11 May Only The Low Cost Survive
I’ve been through many oil market cycles, and there is but one truth. Only the low cost survive.
Oil Cycles Are Personal
My first downturn was in 1985 when I was working for Imperial Oil in Toronto. The demand for oil at the time is around 40 million barrels per day (mbpd) but the available supply is around 60 mbpd, most of which is from the Middle East. Since all that oil wants to be consumed, the market collapses, and prices fall from USD 30 to USD 10.
To rid itself of surplus staff, Imperial Oil launches a financial buyout scheme called Career Change Assistance Program, or C-CAP. Us staffers morbidly call it Kneecap or Decap. I am newly married, and in 2 weeks I’m supposed to transfer to the upstream unit in Calgary, but my transfer falls apart. These cycles get very personal very quickly.
And it takes close to a decade for prices to recover. Imperial Oil survives because it moves decisively to keep its costs low and its debt restrained.
This scenario is playing out again in 2020.
90 Days of Extremes
Each cyclic downturn in oil is unprecedented, but cyclic downturns are all unprecedented in their own particular ways.
For example, the price spike of 1973 was in large part due to the shortage of oil tankers to move crude to market (shipping costs eventually collapsed with the arrival of new carriers). In Canada, the industry has faced distressingly low prices since 2014 because of a lack of pipelines.
Today, in 2020, the cycle is about abrupt changes in both demand AND supply, with the demand side story about the pandemic.
Many other illnesses and afflictions kill more people each year, but in its short life, COVID 19 is now the fastest growing cause of death, and unabated, has the potential to be the leading cause of death globally. Health care professionals believe the impacts are unprecedented outside of localised disasters like tsunamis, earthquakes and war.
The pandemic inspired lockdowns have triggered a global recession. Global GDP will be down by 3%, according to the International Monetary Fund. Global GDP is about USD 91 trillion, and 3% is about USD 3 trillion, which is about the GDP of the UK (according to the IMF). Try to imagine the global economic contribution of the entire UK economy vanishing in 30 days. I’d miss the warm beer.
This decline across so many economies at the same time is unprecedented.
Recessions mean fewer jobs, less commuting, less construction, fewer flights, lower investment, less purchasing, fewer goods made and sold, less shipping. OPEC estimates the demand for oil likely fell by roughly 20 mbpd for March and April, from over 100 mbpd. The drop in demand is unprecedented.
Job losses in particular are horrific. The International Labour Organization estimates that globally some 305 million people will have lost their jobs to the end of June. 50% of the global workforce of 3.3 billion people, who work in the informal economy, are at risk of complete destruction. This much unemployment this quickly is unprecedented.
In response, many economies are attempting to keep the lights on by injecting stimulus dollars into their market. The Globe and Mail reports the stimulus campaigns to be around USD 5 trillion, an unprecedented amount. Those injections are to help keep businesses going when there are no customers, but that doesn’t translate into oil demand.
I interviewed the CEO of a fuel delivery business based in Houston. His company has a clear eye on the demand for petroleum because he delivers it. It’s down. A lot. Diesel, gasoline, jet fuel.
Refineries are impressive manufacturing plants, capable of producing a range of products from a mix of different crudes, but they are not infinitely flexible. With demand so uncertain refineries have over produced petroleum products of all kinds, which have gone into storage. Reacting to this kind of demand shortfall across the entire supply chain is unprecedented.
Fights Over Supply
To understand the supply mayhem, we need to step back to 2008. From 2008 to 2018 according to BP, North American oil supply has grown from 13.1 mbpd to 22.6 mbpd. This much growth this quickly is unprecedented. Russian production overall barely budged, 12.7 to 14.5 and the suppliers from the Middle East only grew from 26.5 to 31.7. North American oil production growth is greater than the Middle East and Russia combined, and the oil is flowing to Asia whose needs for oil have grown from 26 mbpd to 36 mbpd in a decade.
American oil that is relatively more expensive and technically complex to produce by its heavily indebted companies has taken market share from Middle Eastern and Russian oil that is inexpensive and simple to produce from their national champions. This might make sense if that expensive oil commanded a higher price because it was somehow qualitatively better, but it’s not.
By February of this year, the economic ravages of the pandemic and its impact on oil demand was starting to emerge. Remember, China is both the biggest buyer of oil globally, and the starting point for the pandemic. Both customer (China) and supplier (OPEC) could see the impacts of China’s lockdown before anyone else.
OPEC wanted deeper cuts, but Russia balked, and the producers decided to flood the market with oil. Any eventual cuts agreed by the producers are based on recent sales volumes, so the key to minimise the impacts of cuts is to maximize sales. Whether the oversupply was poor decision making or a shrewd move to push the US out of the market doesn’t matter. Supply surged ahead of demand by 20 mbpd over March and April, leading to heaving inventories of 1.2 billion barrels straining in storage.
The speed of the inventory build up is unprecedented.
In addition, the North American oil industry is now in great pain. The fracking segment was already under siege because capital markets were growing increasingly suspicious about the fracking business model and the mountain of debt that these companies have taken on board. These are not low cost businesses, and many won’t survive.
Where supply meets demand is price, and we can see the effects. The price of oil has fallen 85% within the year, from USD 70.25 to as low as USD 9.12, and in some markets under some conditions, the forward price has been negative. The quantum of the fall is not without precedent — it fell farther in 2008, from USD 139 to USD 45.
The pain in the industry is not uniformly shared. 85% of the world’s reserves are controlled by governments that are highly dependent on the proceeds from oil sales and are relatively unresponsive to price moves, carbon pressures, activists, and capital markets. They are trimming to weather through, but they’re not changing course.
Unprecedented global recession, massive unemployment, heroic levels of stimulus, catastrophic demand collapse, heaving production oversupply, colossal inventory build up, price collapse.
In brief, the situation is unprecedented.
There is always oil demand, but with this much market upheaval, only the low cost will survive.
Where do we go from here?
Yogi Berra once said “predictions are hard, especially about the future”.
What facts need no prediction? There are 1.2 b cars in the world, 300 million heavy trucks, 53,000 merchant ships, and 30,000 aircraft. In the main, they want to be put to work. There is oil demand.
But now there are a great many unknowns.
- How long will the virus be among us, unimpeded by vaccine or immunity? It takes years for vaccines to be tested and widely distributed.
- Will we see a continuous cycle of lockdowns and restarts, as the virus explodes and recedes, with accompanying oil market contractions?
- How quickly will economies recover? It took a decade from the bottom of the 2008 recession for the US to be back to full employment.
- Will businesses permanently change how they work, with a more virtual and on-line workforce, less commuting and a reduction in real assets?
- Will there be greater levels of automation? So far, robots and other digital innovations have not contracted the virus. Digital doesn’t commute.
- How quickly will the inventories of crude oil and finished products be depleted? Inventories want to be sold, and impede fresh supplies.
- Will the Chinese government renew its push for electrified transportation to permanently bend its demand curve for oil? China is the only material growth market left.
- Will OPEC and Russia again act in concert in the future to keep expensive US oil in the ground?
How will we survive this? With cash now scarce, those with the lowest costs stand the best chance to survive.
COVID = Digital
6 weeks ago I ordered a set of black out curtains from Amazon for my home office because the window lighting was really bad for my video conferences. I would normally have gone to the mall, but they’re closed.
I applied for and received one of those stimulus loans from the government. Normally I would have had to pay a visit to the bank or government office, but banks and government offices now limit access.
My in-person training course can handle 30 people at a time, but with the pandemic there’s no gatherings. My on-line training course now has 600+ students from around the world, paying with 30 different currencies.
COVID-driven digital has radically transformed my work world, in just 8 weeks.
Last week I spoke with Jim, the CEO of a publicly traded company. His business supplies the upstream industry with drilling equipment. They started 2 years ago to transform the product line to incorporate digital innovations, such as remote monitoring, and remote control. Now, his customers are demanding products that operate independently without forcing people to travel for work, or work in very close proximity to others.
You might think this is all about Zoom, but Jim sees rising levels of interest in:
- remote monitoring,
- automation of all kinds,
- collaboration tools like slack,
- on-line shopping,
- on-line entertainment,
- virtual classrooms,
- on-line food delivery,
- on-line banking,
- on-line government services,
- even in-country manufacturing of printable parts.
It’s become clear that the adoption of new ways of working enabled by digital tools is a critical pathway to lower cost.
Moreover, it turns out that digital innovations are THE key solution to solving the problems of the pandemic AND the cost challenges of the industry. And they’ve been in front of us for a couple of years now.
Those that embrace digital innovations expect cost reductions of 20% or more and productivity gains of 20% or more. Some companies, like Repsol, have staked their future on achieving carbon neutrality, which can only be done if work processes that generate carbon are overhauled, in line with solving pandemic challenges, and lowering costs. Digital is the way forward.
Check out my book, ‘Bits, Bytes, and Barrels: The Digital Transformation of Oil and Gas’, available on Amazon and other on-line bookshops.
Take Digital Oil and Gas, the one-day on-line digital oil and gas awareness course.
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