Changing demand patterns, rapidly growing unconventional supplies, and geopolitical issues are reshaping the very foundations—and future—of the oil industry.
Over the last several decades, the oil industry’s direction and market trends have been fairly easy to understand and forecast. By keeping tabs on global economic growth, strategies of the international oil companies (IOCs), Organization of the Petroleum Exporting Countries (OPEC) production quotas, and intermittent Middle East political turmoil, most industry watchers could stay current with oil’s key drivers. In the last five years, however, rapid shifts in the global energy landscape have created a dynamic industry that often surprises observers, investors, and insiders alike. Seemingly unrelated factors such as slowing growth in China, geopolitical events like the Arab Spring and Russia-Ukraine tensions, and the rapid growth in North American unconventional oil production have all conspired to influence oil market demand and supply.
To get a clear view of today’s oil industry requires an understanding of a mix of key influences, trends, and activities. IHS has distilled the myriad factors down to four main issues that are expected to shape the future of the oil market over the next five years:
- Slowing oil demand growth
- OPEC’s changing strategy
- Strong supply growth in the Middle East
- Increasing success of unconventional oil production in North America
The oil industry outlook until 2020 is changing. These trends, combined with other industry, business, and market forces, will determine the success of oil companies, the service sector, downstream customers, and investors alike.
Quartet of key trends
Remember the concerns about peak oil? M. King Hubbert’s 1956 theory stressed that once the rate of maximum oil extraction was reached, production rates would fall until resources were depleted. The model rings true for specific fields and regions. What Hubbert couldn’t foresee, however, were the changes that might impact the global production and consumption of oil nearly 60 years later. Peak supply is not on the horizon for foreseeable future. Instead, peak demand—or more precisely plateau demand—is very likely.
Significant slowdown in demand growth: IHS forecasts that the demand for oil will slow significantly in the coming decades. Although global economic growth is expected to improve—averaging 3.3% through 2020, according to IHS—the pace will downshift to a more moderate long-term growth rate of 3% through 2040. Because demand for oil is closely linked to the economy through the transport of goods and people, as well as energy use, slower economic growth contributes to reduced demand for oil. However, IHS expects that the link between economic growth and oil demand will weaken gradually, as the world increasingly adopts alternatives to liquid fuels, enhances vehicle fuel efficiency, and embraces the sharing economy.
Forecasters also expect industrial overcapacity in China and slowing growth in several other emerging markets to dampen economic growth. For example, China’s gradual shift from export manufacturing to greater domestic consumption will limit demand for diesel fuel. In Organization for Economic Co-operation and Development (OECD) countries, the economic recovery and low oil prices support steadying of demand in the short term. However, weak demographic trends (such as the aging population in China) and growing consumption efficiencies point to a long-term decline in growth. Overall global oil demand growth is expected to average just 0.6% through 2040.
Changing OPEC strategy: Since its 1960 founding, OPEC’s mandate has been to unify and coordinate the policies of its nation-members, with a goal of stabilizing oil markets and ensuring steady income for producers. For decades, members seemed to move as one in establishing production targets. When ministers agreed to reduce production targets, oil prices typically rose. With the increase in North American production, US imports from OPEC have been reduced by nearly 50%.
Despite requests for production cuts from financially stressed nations, OPEC leaders such as Saudi Arabia argued to let the market determine prices in late 2014. In June, OPEC restated its existing output target of 30 million barrels per day for the remainder of 2015. This reaffirms the organization’s determination to defend its volumetric share of the global oil market—even at the price of hurting struggling producers. With OPEC no longer using production targets to achieve market equilibrium, the oil industry faces continued volatility in both prices and production volumes.
Strong supply growth in the Middle East: In OPEC, three countries hold the key to future growth in supply: Iran, Saudi Arabia, and Iraq. Although each nation is driven by different domestic, regional, and international geopolitical considerations, the net outcome will be an increase in OPEC oil supply. Iran secured a nuclear agreement on 15 July with the five permanent members of the UN Security Council plus Germany. A key Iranian motivation for this deal is to lift the ban on its oil exports and earn much-needed revenue. Iran holds a significant volume of oil in floating storage, supplies that could be brought to international markets very quickly. In the medium term, lifting of sanctions will enable Iran to access much-needed capital and technology to develop its vast oil resource base and grow its oil production.
In parallel, Saudi Arabia has undertaken a strategy to maintain or grow its market share. In June, production reached 10.3 million barrels per day, even in the face of excess supply. Regional tensions between Iran and Saudi Arabia will continue to influence oil policies in both countries and could lead to further growth in Saudi supply as the details of the nuclear deal emerge.
In spite of Islamic State advances and domestic security issues, oil production in Iraq has continued to rise over the last year. Iraqi production increased from about 2.9 million barrels per day in January 2014 to 3.5 million barrels per day in June 2015. Similar to Saudi Arabia and Iran, Iraq has a very large resource base, and its production is constrained by security and infrastructure issues. Iraq’s rising production and export volumes will potentially result in these three OPEC producers fighting for market share in the short and long term.
Impact of unconventional oil production: The rapid development of shale-based oil production, primarily in the United States, dramatically impacts the oil industry. Unlike OPEC production operations, which are centrally controlled by the oil ministries of OPEC member countries, there is no “minister of shale” to oversee production decisions for unconventional oil resources. US exploration and production boasts short and declining cycle times, almost no exploration risk, a highly competitive service sector, and readily available capital markets, even at current low prices. US shale producers are similar to Silicon Valley startup companies in that they have easy access to cash, can make quick and simple business decisions, pay no dividends, and possess an unrelenting focus on growth. Given that they are smaller and more nimble than their international brethren, they can take more risks.
As a result, the US shale market has become an important swing producer in the global oil market. North American crude oil production has increased by 4.7 million barrels per day since 2008. In 2014, thanks in part to shale production, the United States became the largest oil producer in the world. In effect, $70 per barrel is the new $100 per barrel. IHS estimates that the compound effect of well improvements and service-sector cost reduction will make each dollar spent in 2016 over 60 percent more capital-efficient than a dollar spent at the end of 2014. By 2017, IHS expects US production to exceed 10 million barrels per day.
Beginning in the late 1990s, the oil industry embraced the “big is beautiful” mantra. The scale and complexity of projects was huge, global reach expanded through outsourcing, and balance sheets became bloated. Today big oil is struggling economically because of diverse factors, such as poor exploration success in conventional fields, cost overruns, and dividend commitments. Will lower oil prices be the final nail in the coffin? That’s doubtful. Many industry players own conventional fields with vast potential and new efficiencies—including practices borrowed from unconventional operations—that are helping oil companies do more with less. With that in mind, here are several other key issues investors need to evaluate:
Global deepwater: Deepwater developments have proven their ability to deliver scale to even the largest portfolios. Yet moving to “Phase 2” of this industry is challenging for both above-ground and below-ground operations. Some plays within global deepwater require substantial cost reductions to deliver breakeven economics at $60 per barrel. IHS is forecasting a 15% reduction in deepwater costs in 2015, followed by an average increase of 3% in overall deepwater costs between 2016 and 2020. Cost deflation is material in many areas impacting deepwater costs. One question for investors to consider: how long will it take to complete the restructuring of the deepwater cost base?
US unconventionals: A large new supply source typically lowers oil prices, and those lower prices invigorate efforts to reduce the cost of developing new production capacity. The current situation—driven by US tight oil production—is no exception. IHS forecasts lower costs for developing new oil production capacity through 2020. By 2016, the IHS Upstream Capital Costs Index (UCCI)—a broad measure of the cost of developing a global portfolio of upstream oil and gas assets—is projected to be 20% below the 2014 level. US onshore development costs may fall even further than the global average. Tight oil plays in North America continue to deliver substantial gains in productivity and cost reduction. But investors will have to make some choices when “sweet spots” are exhausted, cost reductions plateau, and the cost of capital goes up.
Oil sands: As global oil prices languish, the economics of higher-cost supply, such as the Canadian oil sands, have come under increasing scrutiny. IHS expects oil sands growth to continue but at a slower pace, with output exceeding 2.9 million barrels per day in 2020. This outlook assumes delays for unsanctioned projects, a slower pace of construction for some projects underway, and higher decline rates from more “conventional” oil sands production. However, factors such as a more favorable exchange rate, lower natural gas and diluent costs, and narrower price differentials between Western Canadian crudes and those in global markets have cushioned the blow of lower prices for oil sands producers. Most oil sands production is backed by large, well-capitalized companies—firms that are more capable of riding out periods of lower prices. A strategic issue looming large for oil sands investors is how to address carbon emissions associated with production from oil sands.
Liquefied natural gas (LNG): Buyers of LNG have unprecedented opportunities to procure new supply. Both existing projects and those under construction have a substantial amount of uncontracted LNG available, and the number of unsanctioned project proposals continues to grow. The LNG market is expected to move into oversupply in 2016 with the startup of new Australian and US liquefaction capacity. The next wave of LNG investments is expected to encompass multiple new plays, albeit at a much lower scale than the large volumes proposed globally. Later in this decade, the next round of final investment decisions will likely include projects from Mozambique and Western Canada, in tandem with additional US LNG. Brownfield projects in Asia-Pacific and floating liquefaction projects are also expected to come online. Will there be too much supply? Will buyers value diversification more than price? These are some of the issues that IHS will be paying close attention to in the coming months.
Foundations for success
Lower oil prices are encouraging oil companies to accelerate strategy and portfolio choices. To support growth, players must rebalance their portfolios and recalibrate operating costs to reflect the reality of lower oil prices. Large exploration and production firms must reengineer their processes and operating approaches, rethinking their overall business models and standardizing operations. Some companies are taking steps to upgrade their investment portfolio. The Royal Dutch Shell acquisition of the BG Group is a good example of this strategy. Other firms view lower oil prices as an opportunity to shift their focus to a few core capabilities that will deliver sustainable competitive advantage. The sweet spot for each company differs, of course; but once these capabilities are identified, firms are wise to maintain their focus there.
Most importantly, oil companies must be open to new operational methods that support agility. As the linkage between oil demand and GDP growth weakens, the foundations of oil industry success begin to change. Fallout from factors such as the sharing economy, evolving customer behaviors, and climate change will all change the way that the world consumes oil—probably in ways that are more impactful and long-lasting than are apparent today. Companies that take steps to become more agile will be able to respond faster and more effectively to these changes than those that cling to traditional business strategies.
Atul Arya is Senior Vice President, IHS Energy