| Paul Horsnell, Head of Commodities Research, SCB |
THE next few months are likely to be chaotic for the global energy industry. We expect investment in future capacity, both in conventional and alternative energy, to fall sharply amid a severe squeeze on producers.
OPEC’s decision not to cut output marks the end of four years of remarkably stable oil prices. With OPEC, at least temporarily, abdicating its role as a price stabiliser, the market has by default taken over that role. To an industry such as oil, with its high capital costs, long investment lags and significant geopolitical implications, the prospect of purely market-driven prices will provide little comfort. The past 150 years have been marked by frequent boom and bust cycles in oil, with each low of the cycle squeezing longer-term investment and creating the base for the next boom whenever demand improves again.
The current cycle looks no different: a short-term supply surplus is likely to turn into a medium-term supply deficit, with the industry quickly switching back into its 1990s mode of chronic underinvestment. However, there are some new features to the latest slump. Key among these is the role of fracking and the growth of US shale oil. The boom in US shale oil was created by crude at USD100 a barrel, and how the industry will react to a price downturn is yet to be seen.
Shale oil production is closer to a conventional manufacturing process than traditional oil production. It is driven by cash flow, and can be turned on and off fairly rapidly. Production declines at a very high rate, and intensive new drilling is needed to compensate for the sharp decline from existing wells.
So far the industry has managed to keep up with the declines and grow output further through a mixture of more drilling and productivity improvements. However, this has created a bit of a treadmill, as the higher the output, the larger the effort needed to maintain it. At above USD100 for a barrel of oil the economics of shale oil worked. In the coming months we will discover whether they still work at USD70 and below. The problem is more one of cash flow than cost. Because of the high rate of drilling needed, shale oil is something of a cash monster.
With reduced cash flow and tightened credit conditions, shale oil producers are likely to attempt to delay drilling and hold back on committing cash. Indeed, early data suggests that the number of applications for permits to drill in the US fell sharply in November. We expect to see drilling activity fall significantly over the next two months, and should low prices continue throughout the first quarter of 2015, US oil output growth is likely to fade. The global surplus of oil is likely to correct itself fairly quickly in the first quarter of 2015. The balance, however, looks much tighter for the second half of 2015 as the interim lower prices are set to boost both demand and strategic stockpiling by China.
At the current prices, a significant amount of high-cost non-OPEC oil production will have to be stopped, helping to make the bust in oil prices short-lived. The main danger for the global economy is that the oil industry will respond the way it always has done.
If non-OPEC investment is slashed once more, and the industry again sheds skilled labour at the first sign of trouble, then the next ride up in prices may prove just as wild as the previous ones.