Fortune may yet favor the brave

As the saying goes, “Fortune favors the brave”. This cannot be more true today, as oil prices take a dip, with a wide array of opinions on what the price will do next. I believe the price will stay low, causing a change of behavior among incumbent players. The faint of heart will flee or lay low, while a new breed of investors may emerge, ready to capitalize on the evolving situation.

For those brave few willing to take the risk, the rewards can be plenty. The new oil prices will mean less competition for these new entrepreneurs, as some others will prefer to watch from the sidelines, mesmerized by the magnitude of change from the comfortable situation they faced less than two years ago. Before I discuss this further, let us look back at the events over the past two years.

The oil industry since the second half of 2014 has not been for the faint of heart. As oil crept below the magical figure of USD 100/bbl in July 2014, the industry cast a wary eye, but convinced itself this was a short term phenomenon, citing that shale oil production was inherently expensive and would choke on itself as prices declined.

Seeing the gradual decline in prices, Saudi Arabia decided to protect their own market share and announced they would not be reducing production to balance supply and demand. What followed was brutal and 2015 saw oil ranging between USD 40-60/bbl.

Throughout the year, voices could be heard asking that most annoying of questions — are we there yet? Unfortunately, this was not a child asking their parents if they’ve reached their destination — this time the question was being asked in boardrooms across the world related to that floor at which oil prices would conveniently start rising because production had been choked off. And indeed, as seen by the historical US rig count from Baker Hughes, the response to lower oil prices has been dramatic. Will this wipe out the US shale oil industry? No.​

Historical US rig count from Baker Hughes

Perhaps people forgot the experience of shale gas production in the US, where an industry that started under heady Henry Hub prices in 2008 was able to adapt and continue to grow despite a 60-70% price drop in the ensuing years. It clearly showed the entrepreneurial spirit of the US onshore producers, who high graded the prospects to retain the economic viability of shale gas production. And they did this during a period when the cost of development was still high because oil was above USD 100/bbl.

There are clear indications that optimization in shale oil development has started. While rig count is low, the average rate per well drilled has increased across all the shale oil and tight oil regions in the US. And this has not yet fully factored the reduction in development costs that will surely accompany an across the board reduction in energy prices. When you add Iran’s re-entry into the international trade, the prospects for short term price increase do not appear very robust.

Recognizing this, there are conflicting reports about OPEC and non-OPEC (mainly Russia) producers looking at a small reduction in supply. Again, any such discussions will be followed closely by the US shale oil producers with the likely aim of ramping up in case of a resultant price increase.

Given all this, it is likely that oil will trade in the range of 20 to USD 40/bbl in the medium term. Compared to the predictions of oil prices that were being made in 2014, this sounds like a disaster for oil producers. However, recall the sustained period of the 1990s till 2004 when oil price averaged USD 18/bbl. The industry had fiscal discipline and was able to enact viable projects with good returns for the investors. This discipline was lost when oil prices headed north amidst the rush to not be left behind in the bonanza. A massive retrenchment is now taking place to manage the energy business in the short to medium term as the reality of sustained low oil price becomes clear.

What does this mean for the industry?

The major oil and gas players have had their shares hammered in response to lower earnings associated with the oil price drop. Yet at the same time as their free cash is dwindling, they are expected to show how they will sustain and even grow over the next few years. This is not an easy thing to do, particularly as a convenient reaction to lower revenues is to pull back on exploration. It makes sense that the major IOCs will refocus their exploration and development expenditures on opportunities that are large enough to make a difference to their companies — this means a refocus away from smaller yet attractive opportunities.

And it is precisely such opportunities that can become the domain of the new breed of investors. While the majors could look at these smaller opportunities and feel they should be able to monetize them, the reality is the majors have developed systems during high oil prices to effectively de-risk the developments. For each potential development, a myriad of scenarios are discussed to ensure all possible risks are properly evaluated. This system, while fully understandable and robust, essentially works against smaller projects in a risk-reward balance.

At lower oil prices, scenarios regarding further weakening of prices, reactions of host governments, variability of development costs, and potential security concerns will all favor the majors’ focus towards large projects, leaving space for the new breed in this domain.

So what are the attributes of this new breed? Two words that come to mind are nimble and flexible. Nimble because decisions need to be taken quickly to capture the evolving opportunities, and flexible to be able to adapt to the very scenarios I mentioned above, all the while progressing developments forward. If this is done with a mind-set of oil price in the USD 20–40/bbl range, fiscal discipline will be enforced on all parties. Certainly, there will always be further possible downsides. However, with the right nimble and flexible approach, even those downsides can be developed into opportunities for the future. The new realities of a low oil price environment are shaping the industry, and it is fair to say that while it is still early days, we may very well end up with a scenario where the humble pawn gets to rewrite the rules of the game.

About the author: Dr. Arshad H. Sufi is chairman of METAS Energy. He has more than three decades of experience in the global industry, most recently as president of BG Egypt, and previously as president of BG Oman and BG Nigeria.