Oil prices below $100 will discourage exploration in high-risk virgin frontiers

Last week, the price of Brent marker crude oil fell below $100 per barrel to about $97. The last time the price temporarily fell below $100 was 17 months ago.

The $100 price is generally considered the psychological price level that triggers different actions and reactions from stakeholders.

Above this price, oil importing nations and consumers are wary of negative inflationary and budgetary impacts. On the other hand, upstream producers and investors welcome prices above $100 because they yield good revenues and returns on investments.

Every upstream oil and gas investor makes assumptions on crude oil break-even market prices that will make projects viable. The break-evens are mostly influenced by the unit costs of exploration and production.

High risk and high cost upstream ventures will likely assume base case break-even prices in the vicinity of $100. Low cost and “easy” crude oil producers will assume much lower break-even crude oil prices.

Unit costs for the “difficult” and non-conventional oilfields are in the region of $50-$75, and these include deep ocean ventures and the shale oil developments in the US. The unit costs will obviously vary with the quantity (divisor) of confirmed commercial production. Prolific discoveries will experience lower unit costs and break-even prices.

The mature and “easy” oilfields of the Middle East are said to register unit costs as low as $10 or less, giving them high margin buffer that can survive global oil price shocks.

However, Middle East producers are the most militant crusaders for high oil prices. They will not sit back and allow prices to drift below $100.

The Organisation of Petroleum Exporting Countries (Opec), the cartel of oil producers and exporters, will usually defend the $100 level at all costs by imposing crude production quotas on its members to reduce supply and buttress global prices.

Last week Saudi Arabia (the largest Opec producer) initiated measures to cut down production to force the current prices back to over $100. This action implies that the low oil prices experienced last week are unlikely to persist.

For oil prices to be dropping when there are notable disruptive geopolitical happenings (Ukraine, Syria, Iraq, Libya) the world must be awash with crude oil.
This is the case as consumption in China and Europe is said to be slow, as new crude oil production comes on stream especially from the US shale oil ventures.

From historical observations, oil demand/supply has always experienced swings that impact market prices. When prices are high, investors go for higher cost (and riskier) upstream ventures.

More investments mean more oil, and this starts to drive prices downwards. Reduced prices in turn reduce economic incentives to invest resulting in reduced supply that pushes prices up thus triggering resumption of investments. This cyclic routine continues.

But oil and gas investments cannot be start-stop activities as these are essentially long term ventures with long lead times. Only long term, economically sustainable market prices can ensure continuous investments and stable supply.

In a free global economy, upstream investments decisions are being made daily by individual nations and investors. The only key variable not fully in their control is the level of future global prices.

No one can project prices with any measure of accuracy due to unpredictability of global economic performance and geopolitical upsets.

Ten years ago, an upsurge of oil demand led to cries of oil running out (peak oil). The dynamics have since changed, and it is the oil demand that is slowing down. The ongoing efforts on increased energy efficiencies, gradual conversion to cleaner energy, and increased use of renewable energy are systematically reducing crude oil demands.

This is happening at a time when new technologies are pushing more oil out of the ground in the more difficult and non-conventional frontiers, leading to surplus global oil supply.

Continued successes with shale oil production by the US will most likely lead to increased global marketing competition as surpluses accumulate. US, Middle East, Russia and African producers will be competing for the Far East and European markets.

However, the critical swing supplier to beat will always remain the Middle East due to their huge reserves of low cost oil. The Middle East producers are also under less budgetary pressure and can afford to under-price to maintain their target export market shares. This is while they reserve their options to reduce production to strengthen prices.

What does the above mean for Kenya? Prices lower than $100 will reduce products and electricity costs thus reducing inflation. The reduced oil import bill will reduce stress on the dollar markets. But low prices are not expected to last for long.

In general, persistently low global crude oil prices will reduce appetite for risk in the oil and gas exploration in Kenya. Until sufficiently de-risked, Kenya remains a high unit cost frontier area.

This is why we should be cautious when we talk of prematurely loading more costs (like capital gains tax) on investors.

Wachira is the director, Petroleum Focus Consultants.
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