FORECAST '96 OPERATORS MOVING INTO ERA OF JUST-IN-TIME OIL PRODUCTION

Non-OPEC producers see no limits to productivity

• The direction of oil and gas investment in major hydrocarbon regions for the period 1995-2005.
  Source: "Competition for Capital in the International Oil & Gas Industry," authored by Price Waterhouse and Petroleum Finance Company.

The global petroleum industry has entered a period of demand/ supply cycling and mixed signals by commodity markets, as it awaits the expected surge in oil demand from less developed countries. However, oil prices aren't straying far from the $15-18/bbl range because of the ever-present OPEC surplus.

Sharply improved efficiencies are providing decent cash flows for everyone, including drilling contractors. However, few are taking much comfort. A residual fear of over-supply permeates every transaction. This concern is hampering new capacity construction, a factor that could pose serious problems if the demand for oil escalates too quickly in the coming years.

Relatively stable oil prices at the present are a product of OPEC oil output restraint. Marketing-savvy non-OPEC producers, and not OPEC members, are fulfilling the additional 1-2% growth in annual oil demand. OPEC has little choice but to await 3% plus annual oil demand growth that would be necessary to absorb excess global production capacity, estimated to occur near the year 2000.

Role of technology

The fact that non-OPEC producers can continue to push up production in an environment of $15-16/bbl oil prices is sending a strong message to OPEC. Will this high-efficiency, just-in-time production machine continue to fulfill additional demand, or will the $15-16/bbl oil reserves exhaust soon?

OPEC producers and some industry analysts expect the $15-16/bbl reserves to begin exhausting as early as 1997. Could they be in for a surprise?

Technologies, especially those engaged in boosting production from existing fields, are driving the escalation in non-OPEC output. While actual investment in research and development has dwindled, technical evolution has increased, largely due to two factors:

1. Producers and support contractors are moving new technology from the computer to the field in unprecedented time.

2. With project viability and jobs hanging in the balance, producer technology departments are more willing to try new concepts, regardless of where they are generated.

Major producers are basing project viability on $15-16/bbl oil prices, and in the process, forcing technology departments to come up with economically viable schemes to extract the production. What if this market-driven technical revolution continues into the future?

Most measures of future non-OPEC output growth are based on today's E&P technology, not tomorrow's. And, the fact that non-OPEC producers have such a small proportion of the world's remaining oil reserves (25%) seems to matter little in that environment.

Capacity financing

With the exception of Northwest Europe, the deepwater Gulf of Mexico, and some regions in Asia, areas of the world with the greatest reserve potential are the most unstable politically. Yet these same areas are presenting new opportunities to non-OPEC producers.

This presents a dilemma to the entities that help finance new oil production. The capital to finance additional capacity is available, but the levels of risk in countries with large reserves are discouragingly high. This was the conclusion of a Price Waterhouse/Petroleum Finance Company study, which analyzed how 75 international producers planned to deal with an unprecedented number of opportunities, many carrying higher risk levels than outside investors were willing to tolerate.

Here is the status of capital availability within three traditional capital sources:

• National oil companies: Capital is tight and restricted to maintaining current productivity. Country debt is still high and new capital infusions will have to come from privatization measures.

• International oil companies: Commodity pricing and shrinking downstream margins have forced the majors to sharply focus upstream spending. In addition, investors may have already fully appreciated equity values, which have been the source of new capacity capital for many lately.

• Banks: The governments that fund global lending institutions are financincially stressed, so the banks have reined in lending. Millions they have; billions they do not. In addition, the large national banks that lend against facility or reserve collateral are bailing out of some markets, alarmed at the prospect of getting title to properties with massive environmental problems.

In the past, major operators self-financed most projects because of high project risk levels and relatively low returns. But the landscape has changed in a commodity price environment. Not only are more majors having to depend on equity capital and outside lenders, but a greater share of oil and gas production is coming from larger independents, who are almost 100% reliant on outside capital.

So, the risk level of projects and the availability of capital for those projects may determine whether additional capacity can meet demand in future years at current oil prices. Higher prices, of course, would provide more earnings for producers to re-invest in new E & P as well as enable producers to pay higher risk premiums for the capital they will need.

Avoiding price run-up

If escalating demand for oil cannot be satisfied quickly enough, a run-up in prices will likely take place. This response, even over the short term, is exactly what OPEC and non-OPEC producers should fear most. Sharply higher oil prices produce conservation and political measures that impact oil output and profitability for all producers. A restrained oil price response optimizes oil demand and revenues.

Let's examine the difficulty in financing additional capacity.

Price Waterhouse and Petroleum Finance Company, in scanning the needs of 75 international producers, has estimated the global upstream petroleum sector will require $572 billion to $1 trillion over the next 10 years ($57-100 billion/year) to finance capacity. The range suggests that much of the lower capital expenditure will go to maintaining existing production levels, while the higher figure represents efforts to add capacity.

A widely accepted estimate of the cost of adding production holds that each additional 100,000 b/d of oil output above the 60 million b/d produced daily around the globe will require an infrastructure investment of roughly $1 billion. Thus, 10 million b/d of additional capacity will require an average $100 billion, more if is a non-OPEC bbl and less if it is an OPEC bbl.

If annual demand growth remains in the 2% range in the coming years, bringing on that additional 10 million b/d will require eight years. At 3% demand growth, that period of time dwindles to five years. Simply put, satisfying a 3% demand growth requires an minimum extra $20 billion expenditure each year, above the $57 billion/year minimum cited by Price Waterhouse/Petroleum Finance. Almost certainly, much of that additional capital will have to come from sources that demand lower risks than currently offered.

If demand growth does surge to 3% annually, OPEC's current surplus capacity of 3 million b/d will provide time for producers to obtain the needed capital and deploy it efficiently. Even with OPEC's surplus, some planners speculate that $100 billion in extra upstream investment over the next four years will be necessary to meet pent-up demand from Asia alone. But, if demand growth rises to 4%, all bets are off.

Thus, the strategy, both for OPEC and non-OPEC producers, is to attract that additional capital and deploy it efficiently, while holding oil prices to rational levels. Non-OPEC producers feel they can meet any demands for added production when it develops, as long as they get $16-18/bbl oil prices. But, how about the financing sources: will they accept constrained oil prices, given the level of risk?

Playing field levels

The contrast between OPEC and non-OPEC producers in terms of capacity management has never been as large as now. Both have access to the same cost-cutting exploration and production technologies, but non-OPEC producers have had greater success in managing capital deployment and technology.

While OPEC's production capacity generally has come at low cost, that 3 million of excess capacity has been of little use other than to constrain oil prices. For non-OPEC producers, excess capacity represents a stranded investment and poor efficiency. Thus far, the non-OPEC producers' position has been more useful, although it is likely in time that OPEC producers will develop the same abilities in managing capital, technology, and capacity.

The OPEC nations, however, have an additional problem to overcome. The conventional view of the OPEC producers, particularly those in the Mideast, is that finding, development, and production costs on a per-bbl basis were so low, that no non-OPEC producers could compete and would be at an advantage, sooner or later. However, during the low-price environment of the past 10 years, that view has changed significantly, and perhaps permanently.

For many of the OPEC countries, the costs of maintaining government and social programs, and investment in marginally competitive downstream operations, when added to E&P costs, required that oil prices remain above $13/bbl (OPEC basket) in order to cover costs.

OPEC's Secretary-General Rilwanu Lukman, while bluntly criticizing the lack of non-OPEC production restraint, admitted that in the present price environment OPEC producers have not been able to maintain adequate capital set-aside to provide additional capacity.

The fact that very few OPEC member nations have violated production quotas recently suggests that either price maintenance is an extremely sensitive issue now, or that the touted surplus capacity of 3 million b/d may be over-estimated.

Wherefore oil prices

The commodity status of crude, and the fact that OPEC and non-OPEC producers are on a more even footing competitively, suggests that global oil prices will rise only in lockstep with the technical costs of finding and producing the last bbl. Thus, crude oil prices should increase only slightly over the near term (2-3 years), if at all.

However, if 3% growth in energy demand materializes sooner than expected or it becomes apparent that OPEC's surplus capacity is over-estimated, oil prices will reflect that reality by moving to the high point of its recent range - $18-19/bbl. Stable prices in excess of that figure would likely result in over-production, which would cap the price run-up.

Oil prices in excess of the cost of the last bbl produced will reflect a premium attached to the risk of market aberrations - a Mideast conflict, destruction of major production facilities, an OPEC decision to over-produce, etc. - which could wreck parity between supply and demand. When the aberration passes, however, prices will return to current producer cost levels (marginal cost).

Just-in-time production

The efficiency of non-OPEC producers and their ability to manage capital and technology, brings up an interesting situation. Despite the fact that the non-OPEC nations hold only 25% of all reserves, the market and most producers have no way of measuring the ultimate productivity of non-OPEC countries.

Producers keep applying new technology to extract additional production from reserves that didn't exist until they were needed. This concept of just-in-time production is changing the basis of economic measurement, and perhaps energy and political clout as well.

The market has always accorded economic strength to energy producers and countries in terms of producible reserves. Of course, this means that the Mideast OPEC nations are in the driver's seat for the future, if not now.

But, what if finding and extraction efficiency were to begin taking a position equal to proven reserves as measures of capacity potential. OPEC's vast reserves would be somewhat discounted, unless of course, the OPEC nations were to contract out recovery to the most efficient producers and marketers. That is a long shot for most OPEC producing countries, although privatization will bring about some efficiencies.

So, the model is complete. Efficient producers equipped with the latest technology, largely residing in reserves-depleted non-OPEC countries, are keeping OPEC producers at bay with quick productivity. That productivity and OPEC's surplus output are restraining oil prices in the current environment. The volume of oil being traded in commodity markets today is large enough for traders to fully exploit these surplus capacities and force all producers and consumers to index prices to markets.

Under this model scenario, the only variables which are largely immeasurable are the magnitude of oil demand growth and the real OPEC surplus. Given the evolutionary history of industry technology and the fact that oil is commodity priced, the E&P efficiency gains should not be considered static. In other words, the technology will be there tomorrow to fit the need.

Thus, non-OPEC output cannot be capped by the lack of reserves today, and OPEC's member countries, forced to accept such a future, might find it prudent to pursue individual courses of action. In the future, OPEC may become an organization less of group action than politically friendly oil states.

At the same time that international oil companies are pursuing the most efficient strategies, the national oil companies will have to follow close behind if they are to survive. Unlike the past, reserves alone will not determine success.

EDITOR'S NOTE:

Parallel and contrasting viewpoints on these subjects are included in the "International Focus" and "Beyond the Horizon" columns, appearing respectively on pages 6 and the last page in this issue.

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