Many are the musings and ramblings on the outlook for the oil and gas industry. The few hard realities are that the demand for oil is in a long term (“secular” as we economists like to say) decline. There are permanent structural forces at work here: Slow economic growth, slowing population growth and increasing energy efficiency.
Add to that the unprecedented increase in supply and the makings of a perfect storm are evident. The news is not good for oil market bulls. Because these trends are secular, the price of oil is likely to be low and volatile for many years, if not decades. Why?
First, The US economy, burdened by regulation and declining work force participation, has headwinds along with fewer workers running the economic engine. Retirement of baby boomers is certainly a big and permanent demographic trend. However, more insidious is the low labor force participation rate. At some point discouraged workers quit trying or don’t try as hard and their skills diminish or become obsolete. We simply don’t have the economic horsepower we had even a decade ago despite the massive liquidity influx from the Federal Reserve.
China in a little over a decade became the second largest economy, fueling growth in the rest of Asia, Europe, Africa and to a lesser extent, the Americas. That growth was not sustainable in the long term since it was based on exports. No national economy can grow faster than the rest of the world through exports indefinitely. The strategic shift to internal consumption meant that a short term decline was inevitable. As China’s growth resumes, it will have to be at a slower rate. The consequence is that China is not the salavation of the oil market.
Europe and Japan share a common problem, declining workforces and increasing social services for aging populations. Again, demographics and public policy are anchors on growth. The best prospects for global economic growth are in the developing economies. Growing and younger populations, improving health and education combined with rising middle class expectations set the stage for long term expansion. But, how soon will these fundamentals gain traction?
We turn then to the supply side. The shale phenomenon is not temporary. It is a classic case of a disruptive technology upending and industry structure. In his classic book, the Innovators Dilemma, Clayton Christiansen documents how disruption in other industries led to long term fundamental changes. This new normal suggests that the current over supply of oil is not subject to some kind of mean reversion. Commentators have marveled at the way supply has continued to grow. The truth is individual producers need to increase production to sustain cash flow even though that makes the problem worse for everyone. The nature of shale production allows incremental supply to be added at a relatively low fixed cost. New horizontal laterals and new perforations cost a lot less than a new vertical well. Is also evident that the shale resource base is so enormous, there is ample opportunity to add production in a shorter exploration-production cycle. Thus, as prices rise, new production will be added at a low marginal cost, suppressing prices. Conversely, natural decline curves will serve to partly reduce supply adding buoyancy to prices. We are likely to see prices oscillate in a fairly wide band, my prediction has been between $45 and $65 per barrel (WTI).
Layered on that is the behavior of OPEC. The Saudis actions are probably the one variable in all this, since they could reduce production to some extent, but enough to make a difference? The rest of OPEC and the large non-OPEC producers are much more constrained, largely in the same position as US shale producers.
All of these moving parts set the stage for low prices and high volatility for some time to come. In the very long term, low energy prices will boost economic growth in the emerging markets and help bring supply and demand back into balance. I do not expect to see this any time soon.
What are your thoughts? Please share your predictions and questions.