US tight oil to lead the industry out of the down turn

Capital expenditure is the key indicator of the industry's confidence in the medium term. We forecast global upstream spend in 2017 will be higher, reversing the declines of the last two years. Firmer oil prices triggered by OPEC's November 2016 shift in strategy should inject momentum to the US unconventional-led recovery in spend already underway.

Upstream spend collapsed in the aftermath of the oil price crash of late 2014. Global expenditure hit an all time high of US$760 bn in 2014, including exploration. Two successive years of savage cuts will reduce investment to US$438 bn in 2016, 42% below the peak. Discretionary spend was swiftly withdrawn from unconventionals and exploration, and cuts have spread to all resource themes and almost all geographies over the last two years. Investment in conventional greenfield projects virtually dried up.

Financial stress across the industry contributed to the investment vacuum. Negative cash flow and weakening balance sheets forced companies to preserve capital, cutting costs, dividends and spend. This period of contraction has helped stabilised finances entering 2017. The industry now needs an oil price of just US$55/bbl to break even on cash flow, down from US$100/bbl in 2014 - a more solid platform from which to consider new investment once again.

We forecast that global upstream spend will increase by 3% to US$450 bn in 2017, signalling an end to the decline.

The increase is almost entirely down to tight oil and shale gas, which account for over 90% of the US$13 bn expected additional investment. Exploration spend, included in the numbers, is set to remain in the doldrums, at best flat y-o-y at US$40 bn and 60% below the 2014 peak.

First signs of a pick up have already emerged in the US L48. Rising oil prices in Q2 2016 prompted operators to put rigs back to work in the Permian and Mid-Continent, the lowest break even US tight oil plays. Short cycle unconventional plays are highly responsive to price signals. The L48 rig count has continued to build and is nearly 50% above the May lows (with the Permian up 72%). US independents lifted capital budgets for 2017 by 23% y-o-y on average with Q3 results (even before OPEC moved to cut), indicating growing confidence and the availability of capital.

Enthusiasm is less overt outside the L48 – in fact some international independents plan to cut budgets further in 2017 to rebuild finances.

But more conventional projects should achieve FID. We expect 20-25 FIDs in 2017, a marked step up from the single figures of both 2014 and 2015 though well below the 40 p.a. average of 2010-14. Much of the actual spend on these greenfield projects may not come through until 2018.

Many of the 2017 FIDs will be relatively small, short lead-time projects where costs have been significantly reduced in the downturn – boosting returns and underlining the industry's focus on value over volume. Big projects with long lead times, marginal economics and substantial up front spend will struggle to win funding.

The industry will make investment go much further in 2017. Success in cost reduction in 2015/16 has varied from the spectacularly successful L48, where productivity and efficiency gains have approached 40% in places, versus a global average of 15-20%. Resetting costs means more bang for buck. Our forecast spend is closer to US$540 bn in 'old money', albeit still 25-30% below 2014 levels.

A key question for oil markets is whether it's enough to maintain supply. We estimate over 4 million b/d of oil production in 2021, or 4% of global supply, has been lost to the market from project deferrals since 2014. We continue to think a supply squeeze could push prices up to US$85/bbl (real) by 2020.

Cost re-inflation is a risk for the L48 as activity picks up, and particularly if oil prices rise towards US$60/bbl, the threshold break even for the majority of tight oil resource we model. Many deep water plays in contrast are still out of the money at that price. There is a need for further cost reduction if growth investment is to restart in earnest.

2017 marks the start of a new, muted upcycle in our view, with investment recovering gradually to over US$500 bn again by 2019.