Commentary – The Seesaw Recovery

Source: © Yakobchuk
Source: © Yakobchuk

What will the oil price recovery look like? It’s a topic being hotly debated across the oil capitals of the world; from Dubai to Aberdeen, from Houston to Calgary; in the coffee shops and around family dinner tables, all the way to the boardrooms.

Believers in the stubborn bottom U shaped recovery suggest low prices, lasting a few years, then a graduated recovery. Others have an edgier view: a swift pullback in US light oil production plus instability in the world’s geopolitical hate triangles, all of which combine to make a fast recovery, pushing prices up to $70+ into 2016.

Neither of these situations are representative of what oil traders are likely to scribe. Realistically, we should be thinking of a seesaw recovery, characterized by up-and downs of varying size. The expected price volatility results from the fading of OPEC and the shifting mix of oil supply that is holding up the world’s 93 million barrels of unfathomable daily oil production.

Most of the daily flow, about 87 million barrels, still comes from traditional offshore and onshore wells. What’s notable about this broad category of oil production is that it’s fairly deaf to market signals; in other words, output is slow to respond to the clamour of sudden price changes. It’s true that falling oil prices quickly trigger multi-billion-dollar budget cuts, but axing a deep-water megaproject today doesn’t result in a production gap until several years out. That’s because of the long time lag between making a decision to spend (or not) and the flow of the first drop of oil.

The introduction of 4 MMB/d of North American light, tight oil (LTO) has made the margins of the world’s oil supply more responsive to price. For LTO, the time delay between a price drop, a board meeting, a rig release and an empty barrel is relatively short – measured in a few months. Already, the last couple of weeks have shown that traders are willing to bet on a falling rig count – a 25% drop in US drilling activity from 2014 has, in part, started the first tilt in the seesaw recovery, more ups and downs are coming.

Of course, when oil prices go back up, say somewhere between $60 and $70 a barrel, boardroom chairs will swivel and more US and Canadian rigs will be dispatched again. Predictably prices will quickly retreat on the rig chatter, even though higher prices will be needed to sustain long-term global production. The first firm uptick in oil prices shouldn’t be expected until output growth shows conclusive signs of slowing down.

Yet the chatter of Bakken rig counts will not drive the big swings of future price volatility. For oil producers and their shareholders there is a hardened attitude now: making money trumps growing production at any cost. Today’s corporate directives favour smaller bite sizes of spending, shorter payback periods and greater certainty of profitability. None of this heightened profitability focus is conducive to spending tens of billions of dollars on megaprojects in troubled lands where safety, corruption and civil unrest are issues that compound risk and diminish returns.

Over the next few years big oil producers will ration their spending away from massive megaprojects that have historically been the underpinnings of stable, long-life production. More will be spent on North America’s short-attention-span light oil. It won’t be a smooth transition, and it’s naïve to think that American and Canadian LTO can backfill the global deficit that will be forthcoming as a consequence of declining investment into megaprojects. And that’s why some experts say we’re heading for another sharp $140+ price spike in a few years.

Then there is a contingent that believes in the long sustained downturn tilt of the seesaw. This camp sees long-term, low prices with no recovery; fifty bucks to eternity. Technology, say these advocates, has induced low-cost supply and global oil demand is waning. Besides, substitution with alternative energy is imminent. These arguments have some merit, but a barrel of oil is not a Motorola flip phone. Transitions in oil are far more complex than fast-paced consumer electronics. As well, the efforts to commercialize the magic of hydraulic fracturing in plays outside of North America have so far failed. And although the world’s appetite for oil is showing some signs of easing, consumption is still expected to grow by a staggering one million barrels a day for each of this year and next. There is no way to satisfy that rate of growth at anything less than $80/B. So, for now the long downturn theory does not work.

People dependent on the oil business — from pensioners to school teachers to oil executives —are asking when the oil market seesaw is going to tilt up again. For sure the markets will turn positive. But the fundamentals of the business are getting more unstable, get prepared to hold on, the recovery is sure to be bumpy.