“Oil is becoming increasingly difficult and costly to recover, and the problem of managing the supply chain and profits has become more complex than ever. After weathering the economic downturn, the industry must boost capacity for future demand, and keep a close eye on the economics of oil and gas production.”
So wrote my colleague Allen Avery, in a recent ARC Insight report titled “In an Uncertain Economy, Oil & Gas Industry Spending Must Stay Strong” (available to ARC clients only). Based on some of the points Allen makes in the report (in quotes below), here is why I think the oil and gas industry has the toughest forecasting problem.
First of all, the industry has brutal boom and bust cycles. In 2007, for example, “the economics favored industry investments and project activity. Oil prices rose from roughly $60 to $100 per barrel that year, and by mid 2008, shot up to nearly $150 per barrel. By the end of the year, however, the unraveling global economy squelched demand, and the price had fallen to $45 per barrel.” However, despite the busts, oil production companies need to consider long term demand and continue to invest in developing new fields because “the timeframe of large oil and gas projects can be several years, with first oil coming as long as 15 or 20 years after work begins.”
“In the past, the industry has had difficulty adjusting capacity to meet demand. Scaling back production and refining when demand drops has never been a problem. [But oil companies have been] reluctant to invest in expansions, particularly during prolonged periods of lower prices. The recent oil boom sorely tested this strategy, and oil companies found themselves unprepared for soaring demand.”
The economics of investing in new fields, however, takes great fortitude as the costs to extract oil have increased significantly. “As oil companies venture further afield to find oil and gas, the deposits they encounter have become increasingly difficult to develop. New discoveries tend to be in inhospitable, remote environments, and require more complex extraction methods, such as steam injection and chemical treating. Subsea deposits require an investment in highly engineered equipment that can withstand harsh underwater conditions up to 30,000 feet below sea level. New deposits on land tend to hold heavier oil that is difficult to get flowing. Both types require complex extraction methods, such as injecting seawater or high pressure steam into the well to drive oil or gas to the surface.”
“To make matters worse, the output of oil wells can vary significantly over time, impacting the economic justification to continue running them. Older wells with changing conditions require more frequent testing to determine if their output is sufficient. New wells that appear promising may underperform once pumping starts.”
If you think putting together an accurate forecast for the coming month is difficult, imagine putting billions of dollars at risk on a fifteen year forecast. There are various agencies, analyst groups, and trade groups that make long term forecasts related to oil and gas. For example, the International Energy Agency (IEA) says that demand for oil will rise significantly over the long term due to population growth and reinvigorated economic expansion and modernization of developing countries such as China and India. The IEA forecasts that the world oil supply will need to grow “from its current 84 million barrels per day to 106 million per day by 2030.”
But how many billions of dollars would you be willing to bet at your company based on a third party forecast? Further, the profits a company will garner from these investments also depend on how much capacity competitors develop. This too needs to be forecasted and tracked closely.
I would be willing to put billions of dollars at risk on a fifteen year forecast…if I was retiring in five years.