Oil Producers’ Spending Cuts Are Deep And Savage – But Can Be Quickly Reversed
Opec, the International Energy Agency, and renowned oil historian Daniel Yergin all agree: current oil prices are too low to spur investment. The IEA says the industry will cut spending for a third straight year in 2017, with US$300 billion slashed in the past two years. And they point to the danger of a surge in prices, damaging the world economy when new supply fails to meet future demand.
Yet at the same time, non-Opec supply continues to prove more resilient than expected. The US’s Energy Information Administration increased its estimates of American output: just last month, it thought next year’s production would fall 460,000 barrels per day, but as rig counts increase, this month it upgraded its forecast to a drop of only 260,000 barrels per day. The likely long-awaited start-up of Kazakhstan’s giant Kashagan field at the end of this year offers a further boost.
Part of the solution to this puzzle lies in falling costs. Two-thirds of the industry’s spending cuts are accounted for by lower expenses for everything from rigs and steel to personnel. Only one-third is due to reduced activity. When we consider that the projects getting cut are presumably the least productive per dollar spent, the overall impact on production is even less.
Whether under-investment does lead to future shortages depends on the damage done during the price slump, how available prompt new supply is, and whether demand also grows strongly.
The downturn has been deep and savage, but also short: just two years so far. So far, idled equipment remains usable, and most sacked workers could be rehired. The 1986 price crash took 13 years to turn around, and included a slump-within-a-slump in 1998, when oil prices famously sank below $10 per barrel.
Unlike in previous downturns, when conventional fields with long lead times had to be brought into service, US shale progress should allow a quicker production response. Evidence for this comes from West Texas’s Permian Basin, where output continues to rise. The number of active American drilling rigs has also tended to rebound quickly when prices jump even a little. This could dampen any price rise until, on a timescale of three to four years, new conventional fields also come online.
The global economy is also rather tepid, unlike the surge in western and Japanese demand up to the 1973 oil spike, or China following 2003. A new boom could again drive prices up, but the only large market likely to experience such expansion seems to be India.
If the underinvestment thesis is true, it is not clear what, if anything, its proponents expect the industry to do about it. Should the oil companies invest on the basis of assuming higher future prices – something that got them into serious trouble in the 1980s when the promised price rises did not materialise? Are traders underestimating future prices? Perhaps, but then the forecasters are trying to talk prices up in defiance of market consensus.
Major Opec countries are presumably best placed to invest counter-cyclically. Some, such as the UAE, Iran and Iraq, plan to increase production capacity; others do not. But these goals seem to be set by long-term strategy rather than a bet on rising prices.
The IEA’s motivation for such warnings is clear: as a grouping of the world’s developed economies, mostly oil importers, encouraging more investment now means lower future prices however the market develops. Opec’s motivation is less obvious, other than appearing a reasonable market actor, and avoiding blame should future prices indeed soar.
The industry will indeed need to gear up spending to meet future demand and compensate for declining mature fields. And oil prices often overreact to market imbalances in either direction. Nevertheless, there is no reason why today’s massive spending cuts cannot be reversed in time to avoid another price spike.