How The Downturn Strengthened The Oil Industry

As we explained in the fall of 2020 which was a follow up to our spring of 2020 article the oil industry, in spite of drastically lower wind and solar prices, has continued to exist.

In fact the massive downturn in the oil industry in 2015 combined with Russia and Saudi Arabia fighting driving the prices for crude oil two and sometimes below zero has actually strengthened the industry.

You may think that is an odd statement but what’s happened is the high cost players have been forced out of the industry.   This means that opportunists and lesser skilled companies that needed $80, $90 or in some cases even $100 per barrel of oil to survive are now gone. However their production has not and that is the key.

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What happened is those companies built an infrastructure, and by infrastructure we mean they drilled wells or installed pipes pipelines or invested billions of dollars into high cost oil sands operations and those systems have now been transferred to more efficient companies at pennies on the dollar through either standard mergers and acquisitions or in some cases the bankruptcy processes.

In September of 2020 Suncor indicated they are producing oil at US$27 per barrel:

2020 production guidance has been updated to 60,000 – 65,000 bbls/d, with a reduction to the Fort Hills cash operating costs(1) per barrel range by CDN$2 per barrel, to CDN$32.00 – CDN$35.00.

Their guidance for 2021 show a further decrease in the marginal cost per barrel to about $24

Full year Oil Sands Operations cash operating costs guidance has been revised to CDN$28.00 – CDN$31.00 per barrel.  SOURCE

It is important to note that while painful to the inside players in the oil and gas industry, most of the pain was felt by investors and most of the money lost was initially collected from the public markets .

It’s counter intuitive to those who don’t work in industry that extreme hardships end up strengthening the companies that survive.

Oil & Gas is unlike typical manufacturing which goes away as factories close due to demand shocks.  The demand for oil and gas products is still strong and while it is likely to start declining in the 2030’s, demand is actually increasing globally.  China, India and other countries with hungry growing middle classes want the comforts that you have.  A car or two, home heating, paved roads, consumer goods delivered by big rig trucks.  Today nearly all of those things require vast amounts of oil and gas.

Most oil and gas spending goes into what are categorized as “sunk costs”.  The companies that constructed those systems may come and go but the actual production stays; it just changes  ownership.

The wells that were drilled, the oil sands investments that were made, and the pipelines that word constructed do not become completely abandoned during downturns, their ownership is simply transferred.

There are several notable exceptions to this sunk cost logic:

1. While pipelines are a sunk cost, they are attractive to investors and should be attractive to society at large, because they are unlike pump jacks and SAGD extraction systems in that they can and often are changed to transport different materials.  Pipelines should be thought of a highways that can carry dozens of different materials and are even frequently “reversed” to push product in the opposite direction to their original design.  Today oil may flow south, 5 years from now hydrogen may flow north, and 15 years from now fresh water may flow south again.
2. There are a few oil producing techniques that do have a high marginal cost, most notably fracking.  Oil and gas producers relying on variable costs, like fracking, are not attractive M&A targets and so their production can stay offline during even a prolonged period after oil prices recover.

The bottom line is that the International Energy Agency (IEA), Bloomberg and other reliable sources of energy predictions all appear to be correct.  Oil and gas will die a very slow death and go out with a whimper in the 2100, not a bang in the 2030’s.