5th October 2015
Chris Taylor, investment director and head of research at Neptune Investment Management, explains why he believes sub-$50 oil could be the norm for investors for the next decade or two…
The oil price has more than halved over the past 18 months. Many market participants assume this is a temporary phenomenon. We believe they are wrong.
Our analysis of the changes taking place in the real world suggests the oil industry is adapting to life with an oil price that will not return to its old equilibrium for a decade or two.
This is the result of a massive but largely unheralded improvement in shale resource extraction techniques.
For most, both in government and on the sell side, the long-term historical marginal cost of oil production – estimated by the World Bank to be between $80 and $90 per barrel globally – is still thought of as the long-term equilibrium price for oil going forward.
Our view is that it could in fact be less than half that. This is principally because the old estimation of the industry-wide average break-even point was heavily dependent upon the belief that deepwater – or at least offshore – extraction would be increasingly necessary to meet global demand.
The emergence of US shale though has changed this. Indeed the largest shale basins – such as Bakken, Permian and Eagle Ford – now boast radically lower costs. The evidence suggests these fields have enough untapped potential to meet the needs of the industry in the years ahead at a new, much lower break-even price of around $36 per barrel.
What is most astonishing about these oil fields is the sheer pace at which their productivity is still improving, which more than compensates for the declines in rig counts that have occurred in recent months – a measure the sell side remains fixated on to account for supply-side factors. Our estimates show the return on investment improving by over three times since 2011, potentially rising to almost 40% at $50 per barrel of oil by 2014.
These productivity gains have many causes, including drilling multiple holes from one pad, increasing the length of the average horizontal drill and fracking at far smaller distances. Conoco Philips show that in the Eagle Ford field, the number of frack clusters has increased from 75 spread over 4,800 feet to 150 over 5,150 feet in 2015. This has the knock-on effect of boosting reserves by 30%, as well as cutting average production costs and overall production ties.
Guarding clients’ portfolios against the impact of such a paradigm shift is of crucial concern to us. Our high conviction view on oil stocks, which is formed not in response to market noise or sell side feedback loops but rather real world research, is expressed across our funds.
Whilst energy stocks have become popular territory for bargain hunters in recent months, we have retained significant underweights. Ultimately, productivity improvements will feed through into profits, but for the moment it is likely that they will simply send the oil price down further – taking these companies’ share prices with it. During the current volatility we remain focused on real world risks like this, rather than relying on the powers of diversification alone.
Where can the oil price go from here?
These long-term structural factors form the foundation of our view on oil. However, it is worth noting that in the short-term there is likely to be little support for oil from other areas of the world. OPEC’s stated ceiling for production of some 30 million barrels per day (mbpd) was breached throughout August at an average rate of 32.3 mbpd – nearly 2 mbpd higher than a year earlier. This was largely driven by strong production in Saudi Arabia and Iraq.
The Saudis are still striving to gain market share, whilst the unblocking of infrastructure bottlenecks is supporting growth in Iraq. Added to this is the likelihood that Iran increases production over the coming twelve to eighteen months as sanctions are lifted. These factors are all important as OPEC is trying to stem the growth of non-OPEC production, particularly out of North America.
This requires prices to remain lower for an extended period and therefore there is no reason for OPEC to cut production until there is a larger supply response elsewhere. As yet, we have only seen the global majors delaying high cost, long lead time projects, such as those located in deepwater, which will only impact the supply and demand balance in several years’ time.
Unfortunately for OPEC, any price fall-induced cut to shale production would likely prove only temporary. The ongoing continuous improvement in extraction efficiencies would meanwhile further lower shale operators’ breakeven price. Production would then ramp up again to consistently undermine oil’s medium to long-term achievable price levels.