The Oil Depletion Spiral Revisited

Since our last article on the oil depletion spiral, the descent of oil prices has been spectacular. The WTI benchmark has lately been trading in the mid-70s, a price level which would have been almost unthinkable a year ago.

While many economies are benefiting and motorists are getting relieved at the pumps, should we be out celebrating that the good old days of cheap oil are back again, thanks to perhaps the miracle of the US tight oil revolution which floods the world with so much oil that there is now an oil glut? And what does the slump in oil prices mean to the longer term outlook of petroleum as an energy source? Is it a good or bad thing?

There are many contributing factors to the recent fall in oil prices. The significant ones include:

  • Curbed demand due to a global economic slowdown – everywhere you look, economies the world over are stagnant if not in outright recession, resulting in a lot of demand destruction.
  • Strong US dollar – with the perceived divergence in central bank monetary policies (US removal of quantitative easing while EU and Japan easing further), the US dollar looks poised to embark on a multi-year uptrend. A strong dollar is bearish on commodities in general.
  • Geopolitical factors – it is suspected by many that the sharp fall in oil prices is engineered by Saudi Arabia and the US in order to bring economic pressure to bear to Russia (blamed for the recent turmoil in Ukraine, major backer of Syria) and Iran (Sunnis’ main rivals).
  • OPEC turf war – in an effort to protect its market share both in Asia and the US, the Saudis, the swing oil producer, are determined to drive down oil prices to below the pain thresholds of many oil producing countries.

Medium Term Impact of Depressed Oil Prices

Looking beyond the short term, what would it mean to the oil industry as a whole if the price of oil stays at the current level around $80 per barrel?

In a word: horrible.

As we pointed out in our previous article:

  • The vast majority of oil and gas companies require an oil price of over $100 per barrel to achieve positive cash flow under their current capital expenditures (capex) and dividend program.
  • Nearly half of the industry needs more than $120 per barrel. Most of the US exploration and production (E&P) companies need $130 per barrel or more.

Click for larger image

Cost curve of new oil projects Cost curve for new oil projects (recently producing, under development and pre-sanctioned) USD per barrel


The high breakeven points are a direct result of the fact that new sources of oil are increasingly difficult to find and more costly to produce. The resulting high capex costs are reflected in the aggregate cash positions of the oil companies for the past few years, as shown in the diagram below.

oil majors cash performance

Cash gap for major oil companies (EIA)

Cash from operations for major energy companies has flattened in line with flat crude oil prices, according to EIA’s July 2014 report. For the year ending Q1 2014, the gap between cash from operations (revenue from oil sale) and major uses of cash (capex, dividends to shareholders, company stock buybacks to boost earnings per share) was almost $110 billion in the negative. The cash gap has widened in recent years from a low of $18 billion in 2010 to $100 to $200 billion during the past three years, according to the report.

In other words, since 2010, the revenue these companies received is not enough to cover their cash needs. These cash gaps were filled by either raising more debt from the bond market or selling assets (abandoning new projects) to raise additional cash.

Since the assessment from the EIA report was made when oil was still around $100 a barrel. Oil sustained at $80 a barrel would make the situation worse, and would force the majors to further cut their capex programs in the coming years, further reducing future supplies years down the road.

Medium Term Impact on Tight Oil Industry

Closer to home, the longer term impact of depressed oil prices (yes, depressed at $80) are even more dire for the tight oil industry. Despite the rosy picture painted by the oil industry, financial industry pushing the oil stocks and junk bonds and the mainstream media cheerleading along the way, tight oil might be plentiful short term but it is anything but cheap, as illustrated by the half cycle breakeven price curve below by Wood/Mackenzie Research.

Keep in mind that these are half cycle breakeven prices. A producer needs a 25-30% return on a half cycle basis to earn the equivalent of a 10% return on a full cycle basis, according to the research.


Click for larger image US tight oil breakeven prices


At the current price level, a few companies operating in selective sweet spots would still be making money. A good many of them, however, would be barely treading water or downright losing money.

As if the current predicament is not bad enough, the dim medium term outlook might accelerate a complete re-evaluation of the entire tight oil industry within the investment community.

A survey of 35 independent shale gas- and tight oil-focused companies, accounting for 40% of the unconventional oil production in the US, shows a progressively worsening financial performance from 2007 through 2013. Despite production growth, net cash flow has been negative while debt kept rising, adding to concerns about the sustainability of their business.

cashflow of tight oil companies Free cash flow of 35 US shale gas/tight oil companies (source: Oxford Institute For Energy Studies)

In order words, seven years into the so called tight oil revolution, these companies are still bleeding cash and have yet to demonstrate that it is a commercially viable business. The geological reality of the drilling treadmill would ensure that the high cost associated with their prolific drilling programs will always be a big part of their cost equations.

Up to now, the negative net cash flow has been plugged by a huge amount of debt the tight oil industry has been able to raise via high yield (junk) bonds and public offerings, courtesy of our central banks’ zero interest rate policies forcing yield hungry investors and stock buyers who have bought into the tight oil miracle hype to plough an enormous amount of money into the sector.

All the cash bleeding has been happening while oil was trading over $100 a barrel.

The financial performance of these companies would further deteriorate should oil prices stay depressed. That much is obvious, as reflected in the shale-based stocks down 50 – 70% and pressing new lows in the past six months.

 tight oil equities

 Shale-based stock performance (Barclays and Bloomberg)


If oil prices stay depressed longer, more and more folks in the investment community would start to question the viability of this sector, further restricting these companies’ ability to raise additional debt at low rates. Case in point: the spread between energy and non-energy related B/CCC grade bonds have blown out to +270 basis points this month. Shutting off the critical liquidity conduit from a sector totally dependent on cheap debt would no doubt accelerate the day of reckoning to the entire tight oil industry as a whole.

What Does It All Mean?

Which brings us back to the question whether the slump in oil prices is good or bad.

As a consumer, as in the case of a motor vehicle driver, the widely felt injustice suffered at the pumps has been reprieved and we can maintain the status quo of motordom if only until the next oil shock. As an oil producing country, the major cuts in revenue from oil sale would blow a serious hole in their fiscal plans which could lead to unrest in countries where oil revenues are used to provide social services to keep their citizens from stirring up trouble (think Arab Spring).

From the perspective of international money flows, the disappearing of hundreds of billions of surplus petro-dollars which traditionally get recycled back into US treasuries and other dollar based assets would on first thought look deflationary. But its true effects on the global economy centrally planned by central banks are difficult to anticipate at this point.

From the perspective of an oil dependent society in which the easy oil is depleting and additional barrels are getting harder to find and more expensive to produce, the dynamics of the oil depletion spiral outlined in our previous article remains very much at play:

  • Phase 4 – Price collapse. Depending on the severity of the recession, oil price temporarily collapses. Checked.
  • Phase 1 – Production cut. Oil producers further cut production as price falls, further reducing supply. Checked.

Unless society collectively takes advantage of the price dips and accelerates our transition away from oil dependent infrastructure and economic activities, the re-pricing of oil, not a matter of if but when it comes, will be so much more chokingly dramatic when the recovery of demand collides with reduced supply.




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