The shale revolution has driven U.S. capital expenditures, research, and development in energy for a decade. Investment in upstream drilling equipment, mid-stream pipeline build-out, and downstream processing supported economic recovery following the recession. Plummeting natural gas prices and regulatory challenges to coal after 2008 were not enough to stem the flow of investment dollars. However, falling oil prices during the past year sent capital expenditures crashing and manufacturing orders declined precipitously. Drilling has scaled back and a number of announced investments in liquefied natural gas (LNG) export facilities and petrochemical plants have been put on hold until oil prices recover.
Three theories about why oil prices are declining shed insight into when they will recover. Economics largely explain why prices are low and imply a rise within the next year, albeit to far less than prior levels. Saudi Arabia has stated long-term strategic objectives to thwart potential competition that imply depressed prices for the next three to five years. If shale is challenging the reign of the Organization of Petroleum Exporting Countries (OPEC), Saudi Arabia might simply maintain production to capitalize on current prices, embarking on an end-game as increasing competition continues to drive prices even lower. Understanding when capital expenditures and manufacturing orders will turn around requires insight into fundamental changes occurring in the oil industry and an opinion on which theory holds.
Energy and investment
Investment in energy has grown in both absolute value and as a percentage of total capital expenditures. Throughout the past decade, utility and energy sectors have grown in market share from around 20% of national capital expenditures and research & development to more than one-third, according to Goldman Sachs. Until oil prices dropped at the end of 2014, industry pundits anticipated continued expansion.
The 2008 collapse in natural gas and coal prices did not matter. As long as global oil prices stayed near $100 per barrel, investment in shale exploration, drilling, and production was justified. As natural gas prices continued to fall, rigs simply shifted away from dry gas plays with a high methane concentration to wet gas fields that contained natural gas liquids (NGL) or condensates such as ethane, butane, pentane, or natural gasoline whose prices correspond to oil prices. Higher priced condensates kept wet gas fields economic on a stand-alone basis, effectively relegating natural gas that could be produced into a byproduct that contributed to the nation’s growing supply.Efficiency improvements in unconventional oil production from U.S. shale fields also continued, making domestic oil production more profitable. Investment in energy production, transportation, and processing continued to rise on both an absolute basis and as a percentage of national capital expenditure until global oil prices crashed and investment immediately retrenched. Rig counts declined and production shifted to the most efficient wells. Oil companies began shedding jobs with employment in mining declining by 123,000 since its peak in December 2014, according to the U.S. Bureau of Labor Statistics. Manufacturers and vendors servicing the energy industry were hit hard.
A new world order
The oil industry is facing a new world order. In 2003, Canada’s proven oil reserves increased from below 10 billion barrels to 180 billion barrels with the inclusion of oil sands, moving a non-OPEC country into second place behind Saudi Arabia. In 2011, Venezuela announced that its oil reserves, with the inclusion of oil sands, surpassed Saudi Arabia. Estimates of proven reserves currently only include conventional oil and tar sands. Once unconventional oil reserves are included in country-by-country estimates, the radical changes in global petroleum resources will become even more apparent.
Meanwhile, the U.S. has been capitalizing on its shale oil and gas. With established mineral rights laws, energy transportation infrastructure, trained work force, and relaxed environmental regulations, the U.S. is the world leader in shale resource development. Since spring 2013, the U.S. has been producing more oil than it imports at levels not seen since 1992, according to the Energy Information Administration (EIA). In 2014, the U.S. reportedly produced more petroleum and liquids than any other country, including Saudi Arabia and Russia. In April 2015, U.S. oil field production reached 9.58 million barrels per day compared to the all-time high in November 1970 of 10.044 million barrels per day (Figure 1). In a telling move, Congress lifted the 40-year old ban on crude oil exports on Dec. 18, 2015.
In the face of changing fundamentals, oil prices have plunged to levels last seen following the market crash in late 2008. Investment in energy has experienced a corresponding crash. Is this a short-term phenomena or a new equilibrium, and when will investment recover? It depends on which theory you believe caused prices to fall.
Theory #1: Basic economics
The economics of oil production is changing. If the marginal cost of production were around $100 per barrel, incorporation of North American shale oil into the supply curve drops it to below $80 per barrel at 2014 demand levels. A decline in global demand can reduce long-term equilibrium prices even further – as illustrated by the impact of the recently revised economic outlook for China.
As a result, economics would suggest a new, lower equilibrium for oil prices approaching roughly 70% to 80% of recent levels. In the short-term, however, prices are much lower, driven by a temporary supply glut. Under a pure economic argument, oil prices should recover to their new equilibrium levels within a year as excess supply works its way through the industry under the assumption that economic recovery continues. In the face of flat growth or a global recession, however, recovery will take much longer because demand alone will not absorb excess supply. A return to $100 per barrel prices is not likely in the near future.
Long-term strategic behavior
Saudi Arabian officials have stated intent to act strategically against long-term competitive threats. In the past, the potential threat has been renewable resources that could displace demand for heating oil and fuel oil for power generation. Today, Saudi Arabia faces a three-pronged attack from the shale revolution. Shale oil production is taking away global market share as U.S. production grows, crude oil imports decline, and exports begin. Second, shale natural gas production reduces the price of natural gas, and is a direct substitute for oil in heating and power generation. Third, development of electric vehicles spurred by lower power prices tied to lower natural gas will displace petroleum cars and trucks.
Facing the tremendous growth in shale production in the U.S., maintaining production in the face of increased supply and falling demand would allow Saudi Arabia and OPEC to:
- Determine the marginal cost of production of U.S. shale fields
- Maintain prices at low enough levels for long enough to delay continuing shale development
- Set the industry back so that continuing investment is hindered by uncertainty and capital costs
Under this scenario, prices will remain low for at least a few years – long enough to hurt U.S. producers – before slowly rising to newly lowered long-term equilibrium levels of $65 to $80 per barrel.
Theory #3: Game Over
This last theory is the most interesting, and the most far-fetched given the realities of shale development. Looking at a world map of shale plays and estimated reserves of unconventional oil established by the U.S. Geologic Service, Saudi Arabia may have realized that OPEC’s reign is about to end. Realizing the game is over, Saudi Arabia would be incentivized to engage in uncooperative, end-game tactics, causing oil prices to fall to new levels as world shale production accelerates and alternative energy resources are realized. Continuing to produce oil at current prices would be rational if one believed today’s low prices are still higher than future prices. This game theory explanation of continued production in the face of declining demand would imply prices below $50 per barrel well beyond the next five years.
Energy has driven an increasing share of capital expenditures over the past decade, a trend that declined dramatically in 2015 as oil prices fell. Unlike in the past, when low energy prices drove economic growth, price declines have been met with lay-offs and pull-backs in investment. This will continue until either oil prices recover or economic growth fueled by lower prices can offset energy industry reductions.
Meanwhile, economics imply a relatively quick recovery in investment throughout the next 12 to 18 months unless the global economy declines. Long-term strategic behavior could portend a longer recovery of three to five years. A new world order with a substantial shift in oil supply due to shale plays would imply an even longer recovery.
About the Author: Tanya Bodell is the executive director of Energyzt, a global collaboration of experts who create value for investors in energy through insights. She can be reached at firstname.lastname@example.org.