In 1977 James Schlesinger (first US Secretary of Energy) noted that the energy markets have only two modes: Complacency and Panic. To that I would now update.

Disdain, Complacency and Panic.

Currently there is disdain for oil; we don’t want it, its unnecessary and pretty soon we won’t need it.

But of course the reality is that not only do we still need oil, but the demand is growing. This doesn’t play well, and headline writers love to announce that “oil demand is dropping” when what they actually mean is that “the rate of growth (of oil demand) is decreasing” – why let facts get in the way of a good headline? The day will come when demand drops, but it’s not just yet.

Demand is expected to increase by 1.3mmbbls/d this year, which is less than the 1.7mmbbls/d increase in each of the previous three years. To put this into perspective, global demand was c. 89mmbbls/d in 2012 when I started working in equity investing, and passed 100mmbbls/day in 2018. Ten million barrels/day of extra demand is a very big increase in just 6 years. But as Spencer Dale of BP puts it: “demand is the boring uncle, supply is the excitable niece”.

If you abstract from all the noise, the oil price moves in a macro sense not on actual supply and demand but on the perception of security of supply. Put another way, when “the market” has confidence that there is, and will be, plenty of supply the price is muted (Complacency). Conversely, when the perception is of tightness (think Peak-Oil of 10 years ago, 1st Gulf war in 1991) the price rises (Panic). Currently we are sandwiched between the perception that everyone will drive electric vehicles within ten years and that there is so much spare oil in the US Shale that we will never run out. Moreover, “you should sell stocks in oil companies since most of their reserves and resources will stay in the ground and are worthless” or so we are told.

What is clear is that the US Shale revolution has been, and is, really significant. Whatever the arguments about the cost and sustainability of it, the bottom-line is that the resource is huge and that a lot of oil is coming to market.

How significant is US Shale?

So I’d just like to stop and pause here and ask:

What would the world look like today if we hadn’t had the US Shale revolution?

Currently the US produces about 6.5 mmbbls/d of unconventional oil (often known as Light Tight oil or “LTO”), as a result of a rapid increase since about 2010.

To put that into a global perspective, about 6.5% of global demand has been met by the fortuitous rise in LTO. Or more than 65% of the demand increase since 2012 (using very round numbers) has been met by shale.

It can be argued that US foreign policy has aided and abetted the decline in production from conventional sources such as Venezuela, Libya and Iran over the same period in the knowledge that US shale (and friendly action by Gulf states) could cover the shortfall and not cause runaway prices. A less conspiratorial version is that US foreign policy has been assertive towards these countries in the knowledge that there is adequate supply from elsewhere. Not sure what is the dog and what is the tail here.

Reading the tea-leaves

Looking to the future, we know that there is a lot of production about to come online from conventional projects that have been years/decades in the making. 2019 should see some 2.2 mmbbls of new supply, well ahead of the demand increase. Brazil pre-salt, Johan Sverdrup in Norway etc will add to the surge from shale. On this simple Supply-Demand equation it looks like major oversupply, but we must also acknowledge that the lion’s share of the supply side is met from existing production, which is itself declining. I have discussed this previously, but the key question is the average annual decline in the underlying production: is it 3%, or 4% or maybe 5-6% p.a. ? The difference is huge when compounded over 3 or 5 years, and it is a big unknown (it is the slope of the grey-green interface in the 2nd image below). There is also the question of whether the decline has increased recently due to widespread under-investment. On this latter question we have reasonable visibility on IOCs, but much less on NOCs – with the latter managing c. 80% of the world’s liquid production. Government budgets may well have had priority over capex during the low oil prices of the last five years. Its speculation, but not comfortable.

The IEA who have as good a view as anyone on future supply side data paint the picture: showing firstly how the various elements stack up by country of supply. This is the “excitable niece”.


And then by the cumulative effect:

What is salient here is the quantum: in the next 5 and a bit years, shale has to contribute an eye-watering additional 11.5 mmbbls/day (I am reading that off the graph, so it is approximate: I have eye-balled the 2025 yellow bit (104-87) and then subtracted the yellow wedge at 2019 (which is approx 6-6.5mmbls/day and we know is actually about 6.5mmbls/day – so this seems to cross check.

The implication is that with all the known conventional oil projects we will still need 17 mmbbls/day of LTO by 2025.

The Red Queen problem

As has been widely discussed, the unconventional shale play is characterised by modest flow rates per well and very rapid declines. There are many technological advances which have tweaked and twerked the productivity, but these are (a) incremental and (b) must be on a creaming curve. As I discussed here, the shape of the decline curve is of great significance as a late-life non-zero stable production has considerable value when multiplied by tens of thousands of wells.

If the 1st year decline rate of any given well is 70%, and the second year 30%, the later life years may be only single digit. Thus overtime there will be a wedge of production that should (in theory) churn out stable production – but it is small beer. The bulk of production in any given year is from vintages N-1 and N-2. The implication is that any slowdown to the new well drilling will collapse production back to the underlying wedge. If for example LTO new wells had stopped dead end-2017, by 1 Jan 2019 production would have fallen from 5.2mmbbls/day (peak of orange wedge in image) to 2.75 mmbbls/day (base of blue wedge in image). This is a staggering c.50% or 2.5mmbbls/day loss – similar to losing all of Nigeria and most of Angola.

No one is suggesting that drilling will stop, or that production will fall off a cliff, but equally the scale of the problem starts to become apparent. In 2018, 11,500 wells were added to the well stock, adding 3.7mmbbls/day of net new production, thereby both arresting the decline and adding new volumes. By simple arithmetic we can calculate that about 8500 wells were required to keep production flat at year end relative to previous year exit rate. At $10m per drilled and fracced well, this is $85bn of well capex alone.

Now scale that up to when we have not 6 mmbbls/d of LTO but 12 mmbbls/d or more, and you start to see the scale of the problem. If this stuff was cheap and easy, the uber efficient US would have done it years ago. The next 6mmbbls/d will logically be harder than the first 6mmbbls/d.

The Transition question

In almost any transition scenario based on things other than wishful thinking, we will still need oil for the next 20 years+, so there should be some focus on the supply side. As I discussed previously, activism directed at “Big Oil” whether it be street protests or trillion $ asset managers boycotting/divesting, will only serve to push oil production into NOCs and make it more expensive (which hurts everyone, not just oil execs).

Poor returns, a focus on gas, retrenching to shale, political risk in many places, and now shareholder activism – all chip away at the ability and will to explore for and develop new oil. As the shale bubble pops (you can almost hear the noise from this side of the Atlantic), we may see renewed interest in conventional oil in less convenient places, but this is the now famous “long cycle” investments, where exploration success today is first-oil in ten years time. Too little too late?

Nobody wants to put equity to work in oil these days. As noted at the top of this article, there is more than just complacency, there is also the disdain. This leads to tunnel vision, so whilst we celebrate a “vast” new battery storage (which is the size of a football field) and will power, wait for it… 806 Nissan Leaf’s, we ignore the lack of investment in oil.

All the scenarios suggest investment will be needed in new oil production over the next 20 years to meet levels of demand.

Our rapid transition scenario would still require many trillion of dollars of investment in new oil. (Spencer Dale BP)

And yes, that says “many trillions of dollars”

Mind the Gap

So whilst we are being told to panic about the Apocalypse (2031, if we agree that it is indeed 12 years away); we might think about panicking about the monumental miss-match between the perception of abundance and the reality of imminent scarcity.

I have no doubt the oil can be extracted in the volumes demanded by our societies, but as ever the real question is “at what price”. And yes I am excluding “externalities” in that definition of price.

The answer is “at high prices”, which will in turn cause recession(s) and dampen demand.

If there had not been a Shale revolution, it is highly likely that we would already be in the supply gap. In my view the can has been kicked down the road, but the underlying problem remains: Peak prosperity is behind us, and we are keeping the lights on barely. It’s just a question of “when”.