Oil’s New Math

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by Brian O’Keefe,

from Fortune Magazine,

With prices down by 50%, the world’s foremost experts are reworking their assumptions about crude’s calculus. Here, a primer on the new math.

Jonathan Goldberg was one of the few who saw it coming. Early in 2014 the rookie hedge fund manager noticed something unusual: The amount of crude oil being stockpiled around the world was building much faster than normal for that time of year. The growing excess in supply wasn’t yet reflected in the market, however. Benchmark oil prices continued to hover around the same lofty level they had occupied for the previous few years—near or above $100 per barrel. Increasingly this was considered the new normal.

Goldberg and his team watched closely as the stockpiling accelerated. By the end of the first quarter, the trend was clear. A gusher of new supply driven by the stunning growth in U.S. shale oil production—accounting for most of the 80% spike in overall U.S. production since the end of 2008—was beginning to overwhelm demand. And yet oil prices continued to defy gravity, propelled by fears of supply disruptions. Russia’s conflict with Ukraine and the emerging threat of a new Islamic state in northern Iraq caused crude to hit new highs in late June.

The trader stayed patient, waiting for a catalyst that would spur a drop. By the early fall Goldberg noticed that the cash prices being paid for physical oil were significantly lower than even the suddenly weakening futures prices. He became more confident that it was time to be short oil.

Then the bottom fell out. On Nov. 27, the Organization of the Petroleum Exporting Countries announced that, contrary to the assumptions of much of the oil industry, it would not cut its production to defend higher prices. Crude went into free fall. The price of a barrel of West Texas Intermediate (WTI), a benchmark for so-called light sweet crude oil, tumbled from its June high of $108 to a low in January of $44. Goldberg was well positioned for the crash.

Now the question for Goldberg and others is, what happens next? What are the implications of a 50% markdown of crude—in terms of cost structure, demand growth, and production? Will prices remain low for a sustained period or rebound quickly? To answer that, you have to study oil’s new calculus. For the near term anyway, expect volatility, not consensus. “The only thing that there’s agreement on is that it’s a lot more challenging than the old math.

… the industry as a whole failed to recognize what, in hindsight, should have been obvious: that a developing glut made a price correction almost inevitable—especially with the Saudis signaling that they had no intention of cutting back production.

The fallout from the drop has been swift and brutal. Publicly traded oil companies have lost billions in market value, and both public and private firms are moving aggressively to cut capital spending budgets for 2015—laying off thousands of workers and shutting down hundreds of rigs. This is especially true in the new boomtowns that have powered the shale oil revolution in the U.S. (For an on-the-ground report from North Dakota oil country, see “Waiting for the Reckoning.”) If the downturn drags on, there will almost certainly be bankruptcies and acquisitions.

“What we’re seeing is a textbook implosion with regard to exploration and production capital spending domestically because the industry was leveraged to very high oil prices,” says Bill Herbert, a senior researcher at Houston oil and gas investment bank Simmons & Co.

… the industry is taking a hard look at costs. “Companies are reorienting themselves to a low-price environment,” says Yergin. “A decade ago they had to adjust to a higher price, and costs went way up.” But even before last year’s dive in prices, says Yergin, controlling costs had become the No. 1 issue for top execs at the major energy companies. “If that was a preoccupation before the price collapse, it’s now an obsession,” says Yergin.

… crude production continues to surge as a result of wells already drilled—and stockpiles of the excess continue to grow. In early February the amount of oil in storage in the U.S., excluding the strategic petroleum reserve, reached 417 million barrels, according to the U.S. Energy Information Administration, the highest level at that time of year in at least 80 years.

The oil market remains in what’s known as contango—with the future price of crude trading at a higher level than today’s spot price. That suggests a belief that prices will rebound, at least somewhat.

The outlook for consumption is murky. The International Energy Agency has lowered its demand forecast several times in the past couple of years, and in a recent report cautioned that both China, the biggest demand driver, and the global economy more generally were becoming less fuel-intensive. Still, the IEA projects demand to grow by more than 7 million barrels per day over the next five years. While lower crude prices mean cheaper gasoline in the U.S., which should spur demand, that’s not so much the case in other countries, where taxes represent a higher portion of the cost of gas (as in Europe).

A pair of recent reports suggest that the industry can stay in hunker-down mode for a while—as long as prices don’t crash much further.

After studying oil prices over long periods, the GMO chief strategist has come to believe that there have been two major paradigm shifts when oil reset at higher baseline levels. For decades, he says, the base price, calculated in today’s money, was $16. From there, oil occasionally doubled or dropped by half, but tended to return to $16. The rise of OPEC in the 1970s changed the game, says Grantham, and the baseline price jumped to $35. “Whenever you were down by half, of course, it was the end of the world, it was a New World Order,” says Grantham. “And whenever you went up, the same in reverse.”

Just after the year 2000, Grantham maintains, the cost of oil inflected as finding new supplies became more challenging and expensive. That drove the base price up to $75 or $80 per barrel. Since then we have experienced both the doubling (when oil surged to nearly $150 in July 2008) and the halving (when it crashed below $40 in December 2008). Despite the gusher of U.S. shale oil production, Grantham believes that prices are likely to reset higher again—to a baseline above $100—because, outside of shale, finding new oil is getting harder. And there won’t be enough shale production to cover the declines of existing supplies and meet future demand growth. “If you look at the size of the oilfields discovered, they get smaller and smaller at a heartbreaking rate,” says Grantham. Recent data support the observation. According to IHS, nonshale discoveries have fallen sharply since 2010, and 2014 is “likely to mark” the first year since the 1950s that no conventional giant oilfields (those with more than 500 million barrels in reserves) were found.

But while Grantham projects that oil will surge higher in the medium term, he ultimately—perhaps 20 or 30 years down the road—sees advances in technology making oil virtually obsolete in transportation. “It’s a wonderfully complicated world, isn’t it?” he says.

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