The Fuse

IEA Reiterates Underinvestment Risk, but Likelihood of Price Spike “Slim”

by Leslie Hayward | February 22, 2016

Today at IHS CERAWeek in Houston, Texas, the International Energy Agency (IEA) released the 2016 Medium Term Oil Market Report, urging that consumer countries not be drawn into a false sense of complacency given the current low prices and the global glut in supply—even as the likelihood of a price spike in the medium-term remain slim.

Last year, oil capital expenditures (capex) declined by 24 percent, and this year we expect an additional 17 percent. This is historic, because in the last 30 years we have never seen oil investment decline in two consecutive years.

“It is easy for consumers to be lulled into complacency by ample stocks and low prices today, but they should heed the writing on the wall,” said IEA Executive Director Fatih Birol. “The historic investment cuts we are seeing raise the odds of unpleasant oil-security surprises in the not-too-distant-future. Last year, oil capital expenditures (capex) declined by 24 percent, and this year we expect an additional 17 percent. This is historic, because in the last 30 years we have never seen oil investment decline in two consecutive years. If there was a drop one year, the next year there was a rebound. We expect this drop to have both short and long term implications for oil markets.” He added that the bulk of cuts have occurred in the United States.

Last year’s report began: “Looking at the medium-term consequences of this latest price plunge, the real question is not so much how price and supply growth expectations have been reset; nor whether a rebalancing of the market will occur—for that is inevitable. The issue is how that necessary rebalancing, and the price recovery that will accompany it, might depart from those that followed similar price drops in the past, and where they will leave the market after they run their course.” However, IEA’s latest dampens the expectations of a rocky rebalancing expressed just one year ago. This year’s report states, “We must say that today’s oil market conditions do not suggest that prices can recover sharply in the immediate future,” and added that in addition to efficiency improvements in U.S. shale, deepwater and ultra-deepwater production have also seen dramatic improvements in efficiency and declines in cost.

“Today, we are in an era where abundant resources of oil can be brought to market at costs lower than thought possible just a few years ago.”

Dr. Birol adds that although $30 oil has delayed upstream investment in critical projects, oil’s eventual price recovery will restore investment at some point, although oil will not need to be priced at $100 per barrel for this to occur. “Today, we are in an era where abundant resources of oil can be brought to market at costs lower than thought possible just a few years ago. This implies that although oil prices should start to rise gradually, the availability of new supply will place a cap on how far and how fast they can go.”

With an important caveat: “That is unless there is an unexpected growth spurt in demand or a major geopolitical incident.”

New rules for oil markets

The report also draws attention to the fact that many of the core assumptions underpinning oil market analysis in the past decade have been undermined. Among these, “That oil prices falling to twelve-year lows will lead to a strong demand growth spurt; that oil prices falling to twelve-year lows will lead to a mass shut-in of so-called high cost oil production; and not least that oil prices falling to twelve-year lows will force the largest group of producing countries to cut output to stabilize oil prices.”

Regarding shale, Birol stated, “Are we surprised by the resilience of light tight oil? To be frank: Yes.” He added, “This is the fact of life we still need to realize: We can produce oil at $50 per barrel in a country that is still a net oil importer. I don’t know if this is a failure of OPEC, that’s something I leave to you to judge. But instead of considering it a failure of a group, I would see it as the success of an oil industry.”

The report sees supply and demand fundamentals remaining mismatched in 2016, with supply outstripping demand by 1.1 mbd. Fundamentals will finally rebalance in 2017, but the enormous stocks that have accumulated will continue to dampen prices for years. Demand growth through the forecast period will average 1.2 mbd, down from 1.7 mbd in recent years. However, in a press briefing, Dr. Birol emphasized that the oil market will still require significant investment even to maintain current production levels. “Oil fields are like people—they reach a certain age, and their productivity starts to decline. We need 4 mbd of new oil supply each year: 1 to meet demand growth, and 3 to offset declines in existing fields.”

IEA’s report sees 4.1 mbd net being added to global oil supply between 2015 and 2021, down dramatically from the total growth of 11 mbd in the period 2009-2015.

IEA’s report sees 4.1 mbd net being added to global oil supply between 2015 and 2021, down dramatically from the total growth of 11 mbd in the period 2009-2015. U.S. production will reach an all-time peak of 14.2 mbd by the end of the forecast period (up from current levels around 9 mbd), but only after falling in the short term. LTO or shale oil output “declines by 0.6 mbd this year and by a further 0.2 mbd in 2017 before a gradual recovery in oil prices, combined with further improvements in operational efficiencies and cost cutting, allows production to resume its upward climb. The United States remains the largest contributor to supply growth during the forecast period, accounting for more than two-thirds of the net non-OPEC increase. Freed from sanctions, Iran leads OPEC gains: Iranian oil output rises 1 mbd to 3.9 mbd by 2021.”

IEA sees global oil demand reaching the symbolic mark of 100 mbd in 2020.

“Iron Link” between Middle East and Asia

china oil demand

According to IEA, an “Iron Link” is forming in oil trade between the Middle East and Asia, as the Middle East continues to provide 50 percent of global oil exports, and emerging economies in Asia are the engines of global demand growth.

“The Chinese economy is changing its character,” said Birol. “Industry is slowing and personal consumption is increasing. Manufacturing has gone from 50 percent of China’s economy to 35 percent. The products their economy needs are changing, shifting from fuel oil to gasoline. China is still growing strongly, but less strongly, and we think over the next 6 years China will add 2.5 mbd of growth.”

Additionally, India is replacing China as the largest engine of oil demand, driven mainly by the transportation sector. “With the growing population and growing economy, which we assume will grow around 7 percent or higher per year, Indian oil demand will grow substantially, adding over 1 mbd over the next 6 years. Gasoline growth will be strongest in India, complementing Chinese demand growth,” Birol said. He added that efficiency standards applied to Chinese trucks could have significant long-term impacts on global oil demand growth.

A free oil market?

“The long-term consequences of this new era are still not fully understood but this report aids the debate in shedding light on the outlook for the next five years.”

Throughout IEA’s report and commentary, they emphasized that the oil market has fundamentally changed. The report states, “In 2016, we are living in perhaps the first truly free oil market we have seen since the pioneering days of the industry. In today’s oil world, anybody who can produce oil sells as much as possible for whatever price can be achieved. Just a few years ago such a free-for-all would have been unimaginable but today it is the reality and we must get used to it, unless the producers build on the recent announcement and change their output maximization strategy. The long-term consequences of this new era are still not fully understood but this report aids the debate in shedding light on the outlook for the next five years.”

The CERAWeek conference will include commentary from OPEC Secretary General Abdallah el-Badri, and Saudi Arabia’s oil minister Ali al-Naimi. Following last week’s news of a production freeze between Saudi Arabia, Russia, and various other OPEC members, ideas about the changing nature of the market are sure to remain at the forefront of this week’s conference.