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The Future Of Oil And Gas? Look To The Past

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In the early days of 2017, it behooves oil and gas companies to reflect on the past, while making plans robust to an uncertain future outlook. There are several questions that should be asked:

  • Where are we in the oil and gas price cycles?
  • How will politics and policies affect the business outlook?
  • What are the appropriate strategies?

Learning from the Past

It will not surprise any investor in oil and gas and related businesses that theirs is a cyclical business. Prices run up when supplies fall short of demand, hover on the summit for a few years, then tumble as new supply sources are developed and demand growth slows down (Figure 1).

Sources: BP Statistical Review of World Energy; EIA

Sources: BP Statistical Review of World Energy; EIA

After the collapse of 1986, oil prices remained volatile through 1990, then declined further through 1998 as production from the Middle East, Norway, Iran and Venezuela increased to meet demand growth and replace declines in Russia and North America. One consequence of the price decline in 1998 was major oil company mega-mergers. These resulted in high-grading of projects, reduction in aggregate capital spending and slowdown in production increases, setting the stage for the run-up in prices after 2002.

The period from 1986 through 2002 can be seen in retrospect to have been a “long grind,” as oil prices were set by the long-term marginal costs of incremental production sources needed to satisfy demand growth and replace declining production from mature oil fields and political turmoil.

 

Tightly controlled wellhead natural gas prices in the 1970s led to supply shortages. The 1978 Natural Gas Policy Act (NGPA)

started a process of decontrol and broadened the responsibility the Federal Energy Regulatory Commission held over the industry.

In 1985, FERC issued Order No. 436, which changed how interstate pipelines were regulated. This established a voluntary framework under which interstate pipelines could act solely as transporters of natural gas, rather than filling the role of a natural gas merchant. However, it wasn’t until Congress passed the Natural Gas Wellhead Decontrol Act (NGWDA) in 1989 that complete deregulation of wellhead prices was enabled. Issued in 1992, FERC Order No. 636 completed the final steps towards a competitive market by making pipeline unbundling obligatory.

Natural gas became a traded commodity subject to its own cycles (Figure 2).

Sources: BP Statistical Review of World Energy; EIA

Sources: BP Statistical Review of World Energy; EIA

The decontrolled market opened new sources of supply, enabled by new seismic technologies that uncovered large resources of natural gas under the Gulf of Mexico (GoM) continental shelf. A gas bubble was inflated, holding spot prices below $3/million British Thermal Units from 1989-1999. New markets, notably independently owned cogeneration plants empowered to sell electricity to industrial plants and the grid at prices representing the “avoided cost” that new utility projects would have incurred, caused rapid demand growth.   The bubble burst as gas production in the Gulf of Mexico peaked, natural gas prices increased and LNG import terminals were built.

Higher prices induced innovation on the supply side as George Mitchell figured out how to extract natural gas from tight shale rock, and the technologies were deployed in other gas and then oil shale plays. Natural gas prices collapsed in 2009: demand accelerated as natural gas displaced coal in the power sector, somewhat constrained by limitations on pipeline transportation. New pipeline connections were built despite opposition; LNG import facilities were converted to export facilities.

Mark Twain wrote “History doesn’t repeat itself, but it does rhyme.”  If history were to repeat itself, oil prices would remain low for another “long grind”, mirroring 1986-2002 by declining further over the next 15 years; natural gas prices would start strengthening in 2019.

Politics and Policies

For oil markets, turmoil in the Middle East and Africa withdrew about 3 million barrels per day from world markets between 2005 and 2015. Ideological conflicts, coupled with the demographic realities of a growing number of young men with few employment opportunities, suggest continued instability.

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OPEC’s agreement to reduce production with apparent support from Russia will be tested by inducing expansion of U.S. shale production. But the need for cash to meet social commitments is likely to reduce funding available for capital spending by the national oil companies and will lead to lower production, regardless of the OPEC quotas. The “long grind” seems likely to be shorter this time around, more likely five rather than 15 years.

The past eight years have seen a series of rules designed to suppress coal use, to the benefit of natural gas as well as renewables. Several of these rules are still being litigated, and the new administration may choose not to defend constitutional challenges by various individual states. There may also be a reduction in subsidies and mandates favoring renewables, but natural gas will likely find it difficult to displace coal at the pace seen in recent years. LNG exports will allow further production growth, but the resource available in shale plays in 2017 is significantly larger than the GoM shelf resource available in 1989. Expect natural gas volumes to grow but prices to remain capped by coal through the mid-2020s.

Strategies

For upstream companies, the not-so-long grind through the early 2020s calls for a conservative approach to strengthen balance sheets, sustain dividend payments and drill within cash flows. Prices will be volatile and excessive exuberance will be punished by periods of low prices. However, it will be important to see around corners and monitor closely the factors that could shift the outlook to a new run-up in prices, requiring an expansionary emphasis on capturing new resources and a greater tolerance for debt.

The oilfield services sector has been hammered by the downturn and will likely consolidate further. It remains to be seen whether the consolidation will be lateral or vertical. Halliburton failed in its attempt to strengthen its verticals by merging with Baker Hughes; Schlumberger and Technip have taken a French solution of lateral extension by acquiring Cameron and FMC Technologies, respectively, and the forthcoming merger between GE Oil & Gas with Baker Hughes is also mainly lateral extension of business lines. Historically, oil companies have preferred to purchase equipment and services from best-in-class providers, and the new conglomerates will need to work hard to overcome past preferences and create a persuasive value proposition for bundling purchases of equipment and services from a single vendor.

Midstream companies should be able to resume organic growth as companies “replumb” energy infrastructure, aided by a supportive rather than hostile federal government and underwritten by producers seeking access to liquid markets.

Refiners and petrochemicals companies should benefit from an increasing gap between natural gas (used as feedstock and energy) prices and crude oil (setting international petroleum and petrochemicals products prices) as the oil price cycle will be out of phase with the gas price cycle. Nevertheless, these sectors will see limited volume growth and should continue to focus on limited capital improvements, operations excellence and accretive, synergistic acquisitions.

Well managed companies created value for shareholders through the 1990s by leveraging new technologies, simplifying their organizations to improve productivity, partnering creatively with providers of equipment and services and making acquisitions when prices were low. That playbook should be dusted off and updated for the next five years.


As a consultant, Professor and Energy Fellow Chris Ross works with senior oil and gas executives to develop and implement value creating strategies. His work has covered all stages in the oil and gas value chain.

UH Energy is the University of Houston’s hub for energy education, research and technology incubation, working to shape the energy future and forge new business approaches in the energy industry.

Forbes



6 Comments on "The Future Of Oil And Gas? Look To The Past"

  1. Rockman on Thu, 5th Jan 2017 9:38 pm 

    “…as George Mitchell figured out how to extract natural gas from tight shale rock, and the technologies were deployed in other gas and then oil shale plays.”

    No denying it: George certain gets credit for being one of first big dogs when it came to frac’ng horizontal wells to get the NG out of shales. But he wasn’t the initial driving force behind using horizontal well to get NG out of shales. That began a decade before he began popping the Barnett Shale. That was started around 1990 in Texas in the Austin Chalk formation…a carbonate (think limestone) shale. From Dec 1990:

    “AUSTIN CHALK HORIZONTAL DRILLING PACE CONTINUES TO SIZZLE – Austin chalk horizontal drilling in south central and southeastern Texas continues to boost producing rates and rig count. There are many companies that are now successfully exploiting the hydrocarbons of the Austin Chalk, from small independents to major operators.”

    Players like Columbia Gas Development, Tipperary Corp, Tuskar Resources, et al. But the Big Dog was Union Pacific Resources, one of the most active players and one of the largest independent oil and gas companies in the USA, and the nation’s leading driller. UPR operated throughout the Austin Chalk Trend, exploring for and producing both oil and gas as well as natural gas liquids in South and East Texas and in the Louisiana extension of the trend.

    The AC play was THE hottest drilling play on the planet…just like the Bakken and Eagle Ford during their boom times. Just like those plays companies just kept slamming one hz well after another parallel to the last one.

    And how did that happen when oil/NG prices were so much lower in the 90’s? The AC DID NOT need hydraulic fracturing…it was naturally fractured. But it was a known mediocre VERTICAL play. It wasn’t until hz drilling methods were developed by companies like UPR that the trend exploded. But the play eventually fizzeled for the same reason all plays inevitably do: ran out of viable location.

    The EFS and Barnett were also known mediocre VERTICAL plays…but much worse then the AC. But with hz drilling tech well matured after 10 years of heavy drilling in the AC George Mitchell knew the reserves were there but without the abundant natural fractures that the AC had those plays weren’t going to develope. Fortunately at the same George et al were building the learning curve for frac’ng hz wells oil/NG prices boomed. The rest of the history is well known by everyone here.

    And what’s the next new big tech to save our butts? I have no idea. The drivers of new tech are the service companies like Hallibuton and Schlumberger. And while they keep tweaking existing tech there’s not even a glimmer of the next big Magic Bullet. And with collapse of of ces not only the operastors pulled back hard but so have the service companies…but even harder.

  2. LPG on Fri, 6th Jan 2017 12:03 am 

    It’s truly awesome; you have imparted truly great knowledge.

  3. Davy on Fri, 6th Jan 2017 7:34 am 

    We consistently see growth with oil consumption. The most recent oil and gas glut situation was part of a bubble that itself was part of a financial bubble. This greater financial bubble was the result of a near failure of global economics. Do you see anything wrong with this and a rosy forecast going forward? The problem with people today in all walks of life is a feeling of a status quo especially with the global economy. The ups and downs are in a trend up or stable. People just cannot fathom decline and decay. The ability of fake news to shape a narrative of problems with solutions abounds.

    What should be considered is we are near a break point. We are long past thresholds of normal change. The type of change ahead could be more than what we can adapted to. We are likely in the vicinity of economic change. This is the type of macro reality where decline and decay is not readily visible especially with so much fake optimism delivered by fake and corrupt news. This is a condition a system based on growth cannot survive. The question is how long can it manage against this new and deadly momentum of decline.

    If a real and sustained demand destruction is in progress oil will never recover. Oil is nothing without an economy. Oil people like to think the economy is oil based. Yea, ok, but there was a time when the economy was not oil based. The economy came first and the economy made oil. The economy is everything for oil and without it we will be scavengers with tea pot like refineries we see with ISIS. These status quo’er people should be more than aware that oil is definitely economic based but it is the habituation of a stable economy that allows most to dismiss any thoughts otherwise.

    Post 08 high prices then the glut were driven by bubble economics. If demand destruction from the deflation of these bubbles is in effect we might never see high oil prices again. Stagflation is kind of a mix of inflation in the physical which is less goods and a sentiment deflation that is declining confidence with dropping activity. Confidence is liquidity so this is a mental and physical decline. More people every year just confuses things. No amount of bubble economic measures will arrest this destructive process.

    We may see continued price pressures that pressure oil prices back down any time a range of this decline process is breached. We may see a spike but tell me for how long with so many economic incongruities? I don’t buy into the demand destruction from technology and efficiency either. This is surely playing a role but not a dominant trend. It is just another extender similar to debt and artificial liquidity of today’s financial repression policies. These tools are the last gasp of a civilization struggling to maintain the unmaintainable because there are no other options. If I could be proven wrong I would be happy but I have yet to find any optimism worth more than a few years extension of our survival prospects. Increasingly my pessimism grows daily with new negative news most notably recently with abrupt climate change.

  4. Rockman on Fri, 6th Jan 2017 7:37 am 

    LPG – As said on the X Files: The truth is out there. LOL. But one has to be a really dedicated Internet geek with a lot of free time to dig it out. But that’s the nice thing about member driven sites like this. Someone here usually knows the quick and detailed story on the varied topics covered.

  5. Boat on Fri, 6th Jan 2017 10:23 am 

    The next big thing?

    Chesapeake said Thursday at an analyst conference that it set a new record for fracing by pumping more than 25,000 tons of sand down one Louisiana natural gas well, a process the shale driller christened “propageddon.” The super-sized dose of sand is able to prop open bigger and more numerous cracks in the rock for oil and gas to flow. Output from the well increased 70% over traditional fracing techniques, Jason Pigott, V.P. of operations, said during a presentation.

  6. GregT on Fri, 6th Jan 2017 11:27 am 

    The next big thing?

    https://www.bloomberg.com/news/articles/2016-10-20/chesapeake-declares-propageddon-with-record-frack-in-louisiana

    More Bloomberg BS / propaganda.

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