“Lower for Longer” was right and yet so wrong… Finding the real cost of the marginal barrel.

The Marginal Barrel and why does it matter?

The price of the “marginal barrel” in the world of oil is critical, as it dictates the price of all oil. The marginal barrel is the one (or at least a small number of barrels) that represents the gap between supply and demand. In a market that uses c. 100 million barrels of oil per day, the delta between supply and demand is typically only about 1% or 1mmbbls/day. In normal times the price bounces around within manageable ranges as this ebbs and flows. Price has no correlation to absolute supply (see image in title).

Price shocks occur when the deficit or surplus becomes larger. For example, in 2014 the oil price crashed from over $100/bbl to about $50/bbl before continuing south through 2015 because the US shale patch was adding about 1 mmbbls/d each year from 2012 onwards. Disruptions in conventional supply (Nigeria, Venezuela and Libya) left a gap in supply that was almost perfectly matched. However, when Libya brought back on-stream 1.4 mmbbls/day the market flipped into clear over-supply and the price tanked.

Obviously the 30% collapse in daily demand seen in 1Q 2020 due to Covid is and extreme example of this but is such an outlier it is better to focus on normal dynamics.

Break Even Price

Conceptually it is quite easy to see that as prices slide, production that has a high cost base will become uneconomic and the system will rebalance on the price needed to match supply and demand. This is of course very simplistic as the invisible hand has many puppet strings attached – not the least of which is the inertia in oil and gas projects. This is particularly true of offshore projects, which can have a decade long capex sink from discovery to production.  You can’t plan for the oil price next decade, so you “get what you get, and you don’t get upset”.  

As a side note, valuing O&G on “book value” is a bit daft for exactly this reason. Just because you spent $10 billion on a project does not mean that is what it is worth…. Could be a lot more or a lot less depending on the oil price in the peak production window.

It is also clear that any existing production has a “point-forward” break-even that is very different to any brown-field project. A full life cycle break-even of $35/bbl may have a sub $10/bbl breakeven (OPEX+) on a point-forward basis. So any existing production, at a point in time, will be sustainable at low prices.  the cost of developing new sources of production (and taking into consideration the lag-times noted above) is a better measure of the price of the marginal barrel. What price trigger will suffice to incentivise new projects? This is of course very significant in O&G (as opposed to a widget factory) given that all existing production is naturally depleting.

Shale has/had the advantage of being “short-cycle” and as such could be expected to react quickly to imbalances in supply and demand – hence acting as a dampener to oil price fluctuations.

As such, the full-cycle cost of bringing oil from shale to market has all the hallmarks of price setting at the margins.

Lower for Longer

Whilst not in general a fan of investment bank’s predictions, the Goldman Sachs “Lower for Longer” does seem to have played out since 2015, with the oil price more or less range-bound in the $40-$60 fairway, and shale being the Marginal Barrel.

So far so good.

Why this is not “right”

I believe that, whilst this dynamic has played out much as described, the “correct” price of oil has been wrong for a while now. This is quite a big statement given that I am writing this from my garden shed, and there is a trillion-dollar financial industry that says I am wrong. The market sets the price, right?

But think about the finances of the shale industry. It is well known that the stupendous rise in production of shale has been driven by two factors (1) technology and (2) OPM (“other people’s money” as The Economist put it so well).

Let’s focus on the OPM. Two factors are at play. The first is that vast amounts of cheap money have been injected into the US (and world) economies in the post 2008 period of Quantitative Easing (“QE”). Having lots of very cheap capital distorts any market, and the need for returns pushes capital into ventures which would not be attractive if capital were tight. This has made the WACC for shale companies vey low with both debt and equity having been readily available.

Secondly, much of this money will not be returned. Companies have consistently lost money – and not just “paper” value, but actual cash. For many companies there never was a period of breaking-even, spending more than they were generating.  The “break-even” - at a corporate level) - needs to include all costs, including all G&A as well as financing costs.  In the figure herewith, it seems to show that at the project level, there was always negative FCF even without these additional costs.

With respect to financing costs, there is debt service, but also debt repayment – something that seems increasingly unlikely. But that is another story.  The point here is that the true break-even of the shale barrels should be a function of normal economics. A product that is sold at below cost is essentially subsidised. Now that is a very emotive term, needs careful usage and is one that I have written about previously (here and here). 

It is worth mentioning that the cheapness of the WACC is also true for any modern business (Renewable companies, FANGs) as it is also partly a function of QE (and the cheap energy it provides).  The fact that so much will not be returned is specific to shale.

To separate out these two concepts

(1)  If the shale players could not make money (including adequately servicing their debt) with oil in the $40-$60 range, then it is fair to say that their real break-even is higher.

(2)  If the cost of capital (access to equity and risk-adjusted-returns on debt (if available at all)) rises, which it should, given the vast amounts lost to-date, then the break-even should be higher still.

Image here shows "current market consensus costs of equity (ie required rates of return for projects)" : used with kind permission (original post here)

So, to summarise:

• US shale oil has been the marginal barrel in the world supply for several years. 
• It has consistently been losing money on every barrel produced
• Each barrel has an unintentional subsidy (investors and creditors losing money)
• Such market distortions don’t last forever
• Shale 3.0 will undoubtedly happen (unless Covid does make structural changes to demand), but will look different. 

*Either it will be dominated by low cost of capital IOCs who might make it work at these prices

*Or, it will work at higher prices, which will occur because the WACC for the marginal barrel becomes aligned with reality.

Two counter arguments

Firstly, the QE needed to “fix” the great financial crisis has just been dwarfed by the QE which is underway to “fix” the Covid crisis. It is possible this will just prolong the market distortion. However, I suspect not. Because investing in O&G and US Shale in particular has headwinds around ESG and not unsurprisingly, headwinds about memories of losing money…. The increased cost of Equity has been elegantly presented here.

Secondly, shale oil was the marginal barrel due to a gap that was left by production outages from key conventional producers – notably Libya, Venezuela and Iran, not to mention voluntary OPEC volume cuts. The conventional wisdom is that there are a lot of barrels that could come to market at sub $10/bbl (ramping up existing production and paying just Opex).  In a scenario in which a lot of this oil comes back on the market the price of the marginal barrel (and hence the oil price) will decline.  

The only (big) caveat to this conventional wisdom is that for much of this production, the production cost is only part of the equation. In the same way that the economics of shale production should include G&A and all financing costs, production from Petro-states needs to include the revenues needed to support the state. 

That may sound a bit back-to-front, but it isn’t.  Consider the thought experiment (without naming names…) When oil sells for any price less that that needed for the state budget the state has less money to spend on things like maintenance capex and development capex within its industry. As the oil price drops and revenues drop, so other areas get hit – infrastructure, social spending, maybe even police and army pay. A collapse in the local oil industry through lack of funding then reduces revenues further with a logical conclusion of some form of social collapse and… further collapse of oil production. This of course removes barrels from the global market and pushes prices back up.

Corporations running oil fields and petro-states have surprisingly similar predicaments. No wonder OPEC wants to find a Goldilocks price and stability….

Conclusion

US Shale met something like 70% of the increase in demand for oil in the period leading up to 2020. This oil was sold at an unintentional loss, with the implication that the real price should have been higher. With the current “bust” of Shale 2.0, it is likely that the cost of capital will increase, pushing the real price of a marginal barrel even higher

As I wrote here – low oil (energy) prices have helped create the great market bull-run. According to my analysis, this is all a mirage. Shale oil is not cheap, conventional oil is not cheap (at a sustainable petro-state level).

Higher for Longer?