Kemp: Past Oil Price Slumps Show US Drillers' Inertia

Reuters via Rig Zone ^ | December 15, 2014 | John Kemp

[thackney]

The most important characteristic of the U.S. oil industry is inertia - or to put it another way, drilling and production respond sluggishly even to a large change in prices.

Since 1974, there have been four episodes in which oil prices declined sharply over a relatively short time (ignoring the brief price spike and equally rapid reversal in 1990 associated with preparations for the first war between the United States and Iraq).

These price slumps occurred between (1) December 1985 and July 1986; (2) January 1997 and December 1998; (3) November 2000 and December 2001; and (4) July 2008 and February 2009 (http://link.reuters.com/weq63w).

In each case, the drop in prices was completed quickly, with the peak-to-trough move taking seven months, 23 months, 13 months and seven months respectively.

In the first three episodes, prices fell by about half (58 percent, 57 percent and 46 percent) though the most recent instance during the financial crisis saw a larger decline of around 72 percent.

Each decline in prices brought a downturn in domestic oil and gas drilling. But with the exception of the slump in 1986, the downturn in drilling was proportionately smaller than the fall in prices.

The number of oil and gas rigs operating fell by 65 percent, 21 percent, 16 percent and 32 percent in the four episodes respectively.

If the focus is restricted to rigs targeting primarily oil-bearing formations, the declines are 55 percent, 37 percent and 29 percent for the last three slumps (there are no oil-drilling-only numbers for 1985-86).

In most cases, rig counts started to decline some months after prices turned lower, with delays of three to 12 months normal.

Production losses were even smaller...

[con-surf-ative]

You would think the industry could react much more quickly to reduce drilling and thus volume growth when prices collapse. I think there are three reasons why they don’t (or can’t).

1. Every publicly traded E&P company is judged by the investment market on one metric: production growth. So in order to avoid having your stock punished by the market, you have to not only show you are making money, but that your production is growing at a greater rate than the year before. These companies are forced to think short-term and generally focus on the next earnings call.

2. Long term rig contracts require E&P companies to keep drilling wells even when economics are not as favorable in order to avoid paying penalties under drilling rig contracts. Rigs have been hard to come by and very expensive, so most companies committed to term contracts (1 to 2 years) that cannot be avoided. We can only hope this latest price decline will push down rig rates and give the operators more leverage to avoid term contracts.

3. The industry still doesn’t believe this is a long term decline. I think most E&P companies think this situation is a contrived market manipulation that will run its course relatively quickly, and that things will return to “normal” ($100 oil) soon. Everyone is counting on their competitors to take the hit, and will try to stay afloat until things turn around. I think the longevity of this downturn will take some operators by surprise.

[thackney]

Few outside the industry seem to realize the long-term nature of this game.