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Oil prices to rise within five years as supply restrictions bite

Out-Law Analysis | 12 Nov 2015 | 3:00 pm | 3 min. read

FOCUS: The price of oil has always flirted with volatility, but the past two years have been exceptional, and have come as a considerable shock both to the industry and the wider economy. 

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The response to low prices may, however, cause them to rise again as demand begins to outstrip supply.

Conventional thinking about what is 'normal' has been turned on its head and it is taking the world a bit of time to recalibrate. There's a complex cocktail of geopolitics, physical issues, economics, both macro and micro, to blame, and there's a technology element too. The basic economic principle of supply and demand and how that impacts pricing has come into play in spectacular style.  

While the continuing low oil price can be seen as good news for consumers, both retail and industrial, the impact on the industry has been enormous, and will continue to be for the next few years. The end product of what is a massive capital and operating investment programme has effectively halved in value. That dramatic fact then feeds through the supply chain, into oil services businesses, to the providers of capital: everyone is affected.

The ripple effect through the supply chain is huge, as the producers cut costs and bring in efficiencies, just to survive. In fact, it's been interesting to see how well their supply chain responds. Many of the people who develop and run oil and gas fields have been running very inefficient businesses, protected by a relatively high oil and gas price. That protection no longer exists.

In the short term, we are simply seeing a fight to survive. But in the medium term, those who do make it through will inevitably curtail their investment. That is storing up a problem for the future, because if we cut back on investment and exploration, on development projects, then it is quite likely that future production could struggle to meet future demand.

You see this most starkly in the drilling rig market, where there's currently a chronic oversupply. Drilling rigs are typically for rent on a day rate contact, and many of these are now sitting unused.

The natural effect of this situation is that the rig owners will start to decommission them, leading to a shortage as we get closer to market supply demand being met. That will happen with other items of equipment as well: these are big, multi-million dollar pieces of equipment and no one can continue to offer them without demand.

The supply chain will reduce to a size and capacity that works with today's demand and today's production, and the risk is that when demand returns, the suppliers will no longer be able to meet it. Which brings us right back to basics: supply not meeting demand, which will then increase prices.

Price will therefore stay low for the next year or two, but I expect it to rise within three years. Not to the levels we have seen recently, perhaps, but enough to have an impact on the industry, and on other businesses who are now taking advantage of the lower prices.

There are those who argue that shale oil 'fracking', particularly in the US, will keep the price low by increasing supply. The industry has managed to increase efficiencies, with a reduced number of active onshore drilling rigs while keeping production high and producing at low prices. However, whether they can meet increased demand will have to be seen.

Another impact of the low price has been to stall some of the development of alternative sources of energy. Cheaper energy from hydrocarbons has reduced the apparent need for developing alternative sources. While I believe hydrocarbons will always be part of the mix, it is important to look at other sources. That work has been set back and we might see the impact as demand begins to increase over the next few years.

The oil and gas industry has always been good at finding solutions, and it will do so again. If demand growth is there, the industry will find a way to respond. But that will not come without a cost: the lack of current commitment to future development and production potentially risks supply chain costs rising along with demand. The end user needs to be prepared to start paying for that.

Aberdeen-based Bob Ruddiman is an energy expert at Pinsent Masons, the law firm behind Out-Law.com.