Oil Industry Service Sector – Nimble Like a Ninja

Just like a ninja, the oil industry service sector has responded to the demands of the market place and reduced the cost of doing business in the upstream world by more than 15% in just six months.

It turns out that I was a pessimist when I first wrote about this in February 2015. I thought then that it would take 18 months for there to be such a significant reduction in the industry's cost base. 

IHS UCCI deflated by US BLS CPI & Brent oil prices, also inflated by US BLS CPI to present oil price in 2014 dollars

IHS UCCI deflated by US BLS CPI & Brent oil prices, also inflated by US BLS CPI to present oil price in 2014 dollars

Here is the picture I presented back in February with an update from Q1 2015 tacked on to the end of the data series. The raw data for the chart comes from the IHS Upstream Capital Cost Index ("UCCI"), but when I present my analysis I deflate the IHS index using US CPI so that we can see what is going on in real terms. Based on the response of the industry in 2008 I had thought it would take 18 months for the full effect of the collapse in oil prices to work its way through into the UCCI. But no, we are already down 15% and I wouldn't be surprised if we were down another 5% in 2Q; however, I would still expect the rate of decline to ease in 3Q, even if the oil price stays low, because even Ninja's can't work miracles.

If $50/bbl to $60/bbl for Brent is the new normal, as some commentators seem to think, then I would expect the decline to work its way towards a 30%, maybe even a 35% reduction. The second leg of this decline will probably take a little longer than this first response, but given how quickly the industry has responded that could well happen by 2016.

If $80/bbl is the new normal and $60/bbl the new floor, as I still think. Then I expect we will settle out at a 20% to 25% reduction overall. 

For what it is worth, despite the dismal failure of my last attempt at predicting an oil price movement, I still believe the market will gravitate towards $80/bbl as the price we oscillate around. Nick Butler wrote a sensible piece in June in the FT where he called the next movement in oil prices correctly, he expects the new normal to be $50/bbl to $60/bbl. He could be right, but having tested $52/bbl for Brent towards the end of July, the price has firmed up a tad.

On the other hand Anatole Koletsky's wrote, what I thought a slightly wayward, piece in January 2015 where he announced that $50/bbl was the new ceiling and he expected a trading range of $20/bbl to $50/bbl. If you read the comments to that piece you will see I disagreed with him then and I disagree with him now. It seems pretty clear that $50/bbl is more like a floor than a ceiling, at least based on the three assaults on that price level in January, March and July 2015.

Weekly Brent Oil prices from 2004 to July 2015; Source EIA

Weekly Brent Oil prices from 2004 to July 2015; Source EIA

What I think Anatole and, to a much lesser extent Nick, are missing is that a reduction in the average oil price in 1H 2015 to just under $60/bbl ($57.85 to be precise) has resulted in a halving of the number of rigs drilling in the US, has stopped growth of shale production in its tracks, and brought OPEC's market share closer to its productive capacity.

So despite the fact that today the oil price is just under $53/bbl, I would still contend that $60/bbl is a price that corrects oversupply; we have also learned that sustained $100/bbl prices for Brent create too much supply and choke off demand growth; so it seems to me that in the long run $80/bbl will prove to be the Goldilocks price.