBD will hit the market (there are divergent views about quantity and timing).  And what would happen if the situation in Libya and Iraq would also simultaneously improve? What would be the implications for global oil supplies and the other OPEC members? Iran and other war torn countries would require huge cash flows for the redevelopment of their economies. How will they finance that? By selling more oil than the allocated quota in a regime of lower oil prices.

More oil supplies from OPEC and Russia are likely to further depress oil prices and this probably temporarily reduce some of   US high cost shale oil production. As a consequence OPEC members face the difficult question how to provide the desired cash flows to their respective governments. In the absence of resilient global oil demand OPEC members will have to dip into their sovereign funds. If OPEC members adhere to production quotas and keep oil prices below the magic number of $60/BBL it will probably discourage US shale oil production at least in some of the basins as well as discourage shale oil development in rich resource countries like China (Table-2). Just like technological advancement in horizontal drilling and hydraulic fracturing turned out to be a nightmare for OPEC, OPEC's strategy of maintaining its production at 30 MMBD over an extended period of time will definitely have a knockout affect on some of the US shale basins. The US oil and gas industry is already slashing jobs as a result of the slow down in drilling/fracturing activities. A lower oil price will discourage shale oil production but it will be stiff call for OPEC to meet the government budgetary requirements.

In this market share cold war, who will be the winners and losers? The ultimate winner would be producers, however, in the short term consumers will enjoy a period of lower oil prices. This will helping in the revival of global economies.  US oil demand is generally stronger during summer driving season and lower gasoline prices this year will further encourage travelers on the road. China is also taking advantage of lower oil prices in building its stocks. What we have learned from history is that neither higher or nor the lower oil prices are sustainable for extended period of time. A lower oil price environment over extended period of time will discourage the exploration activities affecting the supply side of the equation while higher oil prices hinder oil demand. With the technological advancement and shale oil revolution one could expect that breakeven cost would keep reducing over time and therefore other conventional oil producers must adjust and learn to live in a new environment of moderate oil prices. We strongly believe that over the longer term market fundamentals prevail and it is neither nightmare for OPEC or nor for shale oil.

Table-2: Top ten countries technically recoverable shale gas reserves[3]

Country	Sale Gas Trillion Cubic Feet (TCF)	Country	Shale Oil Billion Barrels
China	1115	Russia	78
Argentina	802	USA*	58 (48)
Algeria	707	China	32
USA*	665 (1161)	Argentina	27
Canada	573	Libya	26
Mexico	545	Australia	18
Australia	437	Venezuela	13
South Africa	390	Mexico	13
Russia	285	Pakistan	9
Brazil	245	Canada	9
Total	(7795)	Total	345 (335)

*EIA estimates and for ranking estimates. ARI estimates in parenthesis.

Source: Energy Information Administration (EIA)

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[1]                      Advisor oil & gas industry.

 

[2]                      Umama Ghouri is an MBA student at the University of Texas at Arlington, Texas, USA

 

[3]                      These shale oil and shale gas resource estimates are highly uncertain and will remain so until they are extensively tested with production wells. This report's methodology for estimating the shale resources outside the United States is based on the geology and resource recovery rates of similar shale formations in the United States (referred to as analogs) that have produced shale oil and shale gas from thousands of producing wells.

 

 

 

Cyclical Oil Prices – Is it a Necessary Condition to Balance Global Oil Supply/Demand?

Dr. Salman Ghouri[1] and Mian Aneesuddin[2]

During the past 50 years global oil demand increased from 30.8 million barrels per day (MMBD) in  1965 to 92.03 MMBD in 2014 – an increase of 61.28 MMBD. In contrast, global oil production increased by 56.87 MMBD during the same period (BP-Statistical Energy Review June 2015). That is on an average annual growth in demand and supply of 1.22 and 1.15 MMBD respectively. Energy Information Administration (EIA) predicts global oil demand to increase to 113.1 MMBD in 2035. Likewise global natural gas demand is projected to increase to 4760 BCM in 2035 as compared to 3394 BCM in 2014[3].

In order to meet the projected demand for global oil, natural gas and other sources of energy, International Energy Agency (IEA) estimated that during 2012-2035 the world would be needing cumulative investment of $48 trillion during now and 2035, consisting of around $40 trillion in energy supply and the remainder in energy efficiency. The main components of energy supply investment are the $23 trillion in fossil fuel extraction, transport and oil refining; almost $10 trillion in power generation, of which low-carbon technologies – renewables ($6 trillion) and nuclear ($1 trillion)¹ – account for almost three-quarters, and a further $7 trillion in transmission and distribution. Less than half of the $40 trillion investment in energy supply goes to meet growth in demand, the larger share is required to offset declining production from existing oil and gas fields and to replace power plants and other assets that reach the end of their productive life. Compensating for output declines absorbs more than 80% of upstream oil and gas spending. The fundamental question is how and from where the oil and gas industry will generate this level of investment year after year especially during the regime of lower oil prices?

Market Fundamentals

History has taught us that sustained higher oil prices negatively affect the demand, but encourages supply side (assuming other factors remain constant). The most important determinant of the level of exploration activity by international oil companies (IOCs) is the current and most recent past oil prices. The initial response of the industry to increase in oil prices may not immediately lead to an upsurge in exploration activity, but possibly a reappraisal of discoveries made in mature regions deemed uneconomic under lower price scenarios. Therefore, exploration activities in new acreage especially high-risk-high-cost basins are expected to increase after a year or two in response to higher oil prices especially if IOC’s strongly view that pattern of high oil price will continue in the future. Higher oil prices improves profitability of oil and gas industry and therefore they   are willing to invest in high cost unexplored basins (new frontier - deep offshore) in search of sizeable oil fields. In addition high oil prices also induces investments in energy efficiency, conservation, backstop fuel supplies from unconventional crude oil from tar/tight sands, oil shale, gas to liquid (GTL), coal to liquid (CTL)^[4], and other renewable sources of energy – thus reducing the pressure on oil demand in the long run. For example, recently, the sustained higher oil prices substantially encouraged shale oil/gas development, particularly in the USA, which is complemented by innovative technological advancements in horizontal drilling and hydraulic fracturing. Likewise, the world has also witnessed rapid growth in renewable sources of energy; however, it is not a threat to fossil fuels due to its marginal share in total energy mix. Persistent higher oil prices also adversely affected the global economy – slowing down oil demand. Therefore, eventually market fundamentals push the oil prices downward. The recent memories of 2007/2008 and later during 2011-2014 a period of higher oil prices followed by plunging oil prices during 2^nd half of 2008 and 2014/2015 are still afresh.

In contrast to higher oil price regime, lower oil price environment reduces the oil and gas industry profitability and therefore, they immediately take cost cutting measures including cutting back exploration activities. Recently, we have witnessed that it is difficult for most of the OPEC members to balance their budget given the low oil prices, and are forced to deplete sovereign funds (or foreign exchange reserves). That is, in the regime of  softer oil price environment it will be even difficult for the industry to sustain current level of oil production that requires continuous investment in work over, side-tracking, recompletion of wells in different formation, secondary recovery, and EOR and what to speak of new investment in finding and developing new reserves. A sustained lower oil price environment reduce profitability, cutting back in exploration activities, however, increases oil demand, depleting oil inventories and therefore eventually market fundamental will push the oil prices and converge to its long-term equilibrium. 

Implications of sustained higher or lower oil prices

The sustained higher oil prices always encourage exploration activities with some lags. Figure-1 & 2 illustrate the historical relationship between US rig counts onshore/offshore against oil prices. The visual inspection clearly demonstrates that there is indeed a positive correlation between drilling activities and oil prices though drilling activities increase/decrease with some lags. To test this relationship, we have used January 1974 to March 2015 monthly data. Number of rig count onshore and offshore are separately run against the oil prices. The models were suffering from serious autocorrelation and therefore we have used autoregressive moving average (ARMA) of order one. The onshore rig count is more responsive to changes in oil prices than the offshore.  As expected the initial response to changes in oil prices was marginal, however with the passage of each month the response got stronger and stronger. It took 24 months for onshore when a full impact is realized with 0.86 percent increase/decrease in exploration activities in response to one percent increase/decrease in oil prices. For offshore, the response to changes in oil prices for the first five months were negative and statistically insignificant. Thereafter the response was positive but remain statistically insignificant. It took 17 months before we got statistically significant response to changes in oil prices. However, after passage of 24 months the full impact was less than half that of onshore 0.41 percent increase/decrease in drilling activities as a result of one percent increase/decrease in oil prices. The difference between the responses to onshore and offshore drilling is due to magnitude of investment, difficulty, and time required to mobilization/demobilization of drilling rigs. Offshore requires huge capital investment as compared to onshore and therefore more time is required for planning and analyzing before making final investment decision. In case of US shale oil drilling, the response to changes in oil prices is shorter duration of about 5-6 months.    

The lag for example could be due to initially revisiting resources that were deem uneconomic during the regime of lower oil prices or a lag is involved in acquiring new lease/concessions, carrying out seismic surveys etc. Higher anticipated prices will encourage exploration activities, however, it is not like turning the switch on or off rather it requires a number of years before the full impact is fully realized. In a similar manner when oil prices plunge, exploration activities did not die off instantaneously due to contractual commitments, or in the middle of drilling, drilling rig is hired for a number of year(s) etc. Therefore, the trends depict a lag before the impact of increase/decrease in oil prices is fully realized. A similar trend could be witnessed when relationship between oil prices and oil production are analyzed (Figures-3 & 4). The response of oil production to changes in oil prices took longer adjustment times than the drilling rig count.

 

Figure-1: Correlation between US Onshore Rig & Prices  

Figure-2:Correlation between US Offshore Rig & Prices

Figure-3:Correlation between Oil Prices & Oil Production

Figure-4:Correlation between Onshore Rig & Production

 

Figures-5 & 6 depict the best fitted graph for both onshore and offshore based on best estimated model. Onshore drilling is more responsive and requires less number of months to increase/decrease in drilling activities in response to changes in oil prices. Whilst offshore drilling activities are less sensitive, erratic and require more time to respond to changes in oil prices.

Both the models fit quite well as more than 97% of the variations are explained by the given explanatory variables. The higher sustained oil prices results in acceleration of exploration activities leading to more oil and gas discoveries and enhanced production. Whilst lower oil prices over extended period of time not only constrained industry profitability but also hampered the required investment in exploration and development activities.  What we have learned from history is that neither higher nor lower oil prices are sustainable over an extended period of time and world would continue to live in cyclical uncertain environment. That is, lower oil prices over extended period of time will choke the supply side but continue encouraging oil demand that in turn will gradually push the oil prices – another episode of higher oil price will be followed. Though some episodes are short lived while others could hold back for a number of months depending on global economic situation and inventories level. The cyclical movement in oil prices will ensure that neither high nor low oil prices will continue to stay forever – giving a hope of oil and gas industry to continuously progress and also allows to develop new-state-of-the-art-technology.  It appears that such episodic oil price regime is necessary condition in balancing the global supply/demand.  

 

 

Figure-5: Onshore drilling best fit

Figure-6: Offshore drilling best fit

 

Note: the above article has been published in International Energy Investments as well as placed on my linkedin

If you have any comments or share some thought that would add value to readers are welcome.

 

 

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[1] Dr. Ghouri is oil and gas industry adviser. The views, findings, interpretations, and conclusions expressed in this paper are those of authors. .

[2]Mian Aneesuddin is Specialist Oil and Gas Industry, Portfolio Assessment and Economic Evaluation

 

[3] Author’s forecast.

[4] Most of the major energy consuming countries like USA, Europe and emerging economies where demand for energy is likely to increase aggressively – most of them are blessed with enormous quantities of coal reserves. Should the CTL become economically viable, it will encourage construction of CTL – driving down oil demand.