Q3: Dazed and confused: Economic uncertainty rules, but the industry keeps its cool

Following the previous quarter I raised the question: On the road to nowhere, or are we? Following a further turbulent three months, we could well ask the question again.

In Q3, the top line picture for the oil and gas sector was largely mixed with persisting economic challenges including the European sovereign debt and banking crises only offset by relentless Chinese appetite for hydrocarbons.

However, operators' long-term need to increase recovery factors and renew both conventional and unconventional reserves remained, and will continue to create the ideal climate for innovative technology-led services companies to grow.

As a specialist private equity backer focusing on these firms, I think it is vital that we analyse market challenges and opportunities in order to inform our investments and move our portfolio businesses forward in the global oil and gas services market.

Increasing pressure

From July to September, economic hurdles seen in Q2 were heightened even further with the US raising its debt ceiling to narrowly avoid defaulting and a handful of western economies looking increasingly unlikely to meet their finance commitments. These factors reduced investment in and exports from China, slowing the high-growth economy's rate of expansion compared with previous quarters, albeit from a high base.

The International Energy Agency's natural response to these worsening fiscal conditions was to cut forecasts for oil demand. These downgrades were moderate, with a 50,000 barrel reduction to 89.2 million a day for 2011 and a 210,000 drop to 90.5 million barrels a day for 2012. Given that supply remained tight, some markets plan to rely on existing reserves to meet consumption over the coming months, affecting forecasts.

Economic uncertainty has not triggered doom amongst industry insiders though, who are playing the longer game given the sector's favourable underlying dynamics. The current overall picture still appears positive, with a modest increase in global consumption of approximately 1.3 million barrels per day predicted for 2012.

The International Energy Association's (IEA) reference case scenario, spanning 2009 to 2016, highlights the impact of new technology and its potential to reduce the production decline rate in the aging, non-OPEC production base by more than one per cent compared with the 2009 mid-term forecast. However, while this could be feasible, significant investment will be required to make it a reality.

Long-term prospects

In the longer-term, an increase in oil demand of over seven million barrels to reach 95 million per day by 2016 is forecast in the IEA case.

For supply, it predicts global capacity to increase to almost 100 million barrels per day over the same period. This represents a surplus of just five per cent of total production indicating that long-term supply will remain as it stands, although this could change given geo political uncertainty in a number of oil producing states.

The markets

Economic developments naturally took their toll temporarily on oil prices, which moved downward throughout September, partially improving in October following expectations of a bail-out fund for struggling eurozone economies.

Similarly, US natural gas prices declined in Q3, pricing just above their 52-day low of $3.92/Mcf towards the end of September. Producers didn't overreact, with the number of gas rigs actually increasing further in September giving rise to expectations that prices will average around $4.00/Mcf through 2012, evidencing long-term confidence.

In Europe, the natural gas prices continued to track oil prices, and spot gas is trading at more than twice the cost per MM/Btu than in the US, increasing consumer price concerns.

The attractiveness of cheap gas versus expensive renewable energy is becoming apparent and is leading to increased interest in European shale gas.

Ongoing need for innovation

I believe while the present financial turmoil introduces uncertainty surrounding near-term operator activity, any reduction in demand will be short-lived given the industry's positive long-term fundamentals. These will inevitably dictate the global reliance on hydrocarbons, which will increase as developed economies emerge from the downturn.

Despite any wider concerns in the sector, a relative sense of calm continues amongst oil and gas services industry insiders. Why? Because we are in a new paradigm. Oil prices remain high and operators can afford greater investment in new technologies which will, if applied, continually increase recovery factors in both conventional and unconventional reserves.

This creates the model climate for technology-led services companies, whose innovations can meet the present and future challenges of oil and gas production.

As an investor in the space, it is our role to identify, fund and help to commercialise these game-changing technology businesses. Tracking the sector helps us to inform this process, enabling our technology-led portfolio firms to realise their growth potential.