Over the past nine months, the decline in the price of oil, as well as the decline in the stock prices of many energy and energy-related service companies, has caused a great deal of uncertainty for investors. The big fear among many investors today is that the U.S. energy industry will experience a repeat of the 1986 oil crash, which lasted a decade in North America. We believe it is the fear of this “repeat” that has brought many energy company valuations down to levels we have not seen since that time.
On the surface, there are many similarities between the late 1980’s and today, with the most obvious being the significant decline in the price of oil. If nothing else, we believe it is this decline in price that has increased the level of fear and anxiety about owning energy-related companies. However, we also believe there are material differences that make a repeat of the prolonged 1980’s energy bust a low probability event. In this report, we hope to address many of these concerns by highlighting the differences between the current energy environment and other energy market declines over the past 35 years, specifically that which occurred in the 1980’s.
Our research and analysis will show:
• Spare capacity throughout today’s energy markets is significantly different than in past cycles.
• If you look out over the next few years, the energy market appears to be much tighter than the general investing public believes.
• In our opinion, the fear of a prolonged disaster scenario for the energy sector is overblown and largely discounted in current stock prices, presenting an opportunity for very attractive returns in many energy-related companies.
ENERGY INDUSTRY CYCLES
Chart 1 shows that over its history, the price of oil has been subject to very dramatic declines followed by very sharp recoveries. For example, since 1985, during the nine most volatile price swings, the median price decline of West Texas Intermediate Crude (“WTI”) was 52.3%. The largest peak-to-trough price decline was 77.8%. The recoveries were equally quick and dramatic. During this same time frame, the median one-year price increase from the bottom was 83.8%.
Most recently, from its closing peak price of $106.90 on June 16, 2014, through its closing low price of $43.39 on March 18, 2015 (9 months), the price of WTI dropped 59.4%. If WTI’s recovery in the current cycle were to match the median recovery rate after past oil price declines, history suggests WTI could be $79 in the next 12 to 18 months. While this historic assumption is a simplistic comparison, it does highlight the fact that the energy industry has weathered many downturns. In our view, the key difference separating cycles is the magnitude of the supply-and-demand imbalance.
SPARE CAPACITY
By far the most significant difference between the 1980’s and today is the spare capacity of the Organization of Petroleum Exporting Countries (“OPEC”) to produce oil. According to the British Petroleum Statistical Review of World Energy 2014, from 1979 to 1985, OPEC’s oil production dropped from 30 million barrels per day to 16 million barrels per day, leaving OPEC with 14 million barrels per day of spare capacity, which was equal to roughly 23.5% of the 1985 world demand. OPEC’s spare capacity was the result of an oil embargo, the 1980 (Jan ‘80–July ‘80) and 1981-1982 (July ’81 –Nov ’82) recessions, and most importantly, OPEC’s self-imposed curtailment of production in an effort to keep oil prices high. OPEC’s actions kept 23.5% of the world’s lowest-cost energy off the market. In order to meet this 23.5% shortfall, nonOPEC nations rushed into production with higher-cost oil in order to fill the gap (see Chart 2).
Recognizing its policy failure, OPEC reversed course and in 1986, began releasing its 14 million barrels of low-cost crude (i.e. spare capacity) onto the market. This resulted in crashing oil prices, which in turn drove out the higher-cost competitors that had come in to fill the shortfall in supply. It took OPEC roughly a decade to recover its position.
In contrast, as of April 2015, OPEC has 4.29 million barrels per day of spare capacity, according to the International Energy Agency (“IEA”), which is equal to just 4.5% of world demand. This number represents a fraction of the percentage of world demand OPEC enjoyed in the 80’s. Note that OPEC includes Iran, which is still subject to sanctions, as well as Nigeria and Libya which suffer perpetual production issues. Furthermore, the IEA has cut spare capacity margins to virtually zero for Kuwait, UAE, Qatar, Algeria, Nigeria, Angola, Venezuela and Ecuador. We believe the difference in spare capacity materially outweighs any of the similarities between the 1980’s and today, and strongly suggests we are likely to have a materially different outcome than experienced in the 1980’s.
DECLINE RATE OF EXISTING PRODUCTION BASE
The next significant difference is the decline rate of the existing production base (e.g. the amount of oil production that declines year-over-year from existing fields). Many factors affect production decline rates, and because all wells are different, it’s difficult to measure the collective industry decline rate with exact precision. Fortunately, in 2008, several entities undertook the monumental task of tracking the intricacies of historical production declines by basin, well type, geology, country, etc. and published their findings with estimates of worldwide production decline rates tracked over time. Interestingly, many in the industry have argued decline rates are actually higher then these studies suggest (see Chart 3).
These studies also show the following:
• Giant onshore (i.e. land-based) OPEC fields have been experiencing the slowest decline rates in production.
• Deepwater fields have production decline rates that are up as high as twice the average.
• Smaller, onshore / land-based unconventional shale fields have the fastest production decline rates of all.
During the 1980’s, OPEC’s capacity to produce oil represented 50% of demand. Today, even though it produces oil from fields with the slowest decline rates, OPEC’s current capacity represents just 37% of demand. Let’s compare this to deepwater oil and unconventional shale field production, which have become a larger source of the global supply today. When you take into account these two sources of oil have the highest decline rates in the industry, along with the added demand from these sources of oil, it means that future decline rates will likely accelerate.
With the existing worldwide production base of 93.6 million barrels of oil per day, an annual 4% to 5% decline rate from existing production sources suggests the industry needs to replace between 3.7 and 4.7 million barrels of oil per day, 365 days per year, to maintain existing oil production levels. With only 4.5% of spare capacity coming from OPEC, meeting the growth in demand requires development and expansion of new fields. As illustrated in Chart 4, the International Energy Agency estimates that between now and 2020, the replacement of oil from declining oil fields, in addition to meeting worldwide demand growth, will likely require a substantial amount of new production from oil fields not currently producing oil. These new oil fields tend to be more complex and require more capital.
