How do you keep Oil above $50/bbl forever?

In a world of flattening and changing energy demand, with more dense and varied supply, Saudi Arabia’s latest, lone effort to manage global oil prices looks forlorn

————

Everyone seems to like an oil price around about $50-60/bbl these days.

Saudi Arabia, one of the world’s largest oil producers appears to be depend on it, as does much of the international private oil industry.

In fact, a “Goldilocks Zone” has been ascribed to this price span – not too hot to cause consumers pain, not too cold to force producers to make major structural adjustments.

The recent move by OPEC (mainly the Kingdom of Saudi Arabia, KSA) to trim back production by a target 1.2mb/d was also pretty explicit about $50-60/bbl being their preferred outcome.

Why these exact numbers? What does it tell us about the business model operating today in this late extraction period of the oil industry, and what does it suggest for the future?

Can it keep oil above $50/bbl forever? Does this have Goldilocks benefits?

First, the numbers.

There are many ways to dissect the range of oil and gas business models at work today, but it’s probably best to keep it very simple when trying to understand the macro-level oil price, and focus on the big players who clearly try to shape the market, and look at their top-level cash break-even costs.

Between them, KSA, Russia, major international oil companies (IOCs) and US shale producers account for over 40 million b/d of oil production. In terms of liquid fuels for transportation, KSA and Russia alone account for about 40% of the total. KSA and Russia tend to lead in terms of price policy, IOCs and shale focus on technical and financial leadership.

The table below attempts to summarise cash break-even costs of these four major blocs at the business model level – that is, capex plus opex plus dividends or state budget payments for state-controlled National Oil Companies (NOCs).

Table 1 – High-Level Cash Break-Even Models – Selected State / Private Oil Firms

This analysis is a snapshot, and various players will use the cash structure to pursue different strategies – plateau, growth, acquisition, debt paydown and so on. The broad outlines are only being assessed in this note.

First, the state or semi-state players, KSA (Aramco), and Russia. The chart uses Rystad Energy’s estimate of aggregate capex and opex costs per barrel, plus latest updates from Rosneft for Russia as it makes up about 40% of Russian oil production.

Added to capex and opex is the estimate of what the major state oil firms pay in dividends or tax take to the government. For KSA it uses 2015’s state budget target, and assumes 75% needed to be derived from oil revenue. For Russia, it is the actual state payment rate of 2015 based on analysis here.

For the private players, the large IOCs comprise Exxon, Shell, BP, Chevron and Total based on 2015-16 data, and the US shale based on aggregate Rystad US numbers with Pioneer Resources, Continental and Chesapeake energy data used as key examples.

What do these numbers tell us?

First, the KSA numbers likely underestimate the true “fiscal break-even”, the oil price at which it fully funds its expenditures rather than running large deficits – this is estimated at up to $80/bbl all-in.

And KSA seems a outlier, even for state-based oil models, compared to Russia (or Brasil, or even Iraq for example). It has a single monolithic oil arm, Aramco, and attempts to fund national budgets from this one entity. All the other large state players either have international units of their oil champions or in-country presence of international majors supporting resource development. Fiscal take is also more diverse – graduated or internationalized in many of these countries.

It also shows why at around $40/bbl, KSA, and IOCs, start to hurt badly and have made market moves on production cuts, in the case of Saudi Arabia, or rapidly slashed capital expenditures in the case of IOCs. In contrast, Russia has continued to invest in capital expansion, and US shale has managed to hold investment with only a limited draw-back of production.

$50/bbl forever ?

There may be a rational, numerical case for $50/bbl from the chart above. Saudi ministers tend to articulate it as “stabilizing the market, and allowing greater investment in the industry” – even though it is still some way short of providing them with a balanced budget.

And for Russia, other nimbler NOCs, and perhaps US tight oil firms, as they drive down learning curve costs on the vast American shale deposits, $50/bbl likely provides a profitable revenue model.

But its still uncomfortable for many players – the UK North Sea capex and opex alone is higher than $50/bbl, and most of the IOCs will have to borrow to pay sacrosanct dividends long into the future given the state of their complex, and sprawling portfolios.

In fact, outside the main national oil companies, all large private firms are doomed to pursue growth as their reserves to production ratios move towards single figures: so forward capex, a wake of aging fields and unbending dividends propel then towards $50/bbl relentlessly.

So, in reality, $50/bbl only comfortably supports sections of the industry, and not the whole. In time, maybe IOCs and KSA will adjust models structurally to a lower cost base – but it looks unlikely in the short term

In this late extraction period of the oil industry, it seems to need at least $50/bbl for survival, and likely higher for modest growth.

For an industry charged with providing 85% or our energy needs today, and projected to provide over 75% in 20 years time, is this (or an even higher one) a reasonable price?

The question is fundamental – if our energy needs for the next 20 years is to be largely based on this technology : extraction, business model: low-cost state-dominated plus high-cost private, and economic: managed via coordinated supply constraints, then we need to be comfortable with, and prepared for, $50/bbl (or higher) for the foreseeable future.

This is because this structure will not lend itself to normal learning curve improvements. At the low-cost end, production is curbed by major producers to inflate price; at the high-end the complex development model provides no cost improvements on a unit basis (and dividend policies force high real cash requirements).

For transportation alone this requires, assuming a level 50 mb/d pa demand, $20trillion (real) of raw material consumption cost out to 2035. A normal manufacturing learning curve, at least eating inflation, could drive costs down to the $30-35/bbl level, giving $4-5 trillion back to consumers.

Overall, the oil industry seems to have built outwards from a cost-plus model: assuming that the price paid will accommodate an average or marginal cost of extraction. For oil especially, operating as an almost-monopoly due to limited direct alternatives, this has tended toward higher costs and prices over the past 15 years. However, long-term trends in fuel efficiency, and a slowing pace of demand growth, are starting to challenge this cost-out position, and a more competitive energy market pricing model may start to develop.

So, philosophically, is an eternal $50/bbl Oil price a good thing for everyone, consumer and producer alike?

Almost certainly not – normatively it tends to curtail innovation and competitive ideas, assuming the cost growth of traditional business models will be absorbed by consumers.

Practically, it stands in the way of the dynamic energy world that is emerging.

The Future of the Late Extraction Period

What does this simple analysis point to?

The numbers can take us only so far.

The narratives and beliefs behind them are just as important.

Saudi Arabia and the IOCs have the longest established and most rigid models, and also the most dependent on the current oil price levels.

Whilst KSA is attempting to diversify its economy, this is a vast task given the scale and culture of oil wealth dependency, and unlikely to occur in the medium term (the Aramco IPO may be a turning point however).

For the IOCs, their multi-decade accretion of project scale, infrastructure expansion and dividend structure has lead to a very rigid model, and very strong beliefs in oil “cycles” justifying perpetual growth strategies.

Both Russia and US shale appear to have more recent, emergent strategies – willing to adapt using commercial, fiscal and technical tools – ultimately more skeptical about, and more reactive to, future business cycles.

And so the world of oil supply has become, in this late extraction period, very diverse, and very complex: many players are pursuing many motives, but all built around growth.

Whilst KSA has more or less unilaterally halted production growth, there are now numerous reasons why almost every other major player will continue to grow theirs. Saudi Arabia’s plea for restraint to a wide range of non-OPEC producers is effectively an admission of this fact.

Unless everyone co-operates, stops growth, and reigns in production, supply will expand.

Demand

That leaves us with the two biggest unknowns: what is going to happen to oil demand in the medium-term?

And what will be the industry response given the models above ?

The first question is uncertain – but the second has a more likely answer.

On demand, let’s assume conventional oil demand weakens, and then declines, due to global political uncertainty and the relentless ingress of alternative technologies into the energy mix. Overall energy use may stay robust, but oil and gas requirements could still falter due to end-use technologies and efficiency.

Moreover, the longer that OPEC and non-OPEC producers indulge in a preferred price target range, and avoid structural changes to deal with lower outcomes, the more likely overall demand will weaken, as this leaves the back-door wide-open to competing manufacturing technologies such as EV, wind and solar with their quickly declining cost curves. More potently, it will push major consumers, like China, into the embrace of alternatives to a high reliance on imported fuels.

On supply, the chart above is simple, but it indicates that any lowering of the oil price over the next 1-2 years will be accommodated by the Russian and US shale blocs far more easily that that of a singular KSA: it doesn’t bite into their core as significantly on an individual basis, and as a group they have already found ways of executing cost reductions.

Paradoxically, the IOCs rigidity will work in the same direction. Irrespective of prices in the next 2-3 years, IOCs will continue to invest heavily in production growth and supply productivity from the recent era of mega-investment: their intense belief in a redeeming price cycle will dull all short-term financial pains.

Given this, KSA can only pull the production lever back so long before it recognizes that no-one else (again) is going to follow. Controlling a wayward grouping of OPEC players is difficult enough – managing the complexity of the global private, hybrid and state markets will be overwhelming.

So, then, how do you keep the keep the oil price at $50/bbl forever?

The answer is, given a world of weakening – conventional – demand, and complex, growing supply, you can’t.

And soon the last producer attempting this will likely stop trying.

The Aramco IPO is looking less like a turning point, and more like a tipping point.