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Peter Tertzakian

Peter Tertzakian

Peter Tertzakian is Chief Energy Economist and Managing Director at ARC Financial Corp., Canada’s largest energy-focused private equity firm. His career began as a geophysicist…

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Why Oil Could Head Back To $90 Sooner Than Thought

Anadarko oil rig

I don’t know much about fashion, but I have heard that blue is the new black. And I know that by the time I buy blue, everyone else will be wearing green.

In the oil business, modish pundits are now pronouncing, “60 is the new 90,” championing the thesis that productivity gains, cost improvements and price wars have pulled the global clearing price of oil to $60/B, down from $90/B a couple of years ago.

The oilfields of the world share some similarity to fashion ateliers.

Designers in Paris and New York collude every fall to convince us all to wear new colours in the spring. Meanwhile, innovators in Houston and cartel leaders in Vienna claim that $60 a barrel is the new, long-term marginal cost of oil. As a result, a $90-per-barrel breakeven cost has become about as appealing to an oil investor as a wide necktie to a millennial.

Here’s the thing: Not everyone looks good in blue and not all producers have the rocks, expertise and infrastructure to make their financial statements look good at $60 a barrel.

Behind the scenes, the oil industry has become more discerning in its own way.

If there is one new style that’s obvious it’s that “short-cycle” investing is the new “long cycle.” In other words, smaller capital outlays, faster payback and more certain returns have become de rigour for oil and gas investing. No more multi-billion-dollar, decade-plus projects that are subject to the long-term vagaries of geopolitics, the threat of expropriation, corruption, civil war, policy uncertainty or outright obsolescence.

Like a traditional navy suit, investing in short-cycle projects is a fad that’s unlikely to end soon. Premier American oil fields like the Permian, Eagle Ford and Bakken are conducive to drilling when the trading screen flashes $60 in New York. So too are equivalent Canadian oil plays that are becoming trendy.

Related: Texas Is Making An Energy Recovery

More of the world’s oil resources are in vogue too at $60/B, more than there was two years ago. “Half-cycle”, partially developed projects with easily accessible infrastructure can be in business at $60 or less. And cheap Middle Eastern oil never goes out of style – although the above-ground social costs are necessities that can make a barrel considerably more expensive.

But this is all just theory in a world that is largely running on excess oil inventories.

There isn’t any field-tested evidence to suggest that there are enough short-cycle, $60 projects to satisfy our world’s near 100-million-barrel-a-day appetite over the next several years. What is certain is that the geography of places where under $60 works is not as great as where $90 used to work.

From a free-market perspective, it’s long been noted that about 80 percent of the world’s oil resides under state-controlled oil regimes. Twenty percent exists in places like the United States, Canada and the North Sea. Of that 20 percent, a significant portion was of the long-cycle variety, for example big oil sands and frontier Arctic projects. So, the set of investible opportunities is geographically and financially much narrower than it used to be, at least for now. Admittedly, the 80/20 ratio could become less skewed as new processes open up greater quantities of “unconventional” oil in places like Argentina, Mexico, Russia and China. However, North America is almost a decade further up the learning curve after drilling and completing tens of thousands of wells. Other regions have long-term promise for sure, but it will take considerable time to replicate the U.S. experience in a sub-$60/B price environment.

Related: Why Permian Prices Will Keep Breaking Records

Once the oil storage glut clears, producing companies will need to ratchet up their upstream spending. Several hundred billion dollars must be invested over the next few years to bring oil out of the ground from a far more concentrated set of opportunities. And that looks problematic when looking at the historically high correlation between oil price – hence cash flow and investment – and costs (see Figure 1). Piling into North American tight oil plays, or even some new ones abroad like Argentina, has high potential to over-capitalize concentrated areas and drive costs much higher. Land prices in many potentially sub-$60 plays are already inflating quickly.

(Click to enlarge)

All of this is to say that $60 may be the new $90, but only until such time as everyone strips the rack of $60 opportunities, driving costs up again. Then just like cycles in the fashion business, the oil industry might be wearing $90 again.

But all of this fashion lingo is just talk right now. The price of oil hasn’t shown $60 yet. The industry is still wearing a skimpy 50 bucks a barrel.

By Peter Tertzakian for Oilprice.com

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Leave a comment
  • Prashanta on October 19 2016 said:
    Hm. I could really benefit from an investment point of view if oil prices were to rise but the fashion argument is rather weak.
  • Clyde on October 20 2016 said:
    Sounds like this writer will rah rah oil to $250.
  • JHM on October 20 2016 said:
    I like the short cycle / long cycle distinction. The worry is that we may not see a long cycle again. The problem is that if EVs grow 50% annually, oil demand peaks about 2025. After that, the value of untapped oil reserves drops rapidly, even to zero. So if you are sitting on a 70 year (R/P) reserve, your balance sheet is destroyed within 20 years. You forfeit about 70% of the current value of your reserves. So in this scenario, you are highly motivated today to increase production as much as possible. You want to liquidate your reserves as quickly as you can afford to do so.

    This is how the EV transition impacts the oil market right now, even though the market share of EVs is still quite small. It is the mere expectation of EVs that drives liquidation and oversupply of the market. Many investors ignore or dismiss this, but with each passing year EVs will advance and it will become increasingly clear to everyone. So the pressure to liquidate will only increase, regardless when peak oil demand actually occurs. Moreover, high oil prices will only serve to accelerate that transition to EVs. If you game this out, you really do not want oil to get above $60/b.

    The glut can persist until demand begins to fall. So there is not assurance of a long cycle.
  • zorro6204 on October 20 2016 said:
    Once the oil glut clears . . . but what if it never does? There's nothing on the horizon that shows production will be coming down anywhere that matters. The Saudi's are still deploying rigs, the Russians are planning on increasing production in 2017, US production has hit a high plateau, there will be more Canadian oil due to projects already in progress, and Libya, Nigeria and Iran are not subject any OPEC "cut" (which isn't a cut). The Nigerians are complaining about a "huge" cargo overhang in the market.

    I just don't see it, seems to me by 2020 it could be worse. Spending for big project oil is dead because we don't need it. Chevron is relying on 3-5,000 wells in the Permian that perform at $50-60. Statoil has that cap on new projects, and ConocoPhillips has abandoned deep sea projects altogether.
  • Noah on October 20 2016 said:
    Hi Peter,

    Your thesis is right when $60 opportunities to produce are unavailable, supply will slow down and prices will rise.

    However The United States will not be cutting production any time soon with the cost of producing a well around $40/barrel.

    If OPEC actually does cut any production, and maybe they, maybe they won't. With any significant rise in prices, U.S. Companies will gladly increase production since drilling a new well to production takes a week.
  • Andrew Butter on October 22 2016 said:
    Nice - for now no-one is looking long cycle except perhaps ARAMCO who are spending a bunch of money on brown field "maintaining production", I'm running shallow water lift boats there, very sweet. The price it makes sense to got full-stream after shale (not Permian) is the margin, I'm still convinced that needs minimum $90 to rip; Permian new production is now back to the 2014 peak, but the other tight-oil plays (i.e shale oil - Permian is not shale it's just tight), are still at 30% of the peak, and "new" is less than legacy loss. You might like to look out for the post I'm going to put about that on Oilpro and Seeking Alpha; OilPrice.com don't return my mails, obviously they are too high class to want to listen to someone who predicted this fiasco in 2011.
  • Ronald C Wagner on October 23 2016 said:
    So why would it skip seventy and eighty dollars per barrel plateaus?
  • IRVEN LIU on October 31 2016 said:
    I don't think so.....oil price is going to $30 soon.

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