Structural And Cyclical Changes Reshaping Oil Markets (Video)

| About: The United (USO)

Tom Butcher: Shawn, could you provide me with a bit of perspective on where we currently are with oil markets?

Shawn Reynolds: I think that is a great question that will help frame where we have been and where we are going. I like to point out that I have spent quite a bit of time in this industry, going back to the early 1980s, and I have lived through many downturns. In fact, I have experienced possibly eight cycles where we have seen this type of 50% correction in the oil price. This current downturn has been as bad and as long and as deep as I have ever seen in my career. I think that if you speak to anyone in the oil industry, they will agree that this period has been as severe and as tough as we have ever seen. This has really impacted, obviously, a significant amount of activity and investment, and has altered perspectives and changed business models as we go forward from here.

Butcher: Are you seeing any signs of recovery, whether structural or cyclical?

Reynolds: Yes, we are actually seeing both. As I mentioned, there are some changes in business models going on and that represents the structural side. Then there is obviously the cyclical side. As we have pointed out many times, commodities are cyclical, and we have lived through these cycles, both the high points and the low points. When you are at the high point it seems like that situation will never end, and when you are at the low point, it seems like it is only going to get deeper and deeper. The cure for high prices is high prices, the cure for low prices is low prices.

While the cure for low prices has occurred, we have seen a massive cyclical contraction in terms of investment and capital spending. That has leads to lower rig counts, lower activity and eventually to lower production. We are seeing this dramatic decline here in the U.S. We have seen U.S. lower 48 oil production fall more than a million barrels a day as the U.S. rig count went from a high of more than 1,600 rigs to a low of under 400 rigs. We have seen a little bit of a rebound, but we won't see that showing up in production anytime soon. That is the cyclical side, and we see that playing through on a global basis over the next year or more as that continued contraction in spending starts to impact, or creates a supply response.

The structural side is impacted by who provides the most supply in the world, and we get all tied up on oil shale. But oil shale only provides about five million barrels a day for a 95 million barrels a day market. And then you get 30 to 33 million barrels coming out of OPEC, and the rest comes out of conventional. The conventional is represented by what Exxon (NYSE:XOM), BP (NYSE:BP) and Royal Dutch Shell (NYSE:RDS.A) (NYSE:RDS.B) do for a living, and that includes classic exploration stories. These companies have had bad track records in the last few years in terms of their conventional exploration success. 2015 was a year with the lowest success rate in finding new oil reserves since 1947, when these records started being kept. We are referring to minuscule amounts of discoveries and, interestingly, there were record lows in 2013 and 2014 also. We have had three years of record low discoveries. This feeds into to the structural part, and that is not something that happens and gets created due to price. It has a significant amount to do with geology, and with exploration versus shale, and has a much longer-term impact. This means that it will be in 2018 to 2020 that we experience the full impact.

Butcher: Are you saying that the structural impact will be felt over the long term because there have been such extensive cap-ex cuts?

Reynolds: Undoubtedly. Much focus has been given to North American E&P [exploration and production] companies, and how much they have cut because it has verged close to 50% for two years running. That is staggering. When you add that up in dollar volumes, we are talking about hundreds and hundreds of millions of dollars. If you look at the integrated companies, the Exxons and the Chevrons of the world, they have cut by over 25% for two years running. Again, given my perspective and living though several cycles, I have never seen this two years running, particularly with the integrateds. But the dollar volumes involved for the integrateds is in the hundreds of billions, versus the hundreds of millions for the E&Ps. Overall, the amount of money that has come out of the sector is truly staggering, and you have to think rationally that there will be a significant supply response, and we are starting to see it.

Butcher: Of course having the best rock is of paramount importance, but is it also important to have the best technology?

Reynolds: Absolutely. This is all about technology. We have to remember that horizontal drilling and fracturing started about 10 to 12 years ago. It started with shale gas, and as the technology has evolved and made shale oil available, now the cost curve is coming down as technology continues to progress and innovate. But it is absolutely vital that these companies continue to go down the technology route, not only because it, depending on what prices do, makes current prices economic, but it is going to allow higher volumes of shale oil to become economic. You have always got that sweet spot that works today. When prices go up five dollars, that reserve is now worth more. That is also the conventional route: If you have a field in the Gulf of Mexico, with hundreds of millions of barrels, it is worth more at five dollar higher oil prices than it was before. But that is all it is. When you have a sweet spot of shale the price goes up, it is more valuable, but also you now have a bigger sweet spot. You then have more cash flow and you can drill it faster and if prices go up even further it can grow, you've got a bigger sweet spot and you can accelerate that drilling. That means you can accelerate your NAV and your value creation. With shale, technology is going to allow you to expand that sweet spot, accelerate your NAV creation, and that is the value that we really see in the E&P space. That feeds back into that kind of business model differentiation that we see. And if you look at how prices have responded, shale share prices have responded. For this year, with higher oil prices, the E&Ps have outperformed the integrateds.

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