Clyde Blowers Capital (CBC) have been investing in oil and gas related businesses since the late 1980s and have experienced five significant market cycles in that time. As always at CBC, we are forensic in our analysis of our core end markets and are constantly reviewing key macro and micro trends to inform our investment strategy going forward for existing and new investments.
As the industry is well aware, Capex in the sector has experienced an unprecedented decline since the downturn started in June 2014. As shown in the graph below investment in the sector has reduced by over 50% from peak (2014) to trough (2016). The small recovery in 2017 and expected recovery in 2018 is being driven by investment activity in the North American shale market while the rest of the world continues to see falling or flat investment levels. In addition, the proportion of capex invested in exploration has reduced significantly and consequently the reserve replacement ratio (the measurement of production volumes that are being replaced by new investment) has fallen even more dramatically. We consider these investment trends to be unsustainable and they have already caused the markets to tighten significantly.
Source: Pareto Securities Equity Research
The reduction in investment experienced during the downturn has resulted in the lowest level of final investment decision (“FID”) approvals of conventional projects since the 1970s. We are also experiencing the lowest level of discovered volumes (of conventional projects) since the 1940s. This will undoubtedly have consequences on future supply.
The chart below shows the expected decline in non-OPEC production due to the maturity of fields and lack of investment over the past 3 years. Production in this part of the market (which accounts for approximately 30% of global supply today) is highly correlated with investment trends (on a 3-year lag) given the nature of reserves in these regions. Forecast growth in supply is coming from the US, OPEC, Russia and Brazil. However, the recent reduction in investment levels outside of the US do not support the growth in production forecast. Similarly, OPEC’s commitment to production cuts have limited their investment in new capacity, magnifying concerns that historical spending trends do not support the forecast growth in supply. The US has seen an increase in expenditure, however higher levels will be required to reach forecast production growth, due to the nature of wells in the unconventional US market. A significant level of investment is required just to stand still in terms of production. Our view is we need to see a significant increase in investment activity across the board to avoid supply deficits in the next 2-3 years and the US will struggle to meet global supply requirements on its own.
Source: BP Energy Outlook 2018
Oil demand remains robust and is still being driven predominantly out of Asia, in particular China and India, and to a lesser extent in the US and Europe. Around 40% of total oil demand comes from vehicles, so investors are quite rightly assessing the impact of growth in electric vehicles on future oil consumption. Electric vehicles represent around 0.2% of the global vehicle fleet today with just over two million vehicles registered worldwide. There is a wide range of external forecasts predicting what this might look like in 2030-2040. On average, forecasts show a doubling of the global vehicle fleet by 2035 to around two billion vehicles. Even allowing for significant growth from electric vehicle sales, our view is there will still be growth in oil demand coming from the sector as a whole. The majority of increased vehicle demand forecasted comes from the growing middle classes in China and India. Therefore, affordability and support of electric vehicles in these regions will be telling of the potential impact on oil demand. Oil demand is expected to reach 100mb/d for the first time in history by 2020 and we believe this will drive a further recovery in oil prices and investment levels.
Source: BP Energy Outlook 2018
It would appear the supply glut has been culled for now as global inventories reduced through 2017 and look set to continue doing so in 2018. Inventories on an absolute basis (in millions of barrels) will decline modestly, however inventories adjusted for demand look set to decline meaningfully as shown in the chart below. Political tensions between the West and Russia, conflict in the Middle East and the possibility of new US sanctions on Iran adds additional uncertainty to the security of supply.
Source: International Energy Agency
Due to the operating efficiencies achieved since the downturn, the oil majors are set to start generating similar levels of profitability and cash flow as they did when oil was $100+. Some parts of the shale market are producing at breakeven levels of sub $20 as shown in the chart below. Shell and partner Statoil also recently announced the FID approval for an offshore deepwater project in the Gulf of Mexico (the Vito field) with a breakeven of $34/barrel. This coupled with increasing prices bodes well for fresh investment from the majors.
Source: Evercore ISI Energy Research
In our next Oil & Gas sector article, we will focus on how technology is enhancing productivity and efficiency which is beginning to fundamentally change the way the sector operates. The key to how the industry moves forward will be maintaining proactive attitudes towards lowering costs through the adoption of technology and collaboration with the supply chain, even in a more buoyant oil price environment. However, with improved breakeven levels across several areas of the market, the supply chain is set to benefit from an increased number of FID approvals on projects in 2018 and beyond as the industry looks set to bring on additional production capacity. At CBC, we are continuing to closely monitor the signs of recovery detailed in this article as it plays a key part in our investment strategy in the sector going forward.
All information contained in this article was correct to the best of the author's knowledge at the time of publication. All opinions expressed in this article are based on the views of the author on the current climate in the oil & gas industry and should not be taken as investment advice or guidance.