Goldman Sachs, whose super-spike oil forecast of a decade ago generated buzz in the investment community, is now suggesting that the commodity could hit $20 a barrel.

This represents a price level that would be cataclysmic. If nothing else, the hand-wringing of energy investors caused by these apocalyptic visions means we’ve forgotten crucial elements of the oil and gas business. We need a reminder.

The fallacy of OPEC reserves

Oil reserves are the amount of technically and economically recoverable oil. In Canada and the U.S., independent reserve evaluators assess oil reserves. Investors in the energy sector rely on these meticulous judgments of both the amount and the value of underground reservoirs.

The banking sector also makes its own judgments on reserves, relying heavily on these estimates in order to manage the risks of lending to these companies.

The procedure in OPEC countries is different—independent auditors never confirm reserves. These countries are heavily dependent on oil income, and oil gives key political, economic and strategic mileage for these countries. In Saudi Arabia, for example, the petroleum sector accounts for 80% of government revenues and about 90% of export earnings.

To ensure the stable operation of oil markets and achieve the financial goals of its members, OPEC has traditionally allocated production quotas for each member. While this practice theoretically works to control market prices, it creates an incentive to misrepresent the number of barrels under their feet (see “By the numbers”).


By the numbers

Despite several decades of crude production from inflated reserves estimates, few OPEC countries have changed their reserves numbers since 1988 (see Table 1)—making these estimates of remaining crude oil unreliable.

In Saudi Arabia, the state oil company Aramco is in charge of the exploitation of the world’s largest oil field, Ghawar, which has been in production since 1948. After seven decades of production, it’s difficult to tell just how much oil is left. However, the Saudis are mounting a Herculean effort to maintain the nearly five million barrels per day of Ghawar production. By injecting massive amounts of seawater and carbon dioxide into the ground, the hope is to maintain reservoir pressure and sweep the remaining oil to producing wells.

We have no idea how long Aramco can maintain production via injection from aging fields. However, it seems Saudi Arabia is becoming concerned, as it has been venturing into expensive offshore terrain over the past decade. Some experts even assert the country is currently producing crude oil at, or very close to, the limit of productive capacity. The implication is that the world has substantially less spare capacity available.

Table 1: OPEC historical proved reserve estimates (billion barrels)

Year UAE Iran Iraq Kuwait Saudi
1980 30.4 58.3 30.0 67.7 168.0 19.5
1981 32.2 57.0 32.0 67.7 167.9 19.9
1982 32.4 56.1 59.0 67.2 165.5 24.9
1983 32.3 55.3 65.0 67.0 168.8 25.9
1984 32.5 58.9 65.0 92.7 171.7 28.0
1985 33.0 59.0 65.0 92.5 171.5 54.5
1986 97.2 92.9 72.0 94.5 169.7 55.5
1987 98.1 92.9 100.0 94.5 169.6 58.1
1988 98.2 92.9 100.0 94.5 255.0 58.5
1989 98.2 92.9 100.0 97.1 260.1 59.0
1990 98.2 92.9 100.0 97.0 260.3 60.1
2014 97.8 157.5 143.1 101.5 266.6 300.0

Costly OPEC market share gamble

The costly battle to crimp U.S. production growth seems to be working for OPEC. The U.S. oil directed rig counts began to fall in the fall of 2014, and accelerated as OPEC, and Saudi Arabia in particular, made it clear that they would no longer defend the price of oil. Rather, the Saudis would tolerate low oil prices as a means to regain market share. Rigs then continued to fall throughout the year as balance sheet debt ballooned and access to capital got substantially tighter, forcing tough capital budgeting decisions in the new commodity reality.

This was to be expected, as so-called shale oil was regarded as a higher cost source of oil. While it was never the marginal barrel, the act of pushing the commodity so deep into the world’s cost curve for new supply had a marked impact. Chart 1, this page, shows the cumulative amount of incremental U.S. oil production since the November 2014 OPEC meeting in Vienna. It has taken a year, but it’s almost back to the level where it was when OPEC embraced market share (and fiscal deficits). This has been a particular focus for markets so far. Rather than short-cycle-time oil wells, we believe the long lead-time capital investment decisions are what will be telling for tomorrow’s oil prices.

CHART 1: U.S. cumulative production change

Cash crunch outside OPEC

The four of the biggest oil companies—Royal Dutch Shell, BP, ExxonMobil and Chevron—cumulatively outspent cash flow by $20 billion in the first half of 2015, and this cash crunch is causing them to drastically reduce current spending. This is evidenced in recent months by the supermajors collectively trimming budgets by more than $30 billion, laying off workers and delaying major projects. More cuts are expected.

Amidst this cash crunch, it has been costly to shore up balance sheets and protect dividends, and doing so is impairing the ability of the supermajors to maintain, let alone increase, production in coming years. Wood Mackenzie estimates that these four lynchpins of the global oil industry have collectively deferred developing 7.3 billion barrels of oil, natural gas and other liquids due to the commodity downturn. Shell alone has scrapped or delayed about 40 projects, including its $7 billion exploration program in the Alaskan Arctic this year—the company’s most expensive failed exploration project ever.

Chart 2, this page, shows the cumulative delays in megaproject spending until the end of this decade. In contrast to U.S. onshore tight oil drilling, where a well can be brought on quickly and an additional drilling rig added with relative ease, these ambitious decisions do not turn on a dime. The supermajors are making decisions that will impact production additions through 2020.

An oil price spike?

The world seems awash in oil. But the decisions made today are sowing the seeds for the price spike of tomorrow. OPEC is struggling with gaping fiscal deficits because its governments depend on oil revenues. The world’s cornerstone oil fields are not seeing adequate levels of reinvestment and new smaller field developments are being deferred at an increasing rate. This is all happening when there’s an illusory quality to the amount of spare capacity available, and a fallacy around misrepresented OPEC reserve figures that do not tell the full story. With uncertain timing around the inevitable recovery in energy, investors should remain cautious about companies with unmanageable leverage ratios and low-quality assets. Investors should instead focus on companies with access to capital and cost structures that are sustainable during the downturn, as well as on those that can use this environment to strengthen their businesses. Better times are around the corner.


CHART 2: Projects deferrals or cancellations are growing

by D. Mason Granger, P.Eng., MBA, CFA, portfolio manager, Sentry Investments.

Originally published in Advisor's Edge Report

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