Former Shell President Hofmeister Sees Oil at $80 by the Summer

NEW YORK (The Street) -- When a massive truck slams on the brakes to avoid a crash, it takes awhile for it to get back up to highway speed again.

That, in essence, is the problem oil companies will face when they want to increase production if supplies start to fall short. The selloff in crude oil has put drilling on hold. Unless more drilling resumes soon, a surplus of 1 million barrels a day will be exhausted. John Hofmeister, a former president at Royal Dutch Shell (RDSA) , predicts that will happen by the summer and will send prices up to $80 a barrel.

"When that cost correction comes into being, it takes a long time to turn that around," Hofmeister said. He pointed to 400 rigs shut down during the past three months, and Schlumberger  (SLB) and Baker Hughes  (BHI) laying off a combined 16,000 workers.

"This is what the industry does when there's too much oil," said Hofmeister, founder and chief executive of Citizens for Affordable Energy , an organization that promotes natural gas as fuel for transportation.

One reason current supply won't last is because existing oil wells are at risk of "natural declines," Hofmeister said. And just as it will take time for production from the drilling shutdowns to wind down, it will take time to resume canceled and deferred projects. That means there's nothing oil companies can do to prevent a sudden upswing in price. 

Oil prices have slid about 60% since June, a drop that has forced producers to scale back.

The industry is built for boom-and-bust cycles, and so "there is nothing the oil companies can do," Hofmeister said. "They plan their business by low price and high price parameters."

Analysts agree that oil companies are doing what they should -- conserving cash and cutting costs in the face of lower revenue. Most oil producers are cutting back drilling, except for members of the Organization of Petroleum Exporting Countries.

Saudi Arabia's decision in November to maintain its output confirmed the view that it will battle to take market share from non-OPEC players, said Tim Evans, an energy analyst at Citi Futures Perspectives in New York. OPEC has stood fast even as oil has fallen to almost $40 a barrel, severely hurting members with oil-dependent economies, such as Russia and Venezuela.

Hofmeister said Saudi Arabia may decide the cost of maintaining its current output is too great and cut supply, which would lead to the higher prices the entire industry hopes for.

In that case, Evans said oil could go from $40 to $60 or $70, but he noted that "we're not going to see $90 to $100 a barrel until inventories are drawn," saying, "We'll still have this physical overhang that will tend to cap the price recovery," referring to oil from long-term drilling projects that will come on line in the future.

Hofmeister argues that the new projects will be offset by the rate of natural production declines in existing wells -- especially in shale oil.

Not only will the cuts result in a 4% to 5% reduction in oil produced per well in conventional wells, but the "natural decline" -- or decline in oil output from an aging well -- in existing shale oil wells is significantly higher at 30%-40% a year, Hofmeister said.

"So if you apply 4%-5% against 92 million barrels (of current oil demand), that means in order to stay even at 92 million barrels, you have to find 4 to 5 million barrels to replace those declines."

Natural decline in existing wells is never taken into account when oil price is recorded, he added.

If natural decline isn't replaced with new production, the current oil surplus will disappear by midyear, he predicts.

The International Energy Agency, a watchdog agency for countries that import oil, expects global oil demand growth of 1.1%, or about 900,000 barrels yearly, in 2015 and 2016.

Meanwhile, Citi's Evans noted that drilling cutbacks haven't resulted in production declines yet.

"We've cut back on drilling activity, but oil production in the U.S. is still on the way up because there are wells that were drilled in October when the count was 15% higher, but you may have only gotten it tied into the production stream yesterday," Evans said.

These and longer-term projects -- such as Anadarko's  (APC)  recently finished offshore rig off the coast of Louisiana, with 80,000 barrels a day, a project that was in the works since 2009 -- will bring new wells on line to replenish supply, he said.

So despite the drop in rigging activity, Citi still sees higher production for now.

"It's a remarkable U.S. growth story in oil production, and it still has upward momentum," Evans said. "What I would suggest is that while people get excited about drilling rig count decline, they need to pay attention to production numbers as well, because they have yet to soften, and if you're trying to time this market, that's important."

While the Department of Energy estimates that production growth will taper off,Evans noted that "slower growth is not a decline."

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