Why the Oil Industry is Running Into Major Trouble
Over the last year, some deep truths about oil and the oil industry have begun to bubble to the surface. Not necessarily that they were ever hard to see, but they were easy to obscure and maybe more importantly, without too much effort, ignore. No longer. Spread across the oil companies' quarterly reports and the pronouncements of government agencies from the U.S. Energy Information Agency to the International Energy Agency are the hard facts that the era of cheap oil is over. It's impacting the U.S. and global economies and forcing a fundamental rethinking and restructuring of our economic activities and thinking.
Four decades ago, it was abruptly brought to the world's attention oil was a limited resource. This was of greatest concern for the United States, who at that point had built an economic infrastructure completely oil dependent. With only 5% of the global population, the U.S. consumed over 25% of the world's oil, a model neither sustainable or exportable to the vast majority of earth's population.
Nonetheless, little was done to change these circumstances and most amazingly U.S. oil based development was adopted by other parts of the world, most notably China, whose oil consumption in the last three decades has quintupled, becoming the second biggest oil consumer in the world. Simultaneously, the greatest action taken by the U.S. was spending trillions of dollars “securing” much of the remaining conventional oil sources around the Persian Gulf, doing little to nothing to cut demand.
However, during this time, there's been significant change in the industry itself. For most of oil's history, the global industry was run by a handful of private companies in the U.S. and Europe. Today, the five biggest – Total, BP, Exxon, Chevron, and Shell – account for only 13% of global oil, while national companies including Saudi Aramco, Russia's Rosneft, and China National Petroleum Company control over 75%.
This led to a tightening of supply available to the private companies, while just as importantly, an increasing number of former big oil exporting countries, such as Indonesia, Mexico, Venezuela and Norway produce an ever decreasing amount of oil. In the first seven years of the century, the price of oil went up from $10 a barrel to over a $100 dollars a barrel. In 2008, the difference between global oil supply available and growing global demand shrunk to the smallest amount in oil's brief history, helping spike price to $150 a barrel and pushing the world into the worst economic recession in seventy-five years.
With the global recession, supply constraints gained a short reprieve as demand slackened, going down over 12% in the U.S. and over 20% in parts of Europe. Yet, after a brief dip, oil prices remained stubbornly high. For the past two years, even though the global economy remains lackluster, oil remains at $100 barrel. In the past year, the tightening supply and growing cost of any new oil began showing-up in the quarterly reports of the oil companies, who despite having plus a $100 barrel prices, revealed increasingly small profit margins, growing expenditures for all new oil and declining production. In the second quarter of 2013, the oil companies balance sheets became increasingly alarming led by Exxon's 57% profit decline and eight consecutive quarters of production declines.
This disruption continues with the oil companies 2014 first quarter reports. All five top oil companies announced declining production numbers despite increased expenditures. At an oil conference last month, the Houston Chronicle reported Chevron CEO John Watson stated, “That new reality for our industry is that costs have caught up to revenues for many classes of projects. Essentially, for a company like mine and many others, $100 a barrel is becoming the new $20 in our business.”
This is an extremely important development, especially for an industry which for over a century printed money. The oil industry is now becoming ever more capital intensive, not a printer of a money, but a growing capital black hole. Yet incredibly, as shareholders begin to grumble, the old majors begin to cut their expenditures and divest of future reserves to maintain non-sustainable dividend levels. The Los Angeles Times reports, “Exxon's capital and exploration expenditures fell 28 percent in the first quarter(2014), which helped deliver higher profits even though oil and gas production fell 5.6 percent.”
Obviously, not a long term strategy, but what is the oil industry's long term strategy? Well for the last few years, we've heard a lot about the great “shale revolution,” even President Obama hailed it in his 2012 State of the Union speech. Yet, as oil analyst Chris Nedler stated, “Shale's not a revolution it's a retirement party.”
Shale is both expensive and not nearly as plentiful as been propagated. The great shale revolution is greatly distorted by mountains of Wall Street-generated debt. Take for example the greatest shale company, Chesapeake, loaded with debt that's created unprofitable and unsustainable prices. They've found it hard to make much profit in the last couple years – for an oil and gas company, that truly is a revolution.
In order to survive with over 13 billion dollars in debt, over the last couple years, Chesapeake shed billions of dollars in assets. Just last week, the prestigious oil industry publication, “The Oil and Gas Journal” announced Chesapeake's latest divestiture, a rather unintentionally amusing and revealing report on the business and “accounting” of shale:
"Chesapeake Energy Corp., Oklahoma City, has decided to proceed with spinning off its oil field services business, currently conducted through its wholly owned subsidiary Chesapeake Oilfield Operating LLC (COO), almost 3 months after reporting that a spinoff or outright sale of the business was under consideration. COO will also convert into a corporation and change its name to Seventy Seven Energy Inc.
Upon completion of the spinoff and an expected recapitalization, $1.1 billion of consolidated COO debt will be eliminated from Chesapeake’s balance sheet and Chesapeake will receive a $400 million dividend that will be applied to pay off intercompany debt from the oil field services business, the company said.”
But, it's not just the industry leader having trouble profiting from shale, so to the massive oil service company BHP Billiton, who in 2012 wrote down almost $3 billion in shale assets and the old oil companies such as Shell, which this year wrote down $3 billion of their own shale plays. Bloomberg announced recently that "shale debt has almost doubled over the last four years while revenue has gained just 5.6 percent." The entire shale industry has $162 billion in debt and a massive "shakeout" is inevitable.
Importantly, it's not only no one can make money on shale, but there's not nearly as much of it as Wall Street proclaimed. Recently, the Energy Information Agency stated the Monterrey Shale in California, which was being promoted to account for two-thirds of developable shale oil in the US, only contained 4% of previous estimates, a 96% drop! Thus, there's only one-third as much shale oil as been touted in the financial press, that too is a highly suspect number.
Globally, the production of conventional oil – “black gold, Texas Tea” - plateaued ten years ago at around 75 million barrels per day. Meanwhile “unconventional” oil and oil substitutes such as Natural Gas Liquids, have seen the biggest growth in oil accounting. However, they are neither cheap or simple substitutes for crude.
Four decades after learning oil was a limited resource, the world, and especially its most oil dependent member the United States, now face a hard accounting. The present hundred dollar a barrel oil has created a serious drag on a global economy that for a hundred years has grown on cheap oil, while oil has kept its price, despite five years of a largely stagnant or deflating global economy.
All new oil is going to be less plentiful and more expensive. It is going to take increasing amounts of money both to find and bring to the surface. The once mighty oil companies, that strode across the global landscape like giants, are going to increasingly shrink in stature and power.
We need to undertake an all encompassing energy transition which will impact every aspect of our economy and our lives. We can look at what the energy component, particularly that which comes from oil, is of everything, from transportation, to food, to money itself, figuring out how it will be replaced with other sources of energy, accomplished by using less energy, or abandoned.
Ready or not, the great energy transition has arrived. It can no longer be ignored, a new world is in the offing.