It’s no secret that global oil supply has been more resilient than expected throughout the extended period of low prices that began during the second half of 2014. Oil producers have squeezed as many volumes out of existing fields as possible to boost cash flow, while projects that were planned several years ago when prices were high are still coming online, helping add to the oversupply. But a couple of countervailing factors are also occurring, both of which portend a possible tighter market in the future. Sharper-than-expected decline rates as a result of limited investment and a major cutback in capital expenditures for brand new projects are setting the stage for a dramatic market shift by 2018, according to a major consultancy.
Rystad Energy says that oil prices need to be above $70 per barrel in order to offset production declines and stimulate enough new projects to meet demand growth.
Lars Erik Nicolaisen of Rystad Energy, speaking at the Energy Information Administration (EIA) conference in Washington, D.C., Monday, says that oil prices need to be above $70 per barrel in order to offset production declines and stimulate enough new projects to meet demand growth. Right now, capex is not high enough for supply to “materially grow oil supply going forward.” Current “tailwinds” from prior investment decisions and expenditures in non-OPEC countries have brought new supply to the market despite low prices, but the pace of growth from projects begun several years ago is starting to slow.
Oil prices, after recently shooting above the key $50 per barrel level, have fallen back to around $46-$48 amid worries about the global economy, a glut of refined products, and speculator liquidation.
In 2016, capex will be cut for the second straight year, an ominous sign. Last year, some 10 billion barrels of new oil supply was sanctioned, while roughly 34 billion was consumed. This year, the amount sanctioned will be slightly higher at 13 billion—but that’s contingent on a rising oil price during the second half of the year—while demand is about the same. Simply put, upstream activity is nowhere near what’s needed for steady investment to meet demand. “That’s not hitting us in the face right now, but it will hit us in the face sometime down the road,” Nicolaisen said.
In the 1980s, the OPEC cartel held an enormous 14 million barrels per day of spare production capacity. Now it’s roughly just 1 mbd-2 mbd.
The last time upstream spending was cut two years in a row occurred in the mid-1980s. Despite the cutbacks at that time, oil prices remained low for over a decade and a half. This time it’s different, Nicolaisen said. In the 1980s, the OPEC cartel held an enormous 14 million barrels per day of spare production capacity. Now it’s roughly just 1 mbd-2 mbd. Against this backdrop, there is no underutilized oil supply to ramp up quickly to meet demand growth.
“We need non-OPEC, the rational part of the market, to react to this downturn and to reduce supply,” Nicolaisen told the audience. “How long will that take? It’s very different for non-OPEC capex reductions to flow through the market than with OPEC just simply turning the taps and pulling back production.”
‘Brownfield’ investments needed to slow the decline rate
While massive capex cuts are choking off future supply growth, what’s also important is accelerated decline rates at existing fields now that prices have remained low. Typically, companies need “brownfield” capex investments in mature wells in order to slow declines. But low prices and deferred outlays can push mature well decline rates from 5-6 percent to “the natural, underlying decline rate” of 10-12 percent in a short amount of time, Nicolaisen said, making the supply situation even more urgent. “Decline rates can’t be taken for granted,” he said.
Low prices and deferred outlays can push mature well decline rates from 5-6 percent to “the natural, underlying decline rate” of 10-12 percent in a short amount of time
Nicolaisen said that capex would decline by an eye-opening 20 percent this year, with a small uptick in 2017. In order to keep up with demand growth in 2018, double-digit capex growth will be needed. As a result, according to Nicolaisen, oil prices would reach $70 per barrel or higher in a couple of years in order to stimulate the needed supply.
Swing supplier is ‘multipolar’
Besides capex cuts, the absence of a swing supplier also makes the market more vulnerable to a correction to the upside. OPEC, led by Saudi Arabia, abandoned its role as swing supplier in the mid-80s, but it took action in the late 1990s, early 2000s and in 2009 to cut production to shore up prices. During this latest price downturn, however, Saudi Arabia increased supply instead of cutting back, in order to gain market share.
Jamie Webster, a veteran oil market analyst and a fellow at the Center for Global Energy Policy at Columbia University, also speaking at the EIA conference, argued that the U.S., with its shale industry, cannot act as a reliable swing supplier for the global oil markets. Webster said that U.S. shale fails two major tests needed to be a swing producer. First, it can’t produce a sufficient amount of flexible volumes in the short term and second it is not willing to be a “first mover” when necessary to balance fundamentals. In other words, it can’t respond quickly enough when prices rise or demand increases ahead of supply.
“The market is moving from a unipolar OPEC/Saudi [world] into something that is multipolar.”
“This handoff from OPEC to shale is not an easy or simple sort of thing,” Webster said. “The market is moving from a unipolar OPEC/Saudi [world] into something that is multipolar. Different elements from the demand side to different parts of the supply side to storage are going to have a much bigger role than in the past [in balancing the market].”
Webster explained to the audience that shale can work as a “bridge fuel” between crude in storage—which is now the “first mover” and provides flexibility in the short run to cushion prices—and more capital intensive projects that take a long time to bring online.
A contrarian view
The third speaker at the panel, Mike Lynch of Strategic Energy & Economic Research (SEER), provided an alternative view, arguing that fracking technology and shale resources have lowered the price curve dramatically. Lynch, a long-time contrarian and perma-bear, says the lower cost curve has made more and more resources economically recoverable. Given the huge resource base according to reserve estimates, oil prices ought to remain low. Lynch accurately predicted the price fall of 2014, for which he caught flak from others in the industry. “If you search my name on the Internet, you’ll find a lot of people calling me an idiot,” he told the audience, referring to the fact that his bearish forecasts were not popular when prices were above $100.
Whether Nicolaisen’s or Lynch’s predictions turn out to be correct is too soon to determine. But given the volatility seen over the past couple of years and the overall unpredictability of the oil market, nothing should be ruled out. No matter what, there’s turbulence ahead.