Joe Penney / Courtesy Reuters A fuel pump is seen at a filling station in Bamako, January 9, 2015.

Cheap Oil Won't Kill Exploration

How Companies and Countries Can Make the Most of Low Prices

For the second time in a decade, oil prices have taken a major tumble. If energy stays relatively cheap for a few years, a massive redrawing of the economic and political landscape could follow.

Some of the consequences are easy to predict—because they happen every time oil prices drop. China, India, the United States, and other oil importers will gain because falling energy costs will free up money for growth in other sectors. As in the past, it is also likely that major oil-exporting countries—Russia and the countries of the Middle East and Latin America—will face pressure to adopt massive energy sector reforms to attract new, taxable investment.

Cheaper oil could also redraw the geoeconomic landscape in subtler ways. Of course, low oil prices could force some oil and gas producers to stop drilling, since some fields will no longer be economically viable. It could also reduce the capital budgets of the biggest oil firms, whose cash balances are already strained in today’s environment. But the price slump may also create a sizable opportunity for new oil exploration projects, such as deep-water oil and gas fields, which have long lead times (five to eight years) and do not rely solely on today’s oil prices—provided these projects attract funding for critical infrastructure, such as new pipelines. Already, these projects have shown surprising resilience as the excess supply of drilling rigs drives down exploration and development costs.

Winners in this new cheap-oil world will be the firms that have cash to spend and governments that are good at attracting scarce new investments. The result could be a shift in oil exploration—the drilling of new wells in new fields—away from the traditional basins to underexplored places, such as East Africa and even Iraq. If well managed and the economics look favorable to investors, the next several years could see a diversification of world oil supply—a good thing for all big energy consumers since oil security is first and foremost a function of diversity.

KNOWN KNOWNS

Predicting anything about oil and prices is a hazardous business. But some of the effects of the price tumble are easy to guess.

For a country that consumes a lot of oil, the economic effect of a big cut in oil prices is similar to that of a reduction in taxes for consumers. It leaves more money in their pockets because they can spend less on gasoline, get cheaper airplane tickets, and reduce spending on other activities that use oil. They can spend the money instead on other forms of consumption, and all that adds up to more economic growth. In many countries outside North America, the price of natural gas—and thus the price of electricity—is also partly dictated by the price of oil. When oil tumbles, often prices of all energy forms soften as well.

Compared with most other countries, the United States likely will be the world’s biggest economic beneficiary of cheaper oil. The country uses nearly 19 million barrels of oil per day, which is almost double China’s consumption. Although the United States is also a big oil producer—this year, it likely will pass Russia as the world’s second-largest oil producer and may even surpass Saudi Arabia—the country still imports nearly half the petroleum it burns. And the households that spend the biggest fraction of their income on energy tend to be the poorest. For those families, cheap oil nearly always leads to spending more on other things and therefore to even larger benefits across the economy. 

Another predictable impact of cheap oil is its likely effects on the policies of countries that rely on oil exports for revenues. The cash from exports is closely related to some of the world’s most difficult foreign policy problems. This is partly because oil-rich countries can afford to worry less about the opinions of other members of the international community. And in countries where there is civil unrest, it’s partly because of the money that rebels can make by stealing oil from pipelines.

Expensive oil also allows countries to avoid economic reforms and shelter their economies from global economic competition, while cheaper oil has the opposite effect. Cheaper oil can also help the West negotiate with Iran. Already sanctions have put enormous pressure on that oil-exporting country; declining revenues should add more.

FACTORS AFFECTING INVESTMENT

Although many of the effects of cheaper oil are easy to predict, much less apparent is how it will affect investment patterns for new oil exploration and development. With oil prices in the basement, the capital available for exploring new basins is tightening. Firms are becoming much pickier about where they invest their money. Nearly all the major oil and gas companies have pared back their capital investment budgets for 2015. Countries seeking to attract new investment must now compete more seriously with other countries and basins. What is likely to result is a race to become an attractive place to invest.

The competition will be felt in many types of oil exploration and production. One example is in far offshore “deep-water” oil exploration, which is a bellwether for oil markets because it is one of the most important sources of new production. Over the past decade, deep-water has had a spectacular run—driven by improvements in seismic imaging technology and dedicated moves by major oil companies to broaden their portfolios. In fact, deep-water discoveries more than quadrupled over this time frame, as has investment in these fields. All told, deep-water oil and gas production has more than doubled to 13 million barrels of oil equivalent per day. Looking to the next decade, credible projections see deep-water accounting for almost 30 percent of new oil supply—almost as much as shale oil will contribute.

When oil prices were high, few noticed the fact that the cost of deep-water exploration and development soared, on average, 40 percent over the course of five to seven years. Supply chain shortages and the growing complexity of deep-water geologies have been partly at fault, but two factors have been more important in driving higher costs. One is the rising share of oil field profits taken by governments, often referred to as “government take.” The other is more stringent local content policies, which require the manufacturing of equipment and execution of projects in-country with local labor, services, and equipment suppliers. Although such rules can, if well implemented, ultimately save money and build up national industries, so far they have mostly created supply chain shortages and driven up costs, since many countries lack the capabilities to comply with the rules. The time needed to build these local supply chains is typically much longer than project timelines allow.

Government-related costs are deterring investment in countries that were just recently hotbeds of deep-water investment. Brazil is an example. For many years, Brazil saw a decline in production levels. It responded with an open door policy and supportive politics, and the state-owned company became a global industry leader in ultra-deep-water. However, after the pre-salt discoveries in the late 2000s, new constraints were imposed, including more stringent requirements for local content. Local content rules, while well-intentioned, have resulted in supply chain bottlenecks, cost inflation, and a lack of transparency. As a result, delivery times and costs can be far above international benchmarks.

Similarly, in Nigeria, new policies have played a role in investment trends in offshore exploration activity, which has been declining for five years despite the country’s vast potential. Today, government take in Nigeria is nearly 70 percent of oil profits, in contrast to Mozambique and Senegal, where the take is closer to 50 percent.

The good news is that companies that have capital to deploy for deep-water exploration and development still have attractive opportunities to do so. New growth in deep-water will come in part from underexplored basins where host governments are eager to attract foreign capital. Nowhere is the shift more apparent than in Africa, where sales of licenses and equity interests to develop deep-water blocks have grown almost 20 percent per year since 2000. By 2025, Tanzania and Mozambique are expected to contribute the largest growth in new gas production, constituting ten percent of the total, while West Africa oil exploration activity is expected to tilt away from Nigeria and Angola and toward countries such as Ghana and Senegal.

At the same time, real costs for drilling—which today makes up 30–40 percent of the total cost of a deep-water project—are on the decline. Global rig day rates have fallen precipitously from a peak of almost $700,000 per day in 2013 to as low as $300,000 in December 2014, thanks mainly to an oversupply of new deep-water rigs that are just now entering the market. Lower costs today are good news for projects that are now in the exploration phase and expected to produce five to eight years from now, when prices plausibly could be higher. And while the logic we have outlined here focuses on deep-water supplies, the same basic logic applies to many other frontiers in oil exploration and production, such as complex, unconventional onshore fields.

In this new era, government policies will be the key differentiation between countries that get investment and those that don’t, since the oil price drop has made capital for exploration scarce. There are several things they can do to make themselves more attractive.

NEW CHALLENGES

The opportunities in this new geoeconomics of oil are far from guaranteed. Handled badly, the new frontiers for investment will not materialize. But handled well, the upsides can be enormous.

Mozambique is a promising example of good practice. Home to some of the largest recent deep-water gas discoveries, the country’s government passed legislation in late November 2014 that set long-term fiscal and legal parameters for international companies investing billions of dollars into the development of a massive Mozambique gas field and liquefied natural gas facility. The new law covers the 30-year duration of the project and includes investor-friendly terms such as a long-term tax framework—which will be revisited ten and 20 years after the first shipment of natural gas. The International Monetary Fund has praised the fiscal and legal stability the law provides, stating that the Mozambique decree will serve as a “benchmark” for such agreements in other countries.

Many other examples abound as well. In Iraq, massive investment in the Kurdish region has expanded the country’s production, made possible by policies that are realistic about what foreign investors need. Foreign governments, notably the United States, have helped with technical assistance and security—including crucial security and financial support for foreign investors. Firms themselves are playing key roles—for example, by focusing on how that dry region can produce oil while minimizing the use of scarce water.

World powers will also need to help new oil producers strike the right balance between generating local jobs and skills, on the one hand, and imposing high costs on new projects that might affect competitiveness on the other. Multilateral development organizations and countries that have had firsthand experience with these policies could provide this type of support—all rooted in the logic that oil importers will gain from a more diverse supply of oil and nascent exporters will gain from well-earned revenue.

Policies that can adapt to real-world circumstances and are adjusted based at the pace at which local industries emerge can be a good start toward achieving balance. The reforms in Mexico are a good example. That country is now adopting massive changes in energy policy to attract foreign investment and best practices in the country’s oil, gas, and electricity sectors. Already Mexico appears to be adapting the terms for foreign investors who want to explore for oil, in response to the crash in oil prices.

But the biggest impact on the global economy from low oil prices might come from existing oil exporters who must confront economic realities. The financial and political pain of falling oil revenue could present an opportunity for these countries to open up their oil sectors to international firms and practices and develop further interdependencies with the world economy.

Almost certainly, global prices will rise as investment in marginal supplies such as from U.S. shale oil are curtailed and surplus oil is worked from the system. Current prices—in the $40s as we write—are not high enough to support massive new investment in important shale oil fields that would be needed to replace declining production from existing fields.  But that process will take some time, and prices could remain surprisingly soft as global demand is slow to rebound. Indeed, energy-efficiency policies and investment in oil alternatives continue apace, suggesting that surprises in oil demand may keep oil from rocketing back into the stratosphere. The new geoeconomics of oil will reward the countries and firms that deal with this new reality.

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