Bob Robotti on The Supply/Demand Dynamics of Oil

MOI Global: Natural gas prices have been depressed for several years due to abundant supply of shale gas, but oil and gas have historically been cyclical commodities. Do you believe the long-term supply equation for crude oil has changed, or is a substantial oil price rebound only a matter of time?

Bob Robotti: When thinking about the long-term supply function oil and the effect on the supply/demand equation (and therefore oil prices) there are a few facts to keep in mind. First, every existing oil and gas well drilled is depleting. That’s a physical fact. As prices remain low, capital invested in new wells around the world continues to decline. Inevitably the production decline will accelerate. At the same time, lower prices are encouraging demand.

We focus our energy investing on oil and gas services companies – the “picks and shovels” of the oil and gas industry. As volatile as it is, these are 30-40 year assets with better long-term predictability whereas the E&P companies have to remake themselves every 5-6 years. As a result, the level at which the price of oil or natural gas settles is not nearly as important to us as the level of activity.

As for the price of oil I do believe a substantial rebound in oil prices is only a matter of time. The question is how long a period of time? The other extremely pertinent question for us is what equilibrium price is needed to bring on incremental supply. The price that is needed is predicated on the ROI for that incremental production and the commodity price is only part of the equation. The full equation must consider the finding and development costs of incremental barrels of production versus the operating margin realized on the production. So two things will drive future oil and gas prices: (1) the finding and development cost (F&D costs) and (2) the operating cost on the wells developed (lifting cost).

In the current period, drilling and completion costs have declined dramatically (at least temporarily). At the same time, well operating costs have also declined. So in the current environment the oil price needed for economic wells is below where it was a year ago but still higher than the price of oil today.

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