Oil pricing: Is this a ‘new normal’?

After three years of US$100-plus crude prices, some in the energy industry were caught off-guard when prices declined by 40 percent in the fourth quarter of 2014.
A glut of supply – including record production from unconventional development in the US – and slow-growing demand put a quick downward pressure on prices.

Of course, volatility is nothing new in the oil business. Down usually follows up, followed by up again. The end result is that prices tend to revert to the mean following a spike and dip. Adjusted for inflation, the mean today is in the US$70-$75 per barrel range.

If that’s the case once again, there isn’t much to fear; prices should begin to settle at the mean within a few months.

But the question on everyone’s mind these days is whether we are seeing a “new normal.” In other words, are the conditions underlying this most current price shock here to stay? That remains to be seen.

At least in the short term, we likely won’t see much price movement. If OPEC remains resolved to maintain its current production ceiling of just over 30 million barrels a day, and oil demand declines seasonally starting in the first quarter, the market is likely to be over-supplied by as much as 1.5 to 2 million barrels a day in the first half of 2015.

The longer-term answer can’t be found until we unwrap three basic assumptions about the industry:

  • Is the current level of US shale production sustainable for 20-30 more years, even at moderate price levels?
  • Will demand in developing countries – especially China and India and those across sub-Saharan Africa – continue to grow at its current pace, or will those economies adopt conservation technologies more quickly?
  • How will the ever-changing geopolitics of oil and gas play out, especially in Russia, Venezuela and the Middle East?

If sustained levels of shale production are possible, supply levels will remain high for the foreseeable future, and that will continue to exert a downward pressure on prices.

From the demand side, the conventional wisdom has long been that economic growth in developing countries will drive ever-higher levels of oil consumption. This may be a good time to give some thought to challenging the forecasts.   We used to talk about peak supply, only to be proven wrong by advances in technologies making once unattainable reserves commercial. Are we making the same logical assumptions about demand? “Peak demand” may be the new byword as technology overtakes our fundamental economic assumptions about energy consumption.

As we have seen in several business segments, consumers in developing countries sometimes “leapfrog” over traditional technologies to adopt new ones. In a global world, why would we assume industrialization in developing countries will follow the US and Western European trends? For example, consumers in Africa aren’t worried about a lack of landline telephone capacity; they use mobile phones.

Similarly, many developing countries may opt for distributed power generation technology, such as solar, with no concerns about reliability. After all, power for most of the day is better than no power at all and solar can be installed much more cheaply and easily than building a power plant. This is in stark contrast to the US, where consumers demand 100 percent reliability, necessitating peaker plants that offset any loss of sun or wind that might disrupt the even flow of electricity.

Will we see the same rapid adoption of efficiency technologies slowing oil demand? Perhaps drivers in China will use smartphone technology to share electric-powered vehicles rather than purchase new gasoline-powered ones.

Regardless of what the future holds, the integrated majors won’t be harmed substantially. They will see a “new normal” as an opportunity to pursue affordable acquisitions that strengthen their strategic positions. The same holds true for the largest and most secure national oil companies.

Smaller independents – those with high debt-to-equity ratios and a lack of cash to sustain themselves over a long period of US$60 oil – will be distressed.

But the vast majority of companies find themselves in the middle, waiting and watching. If we truly are in a reset, there will be a mad scramble to cut costs and shed assets toward the end of 2015, when a large number of price hedges roll off.

Already we are seeing evidence that companies are reducing their upstream capital spending by 20-25 percent; that number might grow, especially if a sustained period of low prices tightens access to capital.

Other than a reduction in capital spending, where might those cost cuts come from? It’s clear that oilfield service companies benefited the most from the recent run of high oil prices, with gross margins of 30-40 percent that greatly exceeded those of producers, who averaged about 10 percent.

That means there is a lot of give in oilfield services pricing, and we are likely to see companies concede some of that margin back to producers – along with continued consolidation in the oilfield services sector.

This time last year, the domestic energy industry was in the midst of a tremendous run, the likes of which had not been seen in decades. Today, the future is a lot less certain.

The views reflected in this article are the views of the author and do not necessarily reflect the views of the global EY organization or its member firms.