Growing concerns about an upsurge in global oil inventory due to both a historic weakness in underlying demand because of the coronavirus outbreak, and a breakdown in OPEC dynamics have resulted in significant volatility in oil markets, causing prices to plunge toward levels that incentivize producers to shut in existing wells.
The collapse in talks between OPEC and Russia, which prompted Saudi Arabia to announce plans to ramp up output to more than 11 million barrels per day by April from 9.7 million barrels per day, has increased the pressure on all oil producers, particularly higher‑cost, non‑OPEC oil operators, including those in the U.S. and Canada.
In such a rapidly evolving situation, it is difficult to know the ultimate magnitude of the coronavirus‑driven demand destruction, but it is clear that the current reductions are having a meaningful and accelerating effect. It appears that we are now in for a 2008‑style demand shock, which, coupled with the supply shock created by Saudi Arabia, creates an environment in which we could see spot oil prices plummet through the top of the industry’s operating cost curve, or the level at which producers consider shutting in some of their wells. For West Texas Intermediate (WTI) crude oil, we believe the top of the operating cost curve is between USD 25 and USD 30 per barrel.
Staying Ahead of the Curve
We have found it useful to anchor our analysis of the oil market and participants’ behaviors in an understanding of where spot prices are relative to the operating cost curve and the incentive cost curve.
At the lower bound, the operating cost curve represents the commodity price range where capital investment exits the market and oil producers temporarily shut in existing wells. On the opposite end, the incentive cost curve is the price range where operators are prompted to invest in incremental production. Oil prices historically have spent about 90% of the time above the incentive curve, as the base decline rate in global oil output requires ongoing development and incremental production to keep pace with demand growth.
Our research shows that how productivity shifts in these two cost curves tends to drive prices over the long term. Understanding these dynamics aligns with our investment time horizon and can be especially useful in identifying opportunities when near‑term market dislocations occur.
Lessons of the (2014–2015) Fall
The rise of U.S. shale oil and gas production, with its attendant productivity gains as these companies have pushed technology and built scale, has continued to pressure the industry’s incentive cost curve and spurred efficiency gains in oil production operations. The shorter development timelines associated with shale oil and gas wells likewise have helped these players to take market share. As such, we would not be surprised if “USD 45 per barrel is the new USD 50 per barrel for WTI” when we reemerge from this downturn as productivity gains continue to accrue.
However, wells in shale formations exhibit much steeper decline rates than those in the deepwater and other conventional developments. When shale players cut their capital expenditures and reduce their drilling and well completion activities, the decline curve kicks in much more quickly, resulting in a faster production response on the downside. We saw this phenomenon play out during the supply‑driven downcycle in crude prices that took place in 2014 and 2015, after surging hydrocarbon output from U.S. shale players and OPEC’s decision not to cut supply swelled oil inventories.
We would expect this process to play out in response to the recent demand and supply shocks, with the supply adjustment in U.S. onshore plays helping to rebalance the market relatively quickly. We would also expect shorter‑cycle offshore developments that tie in new wells to existing infrastructure to slow down, while investment decisions on longer‑cycle offshore developments will likely be pushed back.
U.S. Oil Patch Faces Pressure
As it stands, we find the current price of crude oil to be relatively reasonable, given the unprecedented and simultaneous supply and demand shock. These low prices will not only chase capital away from the sector—the number of active rigs in the U.S. is likely to drop as much as 50% from February 2020 levels—but we should see existing wells shut in in response to oil prices below USD 30 per barrel. In fact, the material drop in demand levels requires these well shut-ins and reduced drilling activity to rebalance the market and prevent a total fill of inventories.
Productivity Gains Pressure Cost Curve
Oil output per drilling rig, Permian Basin, West Texas
As of March 1, 2020. Source: U.S. Energy Information Administration (March 16, 2020).
The good news is that, while oil prices will be meaningfully challenged in the near term, it should not take long to rebalance the market. Even with Saudi Arabia’s elevated levels of oil production, we expect a V-shaped recovery as we move into 2020, similar to the price collapses that occurred in 1986, 1988, 1998, 2008–2009, and 2014–2015. Once again, low oil prices should be the cure for low oil prices.
With oil prices plunging toward the operating cost curve for the second time in five years, we are likely to see a reduction in the flow of capital to the oil patch. Valuation multiples for U.S. shale oil and gas producers had already come under pressure in recent years, reflecting the market’s concerns about these companies’ returns on capital and terminal values in a future where environmental concerns and growing adoption of electric vehicles could dampen demand. In the current state, we would expect to see an increase in bankruptcies among the weakest exploration and production and oil field service companies, primarily those with lower‑quality assets, weak balance sheets, and near‑term debt maturities.
However, these challenges could contribute to necessary changes that would put the industry on better footing, including a shift in focus from growth at any cost to improving investor returns and free cash flow generation. Industry consolidation also appears likely over the coming years, as scale becomes increasingly important to control costs and increase operational efficiency.
Author: Shawn T. Driscoll, Portfolio Manager at T.Rowe Price. To find out more contact your financial adviser.