Wisdom of the Crowds

Probably the best news in the current oil price slump is that there is now almost a “consensus view” that we are in conspicuous over-supply.    

My previous posts (Sunset in the Desert and Oil’s Kodak Moment) have discussed my decade-scale view on the oil supply-demand balance.  This post considers the shorter-term view, measured in months and years.   The only guarantee in these musings is that I’ll be wrong.

So lets look for some Bright Spots – not easy with stock markets and commodities tanking all around.

Missing Barrels

First there are those missing barrels, by some estimates we have been in over-supply of 2-3 million barrels per day for several months.  Thats a lot of oil.   Yes strategic reserves are filling, as are an unknown number of ships and the storage tanks in Cushing… but with the future curve very flat, no one is making any money out of that (unlike at the start of the year with strong contango).  How much oil?  Well that is anywhere between 150 million barrels and 300 million barrels…. which is a lot of missing oil, even if half of it can be accounted for in the system.

Conspiracy theorists will enjoy finding plausible explanations for the whereabouts of this oil.  Occam’s Razor would suggest a simpler solution – that the over-supply is over-stated, and that the consequent excess crude is in fact a much smaller volume, which has indeed been absorbed into the system.  The EIA has a history of showing over supply and then restating when the hard data comes in.

A smaller over-supply (which some authors think could be as low as 300kbopd) could mean easing back into balance sooner than one might otherwise think. 

Missing investments.  

The North Sea is seeing record production, as is the GOM, Canadian Oil Sands and indeed as are many US shale plays; and this at a time of decade-low prices.  Prices that in many cases are below break-even.   No great mystery here – simply that our business is one that has a long lag-time between investment and results. Production in the North Sea today is a direct result of investments made 3-5 years ago.   Offshore greenfield developments can take 7-10 years to come on stream.

What we will see in the medium term (and again, I have to caveat this with it being a view that excludes major political upheaval in key countries), is potential for higher oil prices, simply due to the massive cuts in investment being made today.   These cuts are a question of survival for most companies, but will cut into the ability of conventional oil to replace the natural decline of existing producing fields.

Low prices driving demand

Demand is reacting to lower prices – nothing spectacular – but there is growing evidence of demand, both in OECD and EMs picking up.  Greenshoots; probably not enough yet to hang one’s hat on.

US Shale production dropping

The precipitous drop in US rig count has not had a commensurate drop in production.  Although there are valid reasons to explain this away (the “fraclog”, increases in efficiency with fewer rigs drilling better wells focused on the sweet-spots, re-fraccing older wells etc), there is also a strong argument that in the medium term, fewer wells will result in production stabilising or declining.   Evidence for the US onshore production reaching an inflexion point is starting to appear.   The start of the decline has probably been delayed by the “dead-cat bounce” of the oil price in Q2, which encouraged fresh money to come into the sector, which has indeed seen a small rise in the number of rigs.

“What is unknown at the present time is whether the recent bump up in the drilling rig count reflects a delayed response to the higher oil prices seen in May and June, or the desperate actions of producers needing to generate any cash flow to try to survive this downturn. ”  Rigzone:Brooks

As noted in my Investor Strike post, there is a big question mark over how a second surge (if it were to happen in response to higher oil prices) in US shale production will be financed – there are some significant losses already for investors, and many others being papered-over by fresh equity and/or hedge positions that will be rolling-off soon.  

Law of Compound Decline

That compound interest is one of the wonders of the world has been attributed to various authors.  We have no such wonder, just depleting assets.  So lets do some math.

Most estimates point to average annual decline of world conventional production as being roughly 5%p.a.  Oil from shale is known to have high initial rates of decline, and a less well known ‘long tail’ of lower decline.  Given that there is a mix of new and old production, I’m going to take a WAG and use 10%p.a. as an average for the unconventionals.

Current world production is circa 93mmbbls/day, some 10mmbbls of that is unconventional.  Applying the above decline rates would indicate that there would be some 5.5mmbbls/day less production in 2016 than in 2015 simply due to depletion of existing oil fields.   However, we know that there are lots of projects coming on-stream in the coming years, despite the downturn, simply due to the timing of investments.  These are projects that got FID several years ago.  So let’s assume that we replace all of that 5.5mmbbls with new oil from new projects in 2016 and that we replace 85% of the 2016 volume in 2017, and then 85% of the 2017 volume in 2018 and so on..  no major drop-off , but a gradual decline in the replacement volumes due to under-investment starting today.

By 2020, using this simplistic math, we have a deficit of c. 4.5 million bbls/day

And that is without any demand side increase – this is just standstill replacement volumes.

Here we see one big difference with 1986 – then OPEC had 13mmbbls/d of spare capacity, today it is probably no more than 2mmbbls/d, and almost all of that in Saudi Arabia. Equally, apart from the US Shale, which has an unknown ability to switch back on, there is little evidence of non-OPEC volumes crashing into the market (unlike GOM, Alaska and North Sea in 1986).  The duration of the supply glut (if it exists) may not be a decades long phenomena. 

The Saudi Arabia wild-card

  1. Policy decisions – so far Saudi Arabia has acted very logically – protecting their market-share in the face of a competitive juggernaut in the US, but there is potential for policy change.  Personally I think that Saudi is very robust to long-term lower prices, so don’t see this as a likely scenario.  And as Robin Mills observed: “Any country that faces an existential crisis because oil falls to $60 per barrel has more to worry about than Texan wildcatters.” 
  2. Terrorism in the Kingdom – several Daesh led attacks, and the instability on the Iraq and Yemen borders have so far been of limited impact.  But what if?
  3. The ‘Peak Oil’ scenario of the Ghawar (and possibly Burgan) field(s) watering-out after years of steady production – a “known unknown”, but as the years tick by, physics says this must be come more and more probable…

So we all agree then ?

Lastly, the consensus view is that it is heading south and there is no way back… short sellers are taking big positions.  

Who remembers 1998?  I was working offshore Angola on the Dalia discovery with Elf.  Oil went below $10 and the development of the 1bn bbl field was looking sub-economic.  All the analysts were agreed that oil was heading lower (with some predictions of $5 oil, and staying below $10 for at least 5 years…).   

So perhaps the best news here is that the consensus view on oil price is (almost) always wrong.

SWAG 

 OK, stick my neck out here – I’d guess that oil will go lower this year, and start to consolidate/build back in end 2015 / early 2016.  At some number (60$/bbl?) the industry will come back and start investing again…  Oil will subsequently be very volatile, reacting to supply-side issues driven by under-investment now, and periods of over-supply as per today.  The oil-price/investment cycle will inevitably be out of sync, it always is.  However, ten years out, I believe we will see a genuine shift in the demand side – with Electric Vehicles taking 10% or 15% of the OECD fleets and removing a critical circa 5 mmbbls/day from demand, leading to a prolonged decline in oil price as demand is steadily eroded.  All numbers plucked out of the air as I write.

Anyone else prepared to make a (wrong) forecast in public?  🙂