This article was written by Clark Williams-Derry and originally published in IEEFA on November 19, 2021.
North America’s oil and gas sector is patting itself on the back for dramatic improvements in its financial performance last quarter. With prices at a seven-year high, fossil fuel companies are finally generating cash—and stock market investors are rewarding them with rising equity prices and glowing reviews.
But today’s market has also exposed a long-term vulnerability for the oil industry: The same high prices that are juicing profits for oil and gas producers are also turbocharging the transition away from oil and gas. Prices have quickly shifted from being too low for oil and gas companies to prosper, to being high enough to endanger long-term demand for fossil fuels.
Understanding how this shift has happened requires a bit of a history lesson.
For most of the last decade, U.S. oil and gas companies competed in an all-out race to boost output. Drillers completed more than 140,000 new horizontal wells since 2010, at an average cost of more than $6.6 million per well. Production soared, quickly boosting the U.S. from an oil sector also-ran to the planet’s top petroleum producer. Wall Street fueled the frenzy, shoveling more than $800 billion into oil industry coffers in the hope that that rising output would lead to robust profits.
Yet the fracking boom had a hidden secret: Even though the continent’s energy industry was producing unprecedented volumes of oil and gas, it had submerged itself in a sea of red ink. Year after year, through high prices and low, oil companies burned through the cash entrusted to them by investors.
During the early phases of the oil fracking boom, from about 2010 to mid-2014, oil prices often topped $100 per barrel. But high drilling expenses, coupled with an imperative to pursue growth at all costs, spurred the industry to spend far more on production—drilling new wells, buying equipment, building pipelines, securing new properties—than it could generate by selling oil and gas. Investors discovered to their dismay that high prices didn’t guarantee healthy profits.
As the fracking boom evolved, drilling costs fell substantially. Fracking technology improved, and cash-starved oilfield service companies cut their rates to attract business. But falling costs also encouraged overproduction that swamped global markets, sending prices and revenues down and keeping many oil companies in the red. Even in 2018, when prices crept into the $70s, most frackers still spent more cash than they generated. Lower costs didn’t guarantee healthy profits either.
The fracking sector’s last hope was that oil markets would converge—somehow, someday—on a “just right” price that would be high enough for companies to consistently generate cash, but not so high as to set off another round of overspending, overproduction, and price declines. Finding that Goldilocks-approved market would require a mix of luck and discipline. Demand would have to outweigh supply, yet the world’s oil producers would need to restrain themselves from producing too much as prices rose.
The COVID-19 outbreak set the stage for that “just right” market. As the pandemic raged last year, oil companies slashed output and new drilling. Uncertainty about the pandemic’s trajectory, coupled with an increasingly cold shoulder from Wall Street, froze the U.S. industry in place. Drilling has picked up since last year, but more slowly than after previous busts. Yet at the same time, massive government stimulus programs, coupled with pent-up appetites after the privations of quarantines, have contributed to a resurgence of global energy demand.
The collision between slow drilling and rebounding demand caused prices to soar. This October, a barrel of oil cost more than at any time since 2014. Even so, most drillers are continuing to hold back, using their bountiful cash returns to pay down their debts and reward shareholders, rather than ramping up drilling.
Still, Goldilocks should be skeptical about whether today’s “just right” market can last. Just as oil prices in the $50s and $60s proved to be too cold, sustained prices in the $80s may be too hot. Oil market analysts at Morgan Stanley argued that demand destruction—i.e., consumers and economies quickly moving away from oil—climbs when oil prices reach $80/barrel. Last week, OPEC signaled that it agrees that high prices are already eroding demand, trimming fourth-quarter global demand oil forecasts by 330,000 barrels per day.
For evidence that high prices are starting to crimp demand, look no further than the surging global demand for electric vehicles. Global EV sales shot up 80 percent this year, rising to 7.2% of the world automotive market, up from 4.3% last year. In the European Union, where gasoline and diesel prices have risen steadily all year, almost 1 in 5 cars sold in the third quarter was electric, up from 1 in 10 the previous year. High prices have clearly played a role in the increase. When fuel shortages and price spikes rocked the UK in September, buyer interest in EVs shot up to unprecedented highs.
Similar trends are afoot in China. Sales of plug-in vehicles—including both pure battery cars and plug-in hybrids—crossed the 20% threshold in the Chinese vehicle market this fall. Even in the U.S., where comparatively low gas prices have made car buyers slow to join the electrification bandwagon, EV sales through the third quarter rose 83% year-over-year. Kelley Blue Book reports that sales of electrified vehicles—including both EVs and hybrids—surged past the 1 million mark last quarter, accounting for 10% of the new vehicle market.
Clearly, sustained high gasoline prices have sent the global EV market into overdrive. Ford, GM, and Volkswagen have all introduced new electrified vehicles into the U.S. market and are poised to roll out more; the reemergence of high fuel prices makes their commitment to electrification look prescient. Meanwhile, the initial public offering of electric vehicle manufacturer Rivian catapulted the company’s market value ahead of both Ford and GM, reinforcing the perception that high gas prices will make pure-play EV companies the winners in future automotive wars.
It’s obviously far too soon to claim that the high prices have doomed the financial performance of oil and gas companies. Until prices fall, we can expect the oil and gas companies to continue to rake in cash.
Still, it’s clear that today’s prices are creating risk for long-term oil and gas demand and that the transportation sector—the oil industry’s main customer—is responding to high prices by accelerating its shift to alternatives. After suffering through years of “too cold” and several months of “too hot,” the oil and gas sector may have finally discovered that there is no such thing as an oil price that is “just right.”
Read the original article HERE.