Boiled Frogs – Inaccurate Metaphor, Accurate Threat

The Oil Industry Has to Start Dealing Properly With Lower Oil Prices

As a metaphor for a gradual threat that goes unheeded, the Boiled Frog has been around for a long time. It turns out that in actual experience, frogs do have a natural survival instinct toward gradually increasing temperature. They will strive to leave water long before boiling point. Refreshing to hear that this cruel image can be discarded as inaccurate.

But the human animal’s frequent hesitation in the face of significant but slowly-building hazards is far more genuine –it’s a dangerous phenomenon, and worthy of a more compelling comparison.

A current example is the Oil and Gas industry response to the now 20month decline in oil price – in fact, more precisely, the lack of reaction to the longer-term issues that may now be at play.

Since the oil price started to fall in June 2014, over 100,000 industry jobs have been cut and over $400bn of investment capex postponed or terminated. It’s the reflexive solution of an industry caught out by events even though the fall has occurred over nearly two years. And its unlikely to be sustainable. It either triggers a reverse of prices, and forces boom after bust – or more likely it misreads the basis of the price collapse, and does not solve the problem.

So, how well is the sector prepared to deal with the causes of the oil price reverse, and the likely changes ahead for the business environment?

In a recent FT article, this concern was restated by posing three key questions to industry CEOs as they announce 2015’s results, and talk about 2016 and beyond.

• First, did they foresee the fall in prices across the energy sector in the past two years? if not, why not?

• Second, what proportion of your producing assets and projects under development requires an oil price above $50 a barrel (or a comparable gas price) to produce a positive rate of return? And what is your strategy if oil, gas and coal prices stay below this $50 a barrel for the next five years?

• Finally, what do you believe are the most significant advances in technology in the energy sector in the past year and how could they affect your business? What are you doing to make sure you capture the benefits of those advances rather than falling victim to them?

Lets briefly take these questions in turn to see how the industry might now respond.

First, oil price expectations. This rapidly-becoming-iconic chart seems to spell out the underlying oil price rationale very succinctly: since the end of 2013, supply has been continuously exceeding demand, and oil has dropped from over $100/bbl to under $30/bbl as a consequence. Simple, but unforeseen. But unforeseeable?

Demand forecasts are tricky to get right even medium-term, but the actual increase was more or less in the mid-range of expectations for the 2-3 year look-ahead. Relying on only bullish forecasts would have been the main problem in terms of over-investment.

Supply? US shale oil production was the major change here, leading to US oil production increasing by over a million bbls per day in 2013, and again in 2014 – making it, once more, the world’s largest oil producer. But this was not unexpected given the investment data and projections from EIA and others. The likely return of Iranian crude should have been a supply upside also.

So, scenarios of oil price contraction were defendable. In fact prices of $25-35/bbl prevailed for much of the decade leading up to price rises from 2004 onwards.

But none of these would have been used in any oil firm calculations in 2014.

The high prices had developed a logic and spending machinery of their own, and sharp declines cannot be factored into longer-term capital investment plans – “hurdle rates” will only gradually be amended. And there is a deep reluctance to make snap corrections in any event – this would kill favoured projects, reverse strategies, cause speculative staff reductions and likely be sharply out of step with peers, attracting analyst concern.

 

With oil prices now revealed as low as $30/bbl or so, it will be safer to dust down the low price short-term action plans and react accordingly, which is what we see: severe capital reversals, and block staff reductions. But this is not viable for more than a year or two.

In sum, its clear that the prior logic of high oil prices was assumed to be robust. There is no longer-term plan yet for a prolonged downturn. The fall in prices is not yet believed.

Second, what proportion of assets require greater than $50/bbl for a positive rate of return?

Since 2010, US oil output has increased by over five million barrels per day using relatively straightforward drilling and recovery technology, allied to the fundamental power of learning curve effects and mass manufacturing productivity gains. Mid-tech manufactured oil increased production dramatically, with a focus on agile, flexible field development.

In contrast, the majors have had to concentrate on more expensive technically-challenging, longer-term projects, where national oil companies allow access and don’t directly compete. These projects also attract a host of “above-ground risks” such as local content issues, infrastructure development and logistic complexity. Thus, in the same timeframe, the combined production increase of the top five oil majors (Exxon, Shell, BP, Chevron, Total) was more or less zero, and typical project size and break-even costs rose sharply, sustained by high oil prices.

As a result, as the Goldman Sachs Top 420 Oil Projects report outlines, traditional global project delivery suffered from relatively high break-even values of over $80-90/bbl, whilst shale oil moved rapidly down the curve toward the $50-60/bbl range and below.

Complex and expensive projects are also very difficult to stop individually and as a collective. Sanctioned projects are generally kept going irrespective of price as so much monetary and human capital is committed. Near-sanctioned projects also go through a vocabulary of cold storage – recycling, re-design, postponement, re-phasing – rather than fundamental exits. This means that the overall investment shape does not change significantly in the short-medium term, only the pace of the approved investment.

Most major firms will therefore continue their current investment plans and scope, and use delays in sanction to play out time until the oil price returns to what’s assume to be more rational levels.

So – the short answer to what proportion of assets require greater than $50/bbl for a positive rate of return is – 100% – there are no realistic plans for a switch to lower cost opportunities among the main players.

There are minor exceptions including extensions to existing hubs eg deep-water tiebacks, or onshore debottle-necking. But the industry will need significant time to re-tool its supply chain to be fully efficient at under $50/bbl – cost structures cannot change anywhere near the pace of price change.

The likeliest strategy for dealing with a prolonged sub $50/bbl oil price will be to continue to hold on investment, and re-look at M & A options. Restarting the in-house capital intensive project engine will be too high a risk without clear price signals, but for majors existing field decline will require producing assets quickly from somewhere.

Third, what do you believe are the most significant advances in technology in the energy sector, and what are you doing to make sure you capture the benefits of those advances rather than falling victim to them?

Put another way, what technology is likely to disrupt the industry in positive or negative ways?

Like most mature industries, oil and gas invests mainly in sustaining technology, incremental and focused on existing operational activities such as drilling or project engineering, and some supporting IT such as 4D seismic. None of these are typically transformative.

But combined technologies in engineering, finance and policy standards are having a major impact on the industry and are likely to continue to do so.

First, as noted already, the rise of manufactured shale oil. This is a mature mid-tech engineering technology, but two other innovations bring it to a disruptive scale: cheap US money allowing multiple new entrepreneurial firms to drive wide-scale investment that oil majors would not fund, and the governmental policy shift to permit its global export. For the first time, such a market-based “entity” has become the effective oil industry swing-producer, with all this might entail for future pricing.

Second, the switch to producing more gas: with the rapid rise of gas projects in most oil company portfolios, especially large LNG ventures, and new exports from the US, there is simply a lot more globally mobile gas available. Most gas projects are traditionally based on long-term sales contracts linked to oil price, but the new widespread availability is causing market change, with a more fluid spot market emerging alongside traditional contracts – this is likely to even out global pricing and push already decreasing margins downwards, following the path set by the oil market in the 1980s.

Third, the long-range growth of the energy decarbonisation agenda. Oil and gas companies have engaged tentatively in this arena in Carbon Capture and Carbon Pricing initiatives – but only at the edges of the issues (see here). In the past five years, only 0.5% of oil major capital budgets have gone into CCS for example. Leadership in the decarbonisation debate will come from elsewhere, such as government departments, analysts and think-tanks, especially after the COP21 event in Paris and the codification of the 2°C target.

Recent analysis from these groups predict that meeting the 2°C challenge might require a 40% reduction in industry capex (over $2 trillion over the next decade) creating “economically stranded” projects, and prompting firms such as BHP Billiton to produce a detailed analysis of the impact on their company portfolio for investors to review.

The oil industry risks becoming relatively reactive in these wider technology developments – by not driving leadership positions in shale oil, overall gas pricing and the decarbonisation agenda the industry is increasingly vulnerable to price pressures driven by new entrants.

Overall, a reasonable response to the three questions might be:

• The oil price is difficult to judge, and we are unlikely to be able to forecast it again, or indeed react any differently due to the typical industry investment life-cycles
• At $50/bbl most oil and gas projects struggle to survive, so we expect a price upturn, but if there isn’t one all portfolios will require major restructuring
• New technologies will tend to drive a focus on more mid-tech oil and increased gas in the industry mix, and the low-carbon agenda impact is uncertain, although it could be profound but we are taking a watching, rather than a leading brief.

Such responses will not do.

In an industry whose pricing structure may have shifted significantly this allows the problems to gather, setting up the next set of snap reactions to events.

As Governor-General of the Bank of England, Mark Carney, noted in a speech to general insurers in August 2015 (an industry body thrust into the front-line of climate economics) – their genius at surviving has been to realize:

“The past is not prologue, and the catastrophic norms of the future can be seen in the tail risks of today.”

He called his speech The Tragedy of the Horizon – a nod to the economic notion of allowing longer-term (known) risks to prevail, as they are unlikely to be too harmful today.

The oil industry should take this notion seriously, and start to assume that the current impact of new supplies of manufactured US oil, more globally mobile gas and the impending challenge of the COP21 2°C targets may transform the industry price structure. New value signals may not be an aberration – and maintaining a course of increasing capital intensity will attract higher and higher risks. Prices may rebound for a while, but longer-cycle structural adjustments may now be afoot.

Where does this leave us?

Depending on oil returning to over $90/bbl is no strategy.

By default it assumes a continued dependence on expensive frontier oil projects, and expects demand to be undiminished by the 2°C target. It is inflexible to any longer-term change in industry pricing.

Instead, oil firms ought to factor new pricing models into their short-term and longer-term views and capex portfolios. And be bold enough to be open on this, not being defensive about how capital investment is healthy under all scenarios.

And start to broach some difficult subjects.

If the fossil-fuel industry is ex-growth as some analysts contend, ask some harder questions: how to make project life-cycles swifter, and avoid a bias toward high-cost, high risk developments? What potential M & A options work in a future lower-price ex-growth scenario? How to work with the low-carbon agenda, rather than passively observe it?

The firms that do this may not like what they see straight away – but they will be clear what lies ahead, and that could be decisive compared to their passive counterparts.

The boiled frog is the wrong image for the industry to remind itself of the new hazards out there – the frog is able to quickly jump free somewhere else. The energy industry today has far more constraints.

Maybe the correct image is something more substantial – a strange horizon, looming, advancing quicker than before.

References:

Goldman Sachs Equity Research : 420 Projects to Change the World, May 2015

BP Statistical Review of World Energy: June 2015

Carbon Tracker Initiative: The $2 Trillion Dollar Stranded Assets Danger Zone: November 2015

Critical Resource: The Heat Is On, November 2015

Financial Times: Nick Butler, January 25, 2016

Breaking the Tragedy of the Horizon : Climate Change and Financial Stability – speech by Mark Carney at Lloyds of London, Sept 2015.