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.
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.
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.