How Low Oil Prices Today Could Lead to a Big Future Price Spike

By Markets Fool.com

Almost everyone in the financial realm has an opinion as to where the price of oil will go next.Some say oil prices will be back over $100 per barrel in the next year, while others say we'll never touch $100 per barrel again. In reality, though, no one has a clue what oil prices will do in the short term. However, looking over a longer period of time we can identify trends that could lead to a major spike in the price of oil by the end of the decade. This very possibilityhas OPEC's leader quite concerned, which is why he warned oil could top $200 per barrel if the industry pulls back too hard.

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The uphill battle with natural decline
In this situation, it's vitally important to have a basic understanding of the dynamics of an oil well. Once drilled, the well will produce an initial burst of production, then output will steadily decline for decades as the reservoir pressure is relieved. This is called the natural decline rate, which tends to curve downward over time.

However, shale wells are known for having a very steep decline rate, as shown in the example below.

Source: SandRidge Energy, Inc. Investor Presentation.

The gray line on the chart shows the average daily production of a well from SandRidge Energy over a 10-year period. That well's production starts at over 300 barrels of oil equivalent, but production is down to less than 100 barrels by the end of its first year. Production then declines by another 50% over the next year. The takeaway: In order to simply maintain production rates, oil companies need to invest to drill new wells.

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However, with oil prices dropping, energy companies are reining in spending on drilling new shale wells, as well as investments in long-term projects such as deepwater drilling, oil sands, and enhanced oil recovery, which take years to develop. This pullback in spending, especially on longer-term projects, will take a toll on future oil production. In fact, the world eventually might not have enough oil supplies coming online to meet growing demand.

Cutting into future growth
Halliburton Company President Jeff Miller has noted this dynamic:

[W]e believe that any sustained period of under investment due to reduced operator spending could lead to an increase in commodity prices. And this largely ignores the possibility of short-term disruptions due to geopolitical issues. So the long-term fundamentals of our business are still strong.

Miller suggested higher oil prices in the future could result from oil companies today holding back spending and underinvesting in supply. That would bode well for the industry's long-term outlook, as undersupply would mean higher profits for producers.

A number of oil companies have already reduced capital spending for 2015, with the bulk of the cuts being made to long-term projects. ConocoPhillips , for example, firstslashed its budget by 20%, then by another15% as the oil market worsened. The company specificallynoted that it was deferring significant investments in emerging shale plays until it has more clarity on oil prices. This sets these regions back at least a year from being able to supply oil to meet future needs. Meanwhile, Canada's Suncor Energy noted that it isdeferring $1 billion in investments this year, including its MacKay River 2 oil sands project and the White Rose offshore oil-field extension. Both projects would have come online later in the decade.

Overall, as much as $150 billion in oil projects might be deferred over the next year as energy companies align their spending with current cash flow rather than projected future supply needs. This has the potential to set the world up for an oil shortage in a couple years as declining supplies won't be met with as many new fields coming online.

Investor takeaway
Many of these projects had to be deferred because the economics only work when oil prices are $100 or more. That said, if oil prices continue to force producers to underinvest then it's very possible output will suffer in the years ahead as the natural production decline eats into supplies. Meanwhile, low oil prices tend to fuel demand for oil. Add it up, and petroleum prices could spike before the end of the decade as the current glut of oil evaporates, leaving the world without enough oil to meet future demand.

The article How Low Oil Prices Today Could Lead to a Big Future Price Spike originally appeared on Fool.com.

Matt DiLallo owns shares of ConocoPhillips and SandRidge Energy. The Motley Fool recommends Halliburton. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.