It’s getting ugly in the oil patch again.
On Monday, the price of benchmark West Texas Intermediate crude closed at $38 per barrel, the lowest level since the depths of the financial crisis in 2009. But that’s just the latest low in what has been a gut-wrenching ride for the oil industry over the past year.
As recently as June of 2014, WTI prices were above $100 per barrel. By January, they had tumbled by half thanks in large part to a supply surge driven by booming U.S. production of shale oil (which I wrote about in a Fortune magazine piece called Oil’s New Math). Producers got a reprieve when prices rallied to around $60 in early summer—only to see a new swoon in recent days.
The immediate reason for the current drop in oil prices is largely the same as the overall market sell-off—new fears about weakness in the Chinese economy. But the stocks of big oil companies have suffered much more than the broader market so far this year. Shares of majors such as Exxon (XOM), Chevron (CVX), and Shell (RDSA) are all off by more than 25% year-to-date vs. an 8% decline for the S&P 500.
To get a better sense of where oil prices might go from here and what the consequences will be, I called up Daniel Yergin, author of a pair of essential books on the history of the energy industry, The Prize and The Quest and easily the most erudite expert on the oil and gas industry. As vice chairman of global information and analytics company IHS, Yergin has access to incredible stores of data about what’s happening in the field. His view? Hard times are coming. Edited excerpts:
We started 2015 with oil prices falling dramatically. They rallied in the early summer to above $60 per barrel. Are you surprised to see prices plunging again?
No, because [in the spring] we could see that the companies thought that they were in for a longer period of low. I don’t think anybody was thinking this low. We were hearing six weeks ago how $70 was the new $100 and $65 was the new $90. But the thing that we kept seeing was that the oversupply of oil was actually growing, not decreasing. Since the big price collapse started last fall, Saudi Arabia, Iraq, and the U.S. have added about 2 million barrels per day of new production to the world market. And with demand growing at about 1.4 million barrels per day, it was clear that this renewed optimism about higher prices was misplaced.
What’s the catalyst for the price reversal happening now?
I think the new factor, although it’s been a factor all along, is the apparent greater weakness and economic uncertainty in China. What we’re seeing now is that what China giveth, China taketh away. And in this case China really gave us the supercycle of commodities. But the relative weakness of the Chinese economy and how it affects demand for commodities is the big new factor because it’s become so much more apparent.
So the China-driven demand story has really turned?
My colleagues in Beijing point out that as the Chinese economy shifts, and there’s less construction, less expansion of cities, less heavy industry, that leads to less demand for oil—because an awful lot of the oil consumption is the form of diesel is really trucks that were part of the giant build-out of China. And if that slows down it means a disproportionate decline in oil demand. Even though people are buying more cars in China than they are in the U.S., they’re not driving them anywhere near as much. People always say ‘China,’ but it was really the build-out of China that was driving global commodity markets.
There has been a confidence that the Chinese really controlled the levers of their economy and could act in ways that other countries could not, and keep this amazing growth story going. But now, obviously, the concern is whether that is in fact true. Or is China in for a weaker period? They’re committed to 7% growth for all of the economic, social, and political reasons, but maybe they don’t control all the tools.
U.S. oil production, including shale oil, has stayed pretty robust this year despite lower prices. Can that continue?
What we’ve seen is not just momentum, but also that the industry got a lot more efficient. We have this tool that we’ve created at IHS called the Performance Evaluator that allows us to look at every oil well, every oil field, every shale play, and what you see is a very wide disparity in the performance of these unconventional wells. In 2014, 30% of the wells were responsible for 80% of the growth. So costs have come down a lot—and the balance between company and service provider has certainly changed a lot in favor of the company—and companies just became a lot more efficient and cut out the peripheral activities. And that’s how they’ve been able to keep going.
So you’ve had companies saying that with oil at $65 they would be back in business with as many rigs as they would have at $100 per barrel. We expect that at the end of this year every dollar spent on unconventional oil will be 65% more efficient than in 2014. This is a very innovative, flexible industry. With that said, I think that with prices where they are, it’s basically panic level.
What will that panic mean for oil companies?
It means that in the autumn as banks are reviewing their loans, if oil continues as this level for another couple of months, we’re going to see a lot of distress in the oil patch.
Back in the winter, there were dire predictions of bankruptcies and acquisitions this year but that scenario hasn’t materialized as quickly as some thought.
Exactly. So I think the dire straits that were anticipated—it’s a delayed reaction and we’re going to see it now. The banks review loans twice a year. I think they could be more flexible in the spring. But at this level, there’s going to be a lot of turmoil and hurt.
Do you see signs that the major oil companies are dialing back their expectations even more than they were earlier this year?
Yes, I think companies are now expecting that prices are going to be in a lower range, longer. This is definitely not a V-shaped recovery. And it’s going to be more of a stretched-out U, with the right-hand side never quite getting back to the level of the left. Because certainly the [Persian] Gulf producers have made it clear that they don’t want to see $100-a-barrel oil again because of what it does to their competitive position.
It was the refusal of the Saudis to cut production last fall that caused prices to really tank. They wanted prices lower to slow down non-OPEC production, such as U.S. shale oil. With prices this low and perhaps staying low for longer, will the Saudis be forced to buckle and cut production?
We don’t think so. We think they’re going to stay resolute. I think this is a shock. But I think from their point of view this is probably a one- to two-year process. They have the wherewithal to withstand it. And were they to step forward and cut now, they would have to ask themselves what they accomplished. They’re whole thesis starting last year was that if they cut production they’d have to cut again and again. So I think they’re going to stay the course.
And then there’s the other key factor, which is the nuclear agreement with Iran. If it goes ahead, that means that some time early next year Iran starts putting maybe 400,000 to 600,000 barrels per day into the market. This is a battle for market share and market position. Given the geopolitics in the region now, the Gulf producers are not keen to make room for Iran. So they’re looking at not only who’s in the market now—and of course Iran is in the market but not with full volumes—but also next year with Iran coming back in. That’s adding to the more bearish outlook of the market.
It’s hard to see what would push prices much higher any time soon.
Yes, it’s kind of like everything has been turned upside down. In recent years we’ve had strong demand growth and tight supplies. Now we have tepid growth and oversupply. But this is part of a cycle. The impact of the cutbacks will not be seen quite as quickly as might have been anticipated last November when OPEC made its historic decision. But it will show up in supplies that are not developed a few years from now.
Can you attach a dollar figure to the projects that won’t get done now?
The industry response is canceling, delaying, and postponing projects that, if you add it all up, would be worth hundreds of billions of dollars. If you exclude the impact of lower service costs, IHS projects as much as a $600 billion reduction in upstream oil and gas spending between 2015 and 2019, compared to what was expected a year ago.
Play prognosticator for me: By the end of the year, are we more likely to have oil prices below $40 or above $50?
Well, who knows because events will intervene that will change things. But at this point for the fourth quarter we’re seeing Brent crude prices below $50. We think that the next few quarters are going to be tough, really into the spring when oil demand goes down and Iran is presumably coming into the market. You say, What could change things? Well, something from left field, some geopolitical event that affects supply. But if you look at it from the point of view of supply and demand, the downward pressure on prices is going to continue.
So oil’s new math is getting enough harder?
Yeah, the new math is going to be even tougher. There was a period of renewed optimism but I think the hard times are really now at hand.