5 Truths CEOs Need to Know About Oil Prices

 5 Truths CEOs Need to Know About Oil Prices
By Adrienne Dawson

For those who remember 1986, the current cost of oil is alarming. And for those in Texas who have or will lose their jobs, it’s hard to take comfort in a bullish forecast that could be years away. As of February 6, we’ve seen 402 oil and gas rigs idled in the U.S., and energy services companies have announced more than 20,000 layoffs — and those are just jobs tied directly to the industry. Communities established around oil production will see job loss and business closures in all sectors as people move elsewhere in search of work.

But energy experts at The University of Texas at Austin urge business leaders not to overreact. “This feels like a sharp correction, but not necessarily a long one,” says Rob Jones, former Executive-in-Residence at the Energy Management and Innovation Center (EMIC) at the McCombs School of Business. That correction will be painful, he allows, particularly for a small subsector of the broader market, but we could be through the worst of it in 24 months.

Here are five things to keep in mind as we move into Q2:

1. The Market Will Adjust
And it will recover, but there will be price instabilities in the meantime.

“We’re in contango, which is unusual,” says Ehud Ronn, professor of finance at McCombs. Ronn’s research focuses on the valuation of energy commodity-contingent securities. Contango is an upward sloping forward price curve, where the spot price today is cheaper than the futures price a year or more out. For refiners (and those with access to storage, such as on VLCCs), that presents an arbitrage opportunity, says Ronn. It’s more profitable to buy at the current spot price, store, and sell forward to lock in the difference.

For Texas, this means surplus oil is going to those marginal storage buyers. “The market seems to be in the hands of the traders who move the price around in response to what they hear,” explains Jones, who is also the former Co-Head of Bank of America Merrill Lynch Commodities. Prices will fluctuate, in part, on these storage plays, he says.

For business owners and managers, that means being aware that markets respond rapidly to new data, such as news of violence among OPEC nations that could threaten global oil supply. Projections (as well as the daily spot price) will react accordingly.

2. Infrastructure Will Adjust
Texas has seen 23 percent of its oil and gas rigs go idle since November according to Baker Hughes. Scott Tinker, professor and director of the Bureau of Economic Geology, agrees it’s significant. But the rigs being pulled offline are likely the least efficient.

“Operators try not to drill uneconomical wells. The rigs will stand up again as drilling costs come down when service companies lower their prices and/or oil prices go up,” he says.

Jones expects rig counts to continue to decline through 2015, but the rate isn’t altogether startling or unexpected. The remaining rigs, he says, are drilling economically attractive shale plays and fulfilling contractual commitments.

And while this may indicate a slowdown in the production of new wells, it doesn’t mean all new development will come to a halt. There are still locations to drill, say both Tinker and Jones, some of which are profitable even at a lower barrel price — and that comes with new infrastructure. “Pipelines still need to get built and trucks still need to haul it. There’s a resiliency to energy activity that doesn’t go away,” confirms Jones.

3. Production Will Adjust
The decline in oil prices is a demand-side shock from weakening European and Chinese economies and exacerbated by oversupply in the U.S., but numerous reports say that production — despite rig closures — will continue to increase into the first half of 2015. This seems counterintuitive, but it’s because of a lag effect in the petroleum industry that can top six months, explains Jones. For a company that drilled a well last May and built the infrastructure to support it during the summer and fall, the well would have just been put into production. That’s a huge sunk cost, and producers are better off keeping those wells pumping at full capacity so long as they can afford it.

But each well also has a decline curve, and for shale, it’s steep. A well’s production naturally declines over a period of time, explains Jones, and it could be 20, 30, or 40 percent per year. It’s part of what makes shale oil difficult and expensive to produce.

As oil companies pull back on drilling new wells, and existing wells experience a natural, predictable decline in production, Texas’ surplus will dwindle. Together with an eventual uptick in international demand, that will bring the state’s supplies into equilibrium.

4. Technology Will Adjust
Tinker of the Bureau of Economic Geology points out that people underestimate technology. It’s a big reason why forecasts — whether economic or geologic — are routinely wrong.

Tinker is the creator of the highly acclaimed energy documentary Switch, which attempts to understand how a worldwide transition from petroleum and coal to environmentally sustainable energy sources could occur.

His experience as the State Geologist of Texas and an energy researcher, along with his travels around the world, have helped him to conclude that technology, more than any other variable, is what will determine the future of energy in Texas.

“It’s the combination of price and technology that will make oilfields economical again,” he says. When there’s demand for any energy source, whether oil, natural gas, wind, solar, or hydroelectric power, the technology will evolve to produce the resource.

“As new sources of energy become more affordable and reliable, they will replace old sources. You might not be able to predict what that technology will be,” Tinker points out, “but you can bet that it’s coming,”

5. Texas Will Adjust
“The market is betting that it will correct somewhere in the $70 to $80 range… and that will be a more rational allocation of resources,” says Jones. “Those returns are solid.”

But experts warn things could get worse before they get better. Uncertainty (due to international demand or Texas surplus) leads to volatility in the market, and spot prices could dip into the $20 or $30 range. But research analysts expect those price drops, should they occur, to be temporary. “Nobody believes that’s a sustainable level,” says Jones.

That isn’t to say it won’t be painful.

Texas E&P companies that have been betting on $95 oil for the long haul will likely go out of business or be acquired. Companies that planned on a $75 price will probably stay afloat. Still, low oil prices are a windfall for those in transportation and retail — which, together, account for about $130 billion (nearly 10 percent) of Texas’ GDP. American Airlines, headquartered in Fort Worth, is expected to benefit the most of all passenger airline carriers, reports Moody’s VP Jonathan Root.

But when it comes to energy, it’s not all about oil. Texas leads the nation in natural gas production and is sixth in the world for wind energy. Natural gas and (in the long-term) alternative energy could provide a stabilizing effect to the local economy, particularly if more LNG terminals come online.

“The market is much freer for gas in the United States, but the one barrier we still have is limits on export terminals,” says David Spence, professor and co-director of EMIC. “Gas is relatively inexpensive here, but not in Europe or Asia, and we see the administration approving more export terminals… That may be a way out of some of this for Texas.”

Adrienne Dawson writes for Texas Enterprise, an online publication of the McCombs School of Business at The University of Texas at Austin.


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