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The “Oversupply” Narrative: Behind the Headlines

 
Last week’s moderate price slip, in which Brent Crude oil dropped to nearly $101 a barrel (from recent highs of $113 in June), and West Texas Intermediate fell to $93 per barrel (from $105, again in June), caused a flurry of press coverage claiming we are now in an undisputed era of “oversupply” in which we have more oil than we know what to do with. “Brent and U.S. crude futures tumbled on Friday to the lowest settlement prices in months, as oversupply in the Atlantic basin and low demand outweighed worries over political tensions in the Middle East, North Africa and Ukraine,” wrote Reuters, while the Wall Street Journal quoted Energy Market Institute analyst Dominick Chirichella saying, “All signs point to a growing oversupply of oil. Clearly the world has more oil than it currently needs at the moment.” Well, good thing we’ve solved that pesky “oil dependence” problem, right? Not so fast. Let’s take a look at a few important details the news coverage seems to be missing. 1) Right now, the United States is propping up the oil market Global supply disruptions are at or near record highs, around three million barrels per day, or almost four percent of daily demand. The central, perhaps only, reason that this hasn’t caused prices to skyrocket is that they have been matched in lockstep with crude oil production growth from the United States. A chart released this week from the Energy Information Administration illustrates the near-perfect correlation.

In fact, the United States is one of the only sources of oil production growth in the global market right now. It has worked out well so far, but near-singlehandedly stabilizing the global market is a big job. It will take supply growth from far more participants in the longer term to actually meet long-term demand forecasts.

2) Shale Supply Runs on a Treadmill It’s important to note that contrary to conventional oil supplies, shale oil and gas resources take a constant flow of new drilling—and new investment—to maintain production growth. The industry relies on sustained inflows of capital to finance its drilling programs, through borrowing, equity issuance and asset sales. The system has attracted some criticism and skepticism regarding the industry’s ability to continue attracting new investment. Why does shale oil production depend on constant inflows of cash? Output from shale wells declines at a far faster rate than that of conventional wells. It is estimated that if all drilling ceased in North Dakota’s Bakken shale formation, production output would drop by 45 percent within one year. In comparison, if drilling ceased in Saudi Arabia’s super-giant Ghawar oil field, production would only decline by 5 percent year-over-year. EIA’s monthly Drilling Productivity Report sheds more light on this phenomenon. While new wells need to be drilled, the industry is also in the midst of an innovation boom that is making each well more productive and unlocking resources long considered unviable. Different chemical mixtures, adding more horizontal wells to every vertical well, and finding new sweet spots have enabled upward momentum in an industry with high costs and competition. It has gone well so far, but as the FT states, “The big question now is how much longer the US shale industry’s growth spurt will last,” adding that, “Few issues are more significant for the future of the world economy.” Unfortunately, continued growth hinges on one critical element: high oil prices, which leads us to our next point: 3) Rig Counts are Highly Elastic Although the shale boom depends on constant drilling of new wells to offset declines of older ones, producers must be confident that it is economically reasonable to “stay on the treadmill” and add new rigs. Last week, Bloomberg reported that the number of oil wells dropped by the most since 2012, falling by 25 rigs. Looking at data from the past year, there appears to be clear sensitivity of rig numbers to oil prices—only logical, since by most estimates it takes millions of dollars to drill a fracking well in the United States, and in some shale plays, the profits are only viable at the margins. As the Financial Times mentioned, the continued success of the American shale boom is a critical matter for the world economy. Sensitivity to oil price movements is a glaring vulnerability.

4) The World Will Continue to Depend on the Middle East Also this week, the head of Saudi Arabia’s national oil company, Saudi Aramco, joined the chorus of voices (including that of Fatih Birol, the chief economist of the International Energy Agency) in pointing out that underinvestment in upstream drilling capacity will lead to supply shortfalls in the coming decade. In its most recent World Energy Outlook, IEA expects global oil demand to increase from current levels between 88 and 90 million barrels per day to 100.5 million barrels per day (mbd) by 2025, and 105.5 mbd by 2035. It’s unclear who will fill that gap. But according to IEA’s recent Energy Investment Outlook, annual capital expenditure in oil and gas has more than doubled in real terms since 2000, with “the epicenter” of this activity in North America’s shale. IEA continues, arguing that gradual depletion of the most accessible reserves forces companies to move into more challenging fields, which will put pressure on upstream costs, underpinning an oil price of $128/barrel by 2035. The report highlights that “massive increase in capital expenditure” over recent years has put many oil and gas companies under pressure to reduce costs and reign in spending—and atypical situation for a high-price environment, but worrying when considering a high-price commodity that requires continued capital inflows to maintain production. IEA also notes, “Meeting long-term oil demand growth depends increasingly on the Middle East, once the current rise in non-OPEC supply starts to run out of steam in the 2020s. Yet there is a risk that Middle East investment will fail to pick up in time to avert a shortfall in supply, due to an uncertain investment climate in some countries and the priority often given to spending in other areas. The result would be tighter and more volatile oil markets, with an average price $15/barrel higher in 2025. By IEA’s estimates, and the estimates of others, Iraq is supposed to carry a significant portion of OPEC’s increased crude production through the remainder of the decade. However, the country’s current state of chaos creates doubts that it will ever deliver on the capabilities of its massive, inexpensive reserves.

5) Spare Capacity is Thin; OECD Stocks are Low In the event of true “oversupply,” we would see two things. First, OPEC’s spare capacity would have risen by now. It remains below 2 million barrels per day—thin by all estimates. Second, OECD commercial crude oil stocks are at the very bottom of their five-year range, suggesting that there is not much spare oil on the market to stockpile.

6) We’ve Made This Mistake Before It is not a rare thing for analysts to forecast that we have abruptly arrived at a new area of oil abundance. In March of 1999, The Economist declared us to be “Drowning in Oil,” and argued we should “welcome the return of normality to oil markets and the end of OPEC’s power.” Of course, global oil prices increased ten-fold in the decade that followed, from around $10/barrel when the article was written to its current range between $100 and $115. Presciently, The Economist warned that while things were temporarily smooth sailing, the global economy was as vulnerable as ever, and oil’s short-term abundant flow was not to be taken for granted. The article urged readers “to keep researching into alternatives to the petrol-powered internal combustion engine.” That lesson remains as valuable now as it was 15 years ago.