The aftershocks of Opec’s decision not to reduce output in November 2014 and allow the market to rebalance itself are still being felt, with prices falling below $30 a barrel in January.
The downturn in prices follows a period when the industry’s spending has been out of control. So naturally, the reaction to rising supplies and ballooning stockpiles has been unprecedented cutbacks in activity and spending.
While it will take many months to reduce the inventory overhang, it will also take the industry several years to recover from austerity and belt tightening. The longer the price rout lasts, the larger the reductions in spending, leading to a gaping supply hole in the future.
In this context, much has been made of the significant cost reductions achieved by producers. Some believe it shows the world can continue to meet growing demand at much lower prices, possibly $50 per barrel.
Undoubtedly, costs have come down — especially given the sharp weakening in domestic currencies of most producer nations. Oil exploration companies will find themselves dictating terms to service companies for the next few years, a significant reversal of roles from the last decade.
This cycle may even spur some much needed efficiency gains in the industry — be it equipment standardisation, or sharing technology and knowledge about challenging basins. This is a natural process, and costs are at an early stage of the deflationary cycle on major projects. Typically it will take one to three years for existing contracts to expire and for renegotiated costs to filter through.
For example, Russian producers have seen costs reduced by more than 20 per cent as the rouble has plummeted, while service concessions due to extreme overcapacity in the US have led to tight oil producers being able to negotiate 30 per cent cost reductions on average. Globally, average cost reductions are in the range of 20 per cent.
Yet our updated cost curve shows prices have fallen much further than costs. Several companies have talked about production cutbacks or missing production targets over the last week, including the likes of Cnooc, Husky Energy, PetroVietnam, Genel and Lukoil.
The latest data from around the world suggest activity is starting to slow, with December 2015 non-Opec supplies falling year on year for the first time since August 2012.
The reduction in costs has given them some breathing space, but the fundamental structure of the industry has not been altered to the point where high cost basins and projects can break even on an all-in cost basis below $70. Ultimately, full-cycle costs determine future investment decisions.
We estimate that $200bn of capital has been taken out of the system since 2014, and that the impact of the cutbacks will not be pretty.
Some may be better equipped to deal with this downturn, but the pain is being felt across all producing companies and countries alike. Project cancellations and deferrals have risen to nearly 6.3m b/d, and with costs cut to the bone underlying decline rates in mature fields are likely to start pushing up.
After all, there is little denying that whether it is exploration in deepwater, or in the remote parts of the Barents Sea, Arctic or even Africa, oil production has not become any easier. Equally, there is little to suggest that all of the cost reduction is structural and not cyclical. Once activity recovers, service companies are unlikely to sit back and let upstream companies reap the benefits of higher prices.
And with oil companies cutting costs by laying off thousands of staff, many of whom will leave the industry entirely, the same skills shortages which led to costs blowing out of control in the last decade are likely to return over the coming years once the market starts to rebalance.