There are two divergent views of what is happening to the oil price within the industry and among serious investors. 2016 may help us to see which is correct.
The first view is that the price is inherently cyclical. What has come down must go back up again and the deeper the trough the higher the next mountain.
The alternative analysis is that the shift we have seen over the past three years is the beginning of a long-term structural shift which will see energy prices materially lower in real terms in the next half century than in the last. Those who take this view believe, to put it very simply, that the likely growth in supply is stronger than the growth in demand.
Of course the two approaches are not totally incompatible. There are clearly still short-term cyclical issues which cannot be ignored. The Chinese economy will come out of recession at some point not least because if it does not President Xi Jinping and the Chinese Communist party will be in big trouble. We will surely have price spikes — after all political decisions, not least in Saudi Arabia, are still important factors in shaping the market and much of the world’s supply comes from countries in the Middle East and north and west Africa, which are inherently unstable.
But the structural factors are more important because they set the upper limit to the extent and durability of any such spikes. No one knows where the ceiling is (my guess is $60 a barrel) but it is clear that if you accept the structural argument you must also accept that the ceiling itself is liable to fall over time.
The overwhelming weight of the coverage of the oil market by analysts and commentators concentrates on the supply side and the volumes being produced and exported from Saudi Arabia or elsewhere. Supply is important but costs matter more.
Some people remain attached to a theory that can be described as resource scarcity. At its heart this theory suggests that resource development follows a linear pattern in which low-cost resources are developed first, meaning that most if not all future development must be more costly. Unfortunately the history of the industry does not support this view. If anything the experience of the past few decades suggests that the opposite is true.
Exploration and production costs are on average lower now than when I joined the industry almost 40 years ago. Multiple technical advances — from advanced seismic analysis to enhanced recovery techniques — allow companies to produce more for less. The cost reductions have been pushed on by each cyclical fall in prices — in the mid 1980s, late 1990s and now over the past two years. When prices fall companies find different and cheaper ways of working. Such cost reductions set a new baseline and soon spread across a global industry.
The North Sea which was said to be uneconomic at prices below $80 a barrel two years ago is still going strong. The break-even price is now said to be around $60 and, of course, in cash terms alone it is much lower. Once platforms and infrastructure are in place the actually operating costs of an oilfield are very low indeed.
In the US despite numerous pronouncements of doom crude oil production in November was up 265,000 barrels a day compared to November 2014. Behind the headline the story is mixed and some areas are clearly more expensive. But the main tight oil provinces such as the Eagle Ford in Texas and the Bakken in North Dakota have carried on producing because costs have fallen. Platts — one of the most serious and objective observers of the market — suggests in its latest report that production in both areas could go still higher, even at current prices. The shale industry in the US is well on the way to being viable at $50 and I don’t doubt that many producers would continue to thrive at even lower prices. If some production is held back waiting for prices to go up again the prospect is of a new surge of supply whenever there is an increase.
The cyclical theory depends on a dearth of new investment creating a supply crunch in two, three or five years. A lot of projects are being postponed but postponement is no more than a signal to project managers to find a way of cutting costs. Many are doing exactly that.
I can well imagine that in 2016 the oil price will bounce back from its current sub $40 level. The Saudis may try to cut production, there could be more conflict in Iraq, terrorists could attack some of the prize targets such as the oil terminals at Ras Tanura and Abqaiq. Anything is possible, something is likely. But the question is how far the bounce will go.
If the bounce is minimal and transitory it will be clear that the structural shift is under way. I hope the companies which are over invested in expensive projects and countries still overwhelmingly dependent on oil and gas revenues are ready.