Navigating the Oil Market’s Rebalancing
TOM BUTCHER: Shawn, thus far in 2016, have supply and demand fundamentals in the oil market shifted as you expected them to?
SHAWN REYNOLDS: I think there is no doubt that the oil market’s supply and demand fundamentals are coming into place and will tighten through the end of the year. However, I think the timing is unclear in terms of how fast or slow this will happen. I do believe that we are likely to see tightening later in the year. The biggest surprise has been the depth of the changes at hand, which have created a sense that tightening might happen quicker than expected; but in our opinion, tightening is certainly going to last for some time.
When we talk about the depth of changes, we refer to the recounts here in the U.S., which have fallen 78%. That is unprecedented in the time that we have been counting rigs drilling in the U.S., which began in the 1970s. We also look at activity levels and investment levels overseas. If we look more closely at integrated oil companies and consider that they cut capital investment plans by 25% in 2015, and are expected to cut another 25% in 2016, we again find that there has been no precedent. These developments have never been experienced in the history of the modern oil industry. While things are more or less playing out as we expected, there are certainly some surprises. They may be taking place slowly now, during the first part of the year, but they will likely speed up and endure for some time in terms of upside price correction.
BUTCHER: What might be some of the long-term effects of those capital investment cuts on the integrated oil companies?
REYNOLDS: It has been staggering to observe the reactions from the integrated companies. Obviously, many headlines focus on U.S. oil shale and the rig count reduction of 78%. If you dig into the volumes that are connected with these two major changes taking place, the E&P (exploration and production) companies and the integrated oil companies will not experience equivalent impact. The impact on the integrated oil companies will be significantly larger and longer term.
What do these reductions in capital investments entail? They mean big projects being canceled or postponed. If you add it all up, we're looking at somewhere between six to 13 million barrels a day of projects being postponed or canceled. These projects were slated to take place between 2014 and 2020 and now they are off the shelf until post 2020, if at all.
We are seeing big projects being canceled by individual companies. For example, Petrobras [Brazil’s Petróleo Brasileiro S.A], or Royal Dutch Shell [Netherlands], or Chevron [U.S.], or Total [France]. Every single one of these multi-national companies is canceling major projects. For example, the French company Total has not approved any major projects in 2014 or 2015 and will likely not approve anything in 2016; and it has nothing on the docket for 2017. Royal Dutch Shell hasn’t approved anything since 2013, except for one project in the deepwater Gulf of Mexico.
This activity is unprecedented, and we believe it sets up a situation where the oil production of integrated companies, which has grown slowly over the years but is still growing, will begin to decline. We expect a multi-year decline that may not begin until later in 2016 or perhaps early 2017. By late 2017, and certainly for several years thereafter, we are likely to see a very methodical decline in overall supply. This will heavily impact the overall oil market.
BUTCHER: For oil and gas exploration and production companies, what characteristics have enabled the successful ones to survive?
REYNOLDS: There are companies that are surviving and thriving. Identifying these strong companies is an important part of our process. We have always looked for a special set of characteristics that allows important and steady structural growth.
What specifically do we look for? We spend time identifying companies with the right acreage and the right geology. That's something we do every day. We look at individual oil well results, and try to figure out what are the sweet spots for a given location. Sometimes consensus is that everybody knows exactly where the sweet spot is; but if you're off by a few miles or a few counties, it can make a big difference in who actually has the best rock. Therefore, we spend a great deal of time looking for the companies with the best rock. That is number one.
Number two is technology. The shale phenomenon in the U.S. is all about evolutionary technology and taking it step-by-step, tweaking small aspects of the technology in order to increase reserve bases, increase production rates, lower costs, and raise returns. We are always looking for companies that incorporate this process as part of its DNA or culture, and not something they're just pulling off the shelf to try because it worked for someone else. It is the scientific culture at the heart of a company that is key in making shale production economic and taking it to the next step in terms of adding unexpected amounts of reserves.
Number three is does the company have the balance sheet, the financial wherewithal to try different ideas? Obviously, if you are squeezed on your cash flow or your balance sheet is stretched, you are not willing or able to try different technologies or methods. You are not likely to risk trying something different and potentially see it fail, only to end up with a dry hole. That kind of outcome is really unacceptable, especially in this environment. But if you do have a strong balance sheet, you're willing to try something new. We have always looked for this profile, and it is especially important in this environment. Last summer, balance sheets became even more critical, not only in terms of flexibility and the ability to try new technologies, but also in terms of simple survival. Can the company survive tough times when the price of oil is low?
The three characteristics we have always considered are the acid base, or the geology, technology, and the balance sheet. This approach has paid dividends during this downturn and certainly in the early part of this year.
BUTCHER: Thank you.
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