December 10, 2015 / 12:43 PM / 2 years ago

Oil producers offset fall in prices by raising output: Kemp

LONDON (Reuters) - The first response of commodity producers to a drop in prices is normally to increase production - ensuring price falls become deeper and more prolonged.

Producers attempt to make up in volume what they have lost in prices. But what might be rational for one is disastrous collectively.

Cuba’s top trade negotiator warned a conference as long ago as 1946: “We know from experience that sometimes a reduction in prices not only does not bring a reduction in production, but as a matter of fact stimulates production, because farmers try to make up by a larger volume in production the decrease in income resulting from the fall in prices.”

He was speaking about sugar, but the same response has been true for other commodities, including petroleum.

In 2015, most oil producers have responded to the slump in prices by raising output, ensuring the market remains flooded and postponing the anticipated rebalancing of supply and demand.

Russia, Saudi Arabia and Iraq have all increased production in 2015. Iran hopes to follow in 2016 once sanctions are lifted.

Combined output from nine of the world’s largest oil and gas companies rose by 8 percent in the first nine months of 2015.

Output from U.S. waters in the Gulf of Mexico was almost 19 percent higher in September 2015 than the same month a year earlier, according to the U.S. Energy Information Administration.

Oil companies have said the Gulf of Mexico remains an attractive prospect even at low prices and they intend to continue increasing production there.

Even in the major shale-producing areas of the United States, production is not falling as fast as had been predicted.

Companies have sought to maintain production volumes even as they slash costs.

North Dakota’s oil output is down only 5 percent from the peak and has been surprisingly stable in recent months.

Bakken producers even accelerated output and sales in October ahead of an OPEC meeting they feared would result in even lower prices, the state’s chief regulator told reporters on Dec. 9.

In Texas, output from the Permian Basin, one of the oldest oil-producing areas in the country with particularly attractive geology, is still increasing.

INVESTMENT REDIRECTED

Some of the increase in worldwide production is the lagged effect of decisions taken to expand when prices were still high. New fields given the go-ahead between 2012 and 2014 are only now coming onstream.

But some of the growth is coming from a deliberate strategy to maximize production from existing fields even as spending on exploration programs and new field developments are cut back.

Britain’s North Sea oil and gas producers have managed to raise output this year by reducing the number of field outages. The new mantra for North Sea operators is to do more with less.

Russia and Iraq have ramped up output from existing assets in 2015 even as they have cut spending on new fields scheduled for development in 2016 and beyond.

In effect, oil and gas producers are sweating existing assets harder to maximize production in 2015 and 2016 even as they cut back on investment needed to maintain and increase production in 2017 and beyond.

Capex is being redirected towards projects which increase short-term output and away from projects with a longer-term focus.

Around the world “nearly 5 million barrels per day of projects have already been deferred or cancel led,” Prince Abdulaziz bin Salman, Saudi Arabia’s vice minister of petroleum and mineral resources, has warned.

“Beyond 2016, the fall in non-OPEC supply is likely to accelerate, as the cancellation and postponement of projects will start feeding through into future supplies,” he said at a conference in Doha in November.

In theory, this creates an even more exaggerated production and price profile, with prices falling further in 2015 and 2016, then rebounding faster and higher in 2017 and 2018.

But there are reasons to be very cautious about both the predicted decline in production and rebound in prices as a result of spending cuts.

RESETTING THE COST BASE

In the second half of the 1980s and throughout the 1990s there were repeated predictions that low prices would soon lead to a sharp drop in non-OPEC output and a rebound in prices, which failed to materialize.

OPEC’s former secretary-general, Ali Jaidah, told the Oxford Energy Seminar in 1988:

”We hear senior managers of oil companies haranguing OPEC, preaching to the organization that the state of the oil world, however depressed, will undoubtedly improve in the next few years.

”They seem to say - please remain strong and confident, we are going through a difficult period just now, but the wheels of fortune are bound to turn in your favor soon.

“I just cannot understand how this low price can sustain investment in high-cost oil areas. Somebody, somewhere must be losing his shirt.”

In practice, the international oil companies learned to survive and even grow at prices which had previously be considered unsustainable.

“Oil companies are accepting that they can’t count on higher prices to stimulate the currently low global drilling pace,” Petroleum Intelligence Week reported in April 1988.

Instead, the international oil companies learned how to find and produce more while spending less money through innovations like three-dimensional seismic surveys and deviated drilling.

Production from areas like the North Sea, which had been dismissed as high-cost, continued to increase as operators learned to do more with less.

The entire cost base of the industry was reset downwards through an intense focus on standardizing operations and squeezing costs as well as cutting wages and staffing.

At the same time OPEC producers Iran and Iraq constantly tried to increase output to raise revenues amid stagnating prices.

OPEC spent much of the late 1980s and 1990s struggling to balance the market in the face of continued growth in non-OPEC production and pressure for output increases from revenue-hungry members within its own ranks.

There was no sustained recovery in real prices until 1999/2000, almost 15 years after prices crashed in 1985/1986 (tmsnrt.rs/1Z0NkGH).

LESSONS FROM HISTORY

There are important differences between the price collapse in the 1980s and the current slump, principally the large amount of excess production capacity inherited from the early 1980s which is not present this time around.

Saudi Arabia’s vice minister of petroleum warned his audience: ”One fundamental flaw in the current narrative is the tendency to compare the current price fall with that of the mid 1980s. But this comparison is simply misguided. Market conditions now are fundamentally different from what they were then.

“In 1985, global oil consumption stood at just over 59 million barrels per day and the available spare capacity was at a historical level of over 10 million b/d ... In 2015, oil consumption is estimated to reach 94 million barrels per day, while usable spare capacity, mainly held in Saudi Arabia, is estimated at 2 million barrels per day.”

But there are also important similarities, including the ambitions of Russia, Iran and Iraq to continue increasing production even at low prices; efforts of the major international oil companies to sustain production and reset their cost base; and the unexpected resilience of non-OPEC production so far in the face of a large price shock.

In the 1980s, countries and companies were repeatedly surprised by the market’s failure to recover, which should be a warning to treat the predicted fall in output and recovery in prices in 2017 and 2018 with great caution.

(John Kemp is a Reuters market analyst. The views expressed are his own)

Editing by David Evans

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