Oil and gas is a trillion dollar industry, and every actor within it, be it national oil companies, multinationals, independents or oilfield services companies, has a stake in oil and gas flourishing. And now these players face an existential question, how will the industry react to new challenges in the shape of electric vehicles and renewables?
Not long ago, technological advancements led to the rise of U.S. shale. A significant increase in U.S. shale oil and shale gas production not only allowed the United States to reduce its oil import dependency but also influenced international oil prices. This may be good news from a consumer perspective, but it was detrimental for most major oil producers, particularly OPEC members.
Oil prices have fallen significantly since mid-2014 because of a myriad of factors, including a significant increase in shale oil and gas production. First, OPEC believed it could challenge this emerging enemy by ramping up oil production in order to bankrupt shale drillers. However, to OPEC’s surprise, events did not materialize as quickly as anticipated. Eventually, after a lag of 5-8 months, there was a plunge in U.S. shale output. Nevertheless, the lower oil prices also severely affected the economies of major oil producing countries, which heavily rely on oil revenues; in some cases, oil contributes over 90 percent of their total export revenues. Thus, most of these countries were looking for higher average oil prices in order to meet their national budgets and to realize their respective long-term visions. A vision that requires huge consistent cash flows.
Subsequently, OPEC turned to old practices, cutting oil production in an effort to revive oil prices. A strong compliance has led to a drop in OECD inventories from 264 million barrels a year ago to 52 million barrels in early 2018. Consequently, in last couple of months, oil prices have been fluctuating in mid-sixties.
History has taught us that nothing lasts forever. We have seen the dominance of coal that was once responsible for industrial revolution; its role is diminishing not only due to the availability of new resources but also due to environmental and economic considerations. The increasing role of oil demand in transport sector was only possible due to perfection of the internal combustion engine that revolutionized the auto-industry in particular.
The dominance of autoindustry for over a century allowed oil demand to thrive as the global transportation sector accounts for 65 percent of global oil demand (road, air, rail, sea). As such, oil demand has substantially increased over time and reached 96 million barrels per day (mmbpd) in 2017. Related: Trump’s Gas Tax Hike Could Make Californian Fuel Cheaper
Based on the historical trend, population growth and economic outlook, most of the international agencies and consultants were of the view that oil demand would reach 121 mmbpd by 2040. However, as the automotive industry becomes more incentivized to build electric vehicles (EVs), this is unlikely.
Surely, EVs won’t replace all ICEs overnight. That transformation would require over decades. Therefore, no one is claiming that oil demand in road transportation in particular will be wiped out suddenly. A speedy penetration of EVs, however, could lead to a significant slowdown in oil demand.
In 2016, I wrote a paper “Will OPEC Use This Strategy To Defeat U.S. Shale?”, the analysis concluded that the U.S. shale oil industry is insensitive to changes in oil prices in the short-term, but will strengthen in the longer term.
When oil prices increase, shale oil production increases and generally recovers the lost share in production but also surpasses its earlier respective peaks. The analysis in the abovementioned article could provide some critical answers to OPEC, offering some clues on how the cartel could defend its market share. One strategy may be to flip flop oil production in order to navigate increases/decreases in oil prices (although this may run counter to their fundamental policy). For example, OPEC members could freeze oil production or even decrease production and allow oil prices to gradually increase between $50 to $78/bbl for 5 to 8 months (lag to respond by shale oil industry) and then increase their production (for 4 to 5 months) to lower oil prices back down to $50/bbl to dampen the revival of shale oil production. This “flip flop” strategy of production will allow OPEC to fetch an average of higher oil prices compared to their strategy of solely defending market share, while at the same time also keep the shale oil revival in check. In 2018, however, not even this ‘flip-flop’ policy will work due to the significant increase in drilled but uncompleted wells (DUC). For example, the number of DUC’s increased from 4128 in December 2013 to 7609 in January 2018. This gave the shale oil industry a greater flexibility to respond promptly when required.
Strategy Wining Short-Term Goals - Collusion
Instead of going it alone, OPEC may decide to collaborate with the U.S. shale oil industry. In this partnership, both parties have to agree to some degree as to how much to produce in order to achieve some reasonable annual average oil prices say between $70 to $80/bbl or even more. In theory, this partnership could work, but many independent oil producers might not see the need to comply.
Yet another problem is how to determine production quotas, especially for U.S. shale oil producers. It is already difficult enough to control production quota among the few OPEC members. How can one expect oil majors and independent shale oil producers to adhere to certain output quota? If such a strategy could somehow be realized, but parties could be winning.
Nevertheless, this policy has its own negative implications. Higher oil prices may speed up the penetration of EVs as they will encourage the autoindustry find ways to bring the production costs of EVs down.
Alternative Strategies – New Business Structure
Instead of collusion, the industry should realize the facts and act accordingly. The senior executives of the major oil and gas companies know the fate of the oil industry very well, even though they avoid acknowledging it publically. The shrewd executives are already in the process of developing alternative strategies to remain in the business, maybe with a different structure. Eventually executives of NOCs should also realize that continued dependency on oil revenue alone could be self-defeating and may hold them back from their respective national visions. The oil industry has to develop alternative business models to diversify oil based economies sooner rather than later.
By Salman Ghouri for Oilprice.com
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