#43. Oil – where next?

In my previous article, I discussed the collapse in oil prices, explaining that the greatest mystery wasn’t the price slump so much as the preceding resilience in the face of the growing bubble of surplus supply. Comparing 2014 with 2011, demand had increased by 2.9 million barrels per day (mmb/d) whilst supply other than OPEC crude had ballooned by 3.9 mmb/d, making the recent price correction not just inevitable but long overdue.

Here, I’d like to look ahead a bit, setting out what I think may lie ahead for oil markets. Before I do, though, it’s necessary to dip briefly into the past. During the 1973-74 “first oil crisis”, the price of crude shot up, averaging $11.58/b (about $56/b at today’s values) in 1974 compared with $2.48 (equivalent to about $14/b) in 1972.

Initially, there wasn’t much that anyone could do about this – demand dropped briefly but then began growing again, and there was no immediate surge in supply.

Scroll forward to 1980, however, and a lot had changed – demand had declined as new fuel-efficient vehicles reached the market in significant numbers, and non-OPEC production surged in response in huge investment in areas like the North Sea. Confusingly, the slump in demand coincided with the “second oil crisis”, which pushed the average price up to $36.83/b (say $106/b in today’s money), but it was the longer-term response to the first oil crisis that was really behind the sharp correction in the relationship between demand and supply. (OPEC tried, Canute-like, to prevent the inevitable, but their price support effort cracked open at the end of 1985).

The point of this history is that, whilst oil markets certainly do respond to changes in price, they can only do so slowly. When markets are severely over-supplied, as they are now, there is almost no price that is too low.

So, when oil markets reach “peak glut” – and they will be building in to that over the coming two or three months – it is by no means impossible for prices to fall even further than they already have. I’m not forecasting $25/b, but I certainly wouldn’t rule it out.

Conversely, when there is a shortage of supply, there is almost no price that will restore short-term equilibrium, which is what happened in 2007, when Brent crude topped out at nearly $150/b.

Critically, there is very little that consumers can do, in the short term, to respond to price volatility. Just because prices have slumped, it doesn’t follow that we’ll all start driving a lot more, or all go out and buy gas-guzzlers. Likewise, producers aren’t going to shut in huge quantities of production, because cash flow remains positive for any producer who can cover cash opex costs.

What will happen, however, is that capex will be slashed, with little impact on immediate supply but with game-changing implications a few years down the line.

The pinch-point in the system has to be shales. I’m not expecting much of a decline in output in the coming few months, but what I do expect is that capex will dry up, as shaleco bonds turn to junk, shaleco equities bomb and shaleco IPOs become toxic. The ending of the “drilling treadmill”, which was probably due to happen two or three years from now anyway, will come much sooner as the markets starve shale operators of investment.

This is where the shale industry’s scary decline rates kick in, when annual per-well output declines of as much as 60% are no longer offset by new drilling.

Earlier, I referred to the imbalance created by a supply increase of 3.9 mmb/d, compared with demand growth of 2.9 mmb/d, since 2011. Within that supply increase, non-conventional output from OPEC countries contributed 0.5 mmb/d (13% of the increase), but much the biggest contributor was US shale output, which accounted for 71% of all increases in non-OPEC supply between 2011 and 2014.

As its proponents will tell you, shale operating costs, though high, remain covered by oil prices as low as $50/b. What they will not tell you is that shale’s Achilles’ Heel is capital costs, which are ultra-high because of the “drilling treadmill”, which is the continuous need for new wells to offset the sharp declines from existing producers.

As things stand, the oil market is oversupplied by an annualised 1.0 mmb/d or so, but the pressure right now is much greater than that. Given the time required for transport, shipping and distribution, any oil bought after the end of November isn’t going to reach the end user until the winter demand peak is waning. By February, crude purchasing is likely to be at least 4 mmb/d lower than it was in November.

In other words, the world will be awash with oil this spring.

To correct the disequilibrium, we need rebalancing to the tune of between 1.0 and 1.5 mmb/d. That clearly isn’t going to happen this year. But, looking ahead to 2016, it is quite conceivable that demand will have increased by perhaps 1.3 mm/d, whilst all supply (other than OPEC quota crude) may have decreased by close to 1.0 mmb/d, restoring equilibrium (see table). There could be further gradual increases in the call on OPEC crude in subsequent years.

Oil supply and demand projections

Summarising all of this, if OPEC supplies 30 mmb/d of crude:

– The market will be oversupplied by as much as 4 mmb/d this month, and something similar in February, putting further severe downwards pressure on prices.

– But shortfalls could emerge during 2016, becoming progressively more pronounced after that.

In the past, an adjustment of this magnitude would have taken several years, a time-scale determined mainly by the relatively slow decline rates of conventional production sources in the absence of sufficient capital investment. This time, though, the quick-decline/high-capex nature of the shale business is likely to compress the process of adjustment.

With the markets heavily glutted, there is almost no limit to how far oil prices could fall in the coming months. A year or so on, however, a slump in shale output, combined with modest growth in demand, could have mopped up today’s excess oil and left us short of supply.

That’s when the fundamental reality – which is that the world’s oil supply slate goes on getting costlier to produce – will reassert itself.

FOOTNOTE

It may help readers if I insert here my estimates of monthly stock changes, in millions of barrels per day, with forward calculations based on OPEC crude supply of 30 mmb/d.

Red boxes indicate supply in excess of purchasing requirements, whilst blue boxes indicate a shortfall. As you can see, prices ought to have fallen sharply in early 2014, but didn’t. By the closing months of the year, however, the cumulative surplus was severe enough to combine with the current surplus to force prices lower.

After some grim opening months – which are likely to exacerbate the existing surplus – the outlook becomes progressively better.

monthly stock change

10 thoughts on “#43. Oil – where next?

  1. Yes, at the moment the peak oil deniers are doing cartwheels squealing “I told you so! Peak oil was always a myth! Look, we’re awash with the stuff and it’s as cheap as chips!” However, your analysis, Tim, makes the point that when this particular, short-term characteristic of the bigger peak oil picture is over and done with, the more familiar reality of peak oil will kick in.

    My reading of your analysis – or the its implications anyway – and other analyses I’ve seen (largely outwith the mainstream media) indicate that we could see the oil price soaring again in the timeframe 2016 – 2019.

    The peak oil sawtooth is becoming more evident: the oil price goes up, drops, goes up again to a point higher than the previous high, drops, but not as far as the previous drop, goes up again to a point higher than the previous high, rinse and repeat.

    The challenge is to know at what point/price the upward rising sawtooth effect collapses altogether and we find ourselves in a whole new world – possibly more precipitously than some might imagine?

    • Thanks – you are right, especially about the saw-tooth, a classic oscillation which I predicted in my book.

      What shale amounts to is the production of oil that isn’t needed yet, as its outside today’s market-clearing parameters.

      That makes shale investment irrational – but then, so much investment is indeed irrational.

      Loosely speaking, an investor can put money into something for one of two reasons. First, because he has done his homework, understands the fundamentals and has made a considered decision. Alternatively, he can ignore or misunderstand the fundamentals and instead buy on hype. Shale is a classic example of the latter, helped, of course, by loads of QE money looking for a home, and hyped by Wall Street’s love of trading, bond issuance and IPO commissions.

      The big question, short term, is how much shale production is lost. I’m betting that maybe 0.2 mmb/d will be lost this year, itself not much out of a 4.1 mmb/d total, but that’s a big reversal from adding 0.6 mmb/d last year. Indeed, 2014 growth of 0.6mmb/d is itself a long way down from growth of 1.2 mmb/d in 2013.

      My logic here is that wells already drilled might as well be kept running. Then I see output declining by about 10% annually, probably a modest forecast given much higher per-well deline rates. I’m not expecting much demand growth – maybe 0.7 mmb/d this year, vs 0.8 mmb/d in 2014, and this despite lower prices.

      But yes, it stacks up to a lot of volatility and a big rebound.

  2. Tim,

    I find myself wondering if the upswing might be coming a bit more quickly than you expect. I’ve seen data suggesting US gasoline demand was up 7% year on year in December. Looks like the yanks are keen to start driving again. I wonder just how much pent up demand might spring out over the next 6 months or so. The danger is that prices stay low long enough just to cripple the industry, slash capex, cut projects and slow down shale, and then demand picks back up and you run into another price spike with the industry’s capacity to rapidly increase supply severely degraded.

    There is, however, a growing backlog of drilled but not fracked wells in North Dakota (potentially the drillers have tighter contracts than the frackers?), which might be able to provide something of a release valve.

    Relatedly, the recent collapse of copper is also a worry. It rather hints that something beneath the bonnet isn’t quite right.

    • Sam

      Point taken, though demand upside might be blunted by past improvements in vehicle fuel efficiency? An upturn in sales of SUVs and similar, though it cannot happen for a while, might build more upside into demand?

      On drillers and frackers, I see it as part of the high-capex, high-depreciation-rate treadmill. I’m not looking to see huge output losses yet, but (in my footnote) I noted that the rate of expansion has already slowed – so my best estimate is, net loss of 200 kb/d this year, rather more than that next year.

      Copper is HUGELY energy-intensive, so can be expected to respond quickly to cheaper oil prices – just think how much energy is involved in shifting 500 tonnes of rock to get at 1 tonne of copper.

      But I agree that the economy is faulty under the bonnet. My book explains this as a divergence between the twin economies – the physical economy of goods and services, and the financial economy consisting of created “claims” on these goods and services. Aggregate claims far exceed what the real economy can deliver, but central bankers and govts cannot face the implied destruction of value within the financial economy, where I put excess claims at well in excess of USD 70 trillion. Bluntly, how are you going to take that away from people who “own” those claims on a real economy that can’t deliver?

    • In short, there’s going to be trouble at t’ mill in the not too distant future.

      I struggle (manfully) to fend off the permanently intrusive idea that in the coming, say, decade or so we’re going to experience unprecedented ructions to the global socio-economic order. Just saying.

    • Tim,

      You might well be right, I was just shocked at the apparent uptick in demand in the states in December. I assume that you think the price is likely to spike back up before the end of the year though, which is certainly where my thinking presently lies.

      The decline figures you cite are certainly possible. The whole thing is so fast moving I think it’s near impossible to call what’s going to happen. I take your point on copper, and indeed many other mined commodities, they might well rebound with all the cheaper fuel now. There’s so many feedbacks!

      And I agree completely about the divergence between real wealth and excess claims on said wealth. It’s definitely going to be a cause of some considerable grief going forwards!

      Incidentally, I recently came across the following paper which might take your interest:

      http://iopscience.iop.org/1367-2630/16/12/125008/article

    • Indeed. The fundamental points, for me, are two:

      1. We have been producing oil at higher than optimum cost – an irrational activity, which necessarily results in glut. The restoration of equilibrium will take place when this production has been put out of business. This suggests a two-stage price recovery – “normality” ($80/b?) later this year, followed by over-correction to higher levels, perhaps in 2016.

      2. Energy prices drive a huge proportion of the economy – notably minerals and food production – so oil price volatility sets off oscillations across many sectors.

    • Partly natural caution, partly related to necessary cutbacks. And not impossible, I suppose, though I stick with my forecasts (hitting $80 late this year, averaging $80 next year, are my working assumptions at the moment).

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