The Fuse

IEA’s Sadamori on Oil’s Underinvestment Risk and the Continued Importance of Strategic Reserves

by Leslie Hayward | December 02, 2015

Keisuke Sadamori is the International Energy Agency’s Director for Energy Markets and Security, leading an administrative structure that includes several core functions of the IEA, including monitoring global oil markets and responding to energy supply disruptions. He spoke with The Fuse on how IEA member states are adapting to a shifting global oil market, as it currently operates without OPEC playing a role in balancing supply.

Hayward: Let’s begin with a discussion of the oil underinvestment risk. What does this risk look like, and what are the implications for the global economy of a mild and a severe market rebalancing?

Sadamori: We just released the World Energy Outlook (WEO) 2015, and one of the most important messages was on this topic of underinvestment risk. Our central oil market outlook is the New Policies scenario (NPS), but due to the recent situation with low oil prices we ran another hypothetical scenario called the Low Oil Price scenario. So, in terms of underinvestment and its implications to the producers and consumers, the NPS assumes that the price will gradually recover to the $80 per barrel in 2020—this is what we see as a mild rebalancing.

We have to prepare for the Low Oil Price scenario which sees prices around $50-$60 per barrel well into the 2020s, in which the $750b in required investment is not foreseeable. In such a price environment, we see investment falling to $600b annually.

We have already seen upstream oil and gas spending drastically decline, down 20 percent in 2015 from last year. According to the NPS, prices will gradually recover and we can probably secure $750 billion in global annual upstream investment, which would help prevent serious underinvestment in the oil and gas sector. We understand $750 billion as the necessary baseline to meet demand. On the other hand, we also have to prepare for the Low Oil Price scenario which sees prices around $50-$60 per barrel well into the 2020s, in which the $750b in required investment is not foreseeable. In such a price environment, we see investment falling to $600b annually.

The outcome is that upstream investment will shift to lower cost resources, away from non-OPEC producers, and towards the Middle East. This entails much higher geopolitical risk because of the general instability in the region—leading to higher energy security concerns for consumers. Additionally, with prices in the $50-$60 range, we will see a significant increase in demand.

I will note that when we talk about the $750b needed in investment, bear in mind that the vast majority of that, about 85 percent, is needed only to compensate for the natural decline of existing fields. It’s actually a very tight investment requirement in terms of maintaining production capacity.

Looking at non-OPEC supply, shale is discussed in WEO 2015 as an important force moderating oil prices in the forecast period because of its flexibility. At the same time, shale production has been highly resilient: Will we see adjustment in the near term? What is enabling resilience in U.S. shale?

The EIA (Energy Information Administration) data shows that the price decline began mid-2014 but light tight oil (LTO) continued increasing production through 2014 despite the downturn. This resilience against low oil prices in the past several months is due to efforts to enhance well productivity. While shale producers were ramping up, there was a dramatic inflation of oilfield service costs: Producers are now trying to cut this inflation, and they are focusing in on the “sweet spots.” They have eliminated many marginal wells, and these efficiency efforts have helped LTO to keep its upward trajectory, but although it has lasted a long time, those efforts have come to their limit and on a month-over-month basis U.S. LTO has begun to decline as of summer of this year, despite having increased on a year-over-year basis.

We expect to finally see a year-over-year decline in 2016, and our most recent forecast says production will drop by around 600k barrels per day. At that point we will finally see a substantial decline in LTO… But shale producers do have a flexible nature and are quite price responsive, putting a lid on oil prices. If prices rise again, they can ramp up production much faster than conventional oil.

Is that decline, 600k barrels per day, enough to rebalance the current oversupply?

It’s difficult to say because of so many other factors—U.S. LTO is only one of many high cost producers. Another example is Brazil, they have been fairly successful in developing their deepwater resources, but they are now suffering from both low oil prices, as well as the corruption scandal around Petrobras. They might have a harder time next year.

The other big player is Russia. They have shown quite good performance this year—recording a post-Soviet production record very recently. We expected the combination of low oil prices and sanctions to hit their production sector, but so far we haven’t seen much of a decline. We currently assume their high levels of production to continue next year, but it’s quite uncertain.

We would expect excess supply over demand to rebalance at some point in 2016, but there’s another big player: Iran.

The other part of the equation is demand. Demand growth hit a bottom in mid-2014, but low oil prices have stimulated robust demand and this year we see almost 2 million barrels per day of increase. We would expect excess supply over demand to rebalance at some point in 2016, but there’s another big player: Iran. If they succeed in returning to the oil market they will probably add several hundred thousand barrels per day of supply, which will change the market balance.

So right now, even though the oil market is oversupplied, Saudi Arabia’s spare capacity is very low. Do you think commercial stocks can serve as a kind of substitute for spare capacity, in the event of unplanned outages?

I’m not sure we can call it a substitute for spare capacity… But it’s true that we have a comfortable and well supplied market right now. The stock level is extremely high, with almost 3 billion barrels in OECD inventories, so this is a good cushion for the market. Overall, the excess supply combined with high inventories should provide a very good cushion for an unplanned outage. So yes, commercial stocks can work as a shock absorber.

Are there any logistical challenges to having commercial stocks and strategic reserves play this role?

There can be logistical challenges, yes. As I understand, the Quadrennial Energy Review in the U.S. led to the conclusion that as the flow of oil around the continent has changed with new U.S. production capacity, it has created challenges with release of oil from the SPR. The system was originally designed to import crude to the Gulf region, refine it, and let it flow to the rest of the country. But now, so much crude is being produced in the continent that many of these flows have been reversed, undermining the original design. I understand the Department of Energy (DOE) is trying to address this issue, so there is some logistical fine-tuning to make us better prepared, but of course it will all depend on the region and the nature of the disruption. Overall, we consider that the fairly high inventory levels of both crude oil and refined products create a relatively comfortable situation.

Also on the topic of the Strategic Petroleum Reserve—there has been recent U.S. legislation that enables sale of the SPR to fund other government programs. What’s the IEA’s perspective on this decision, and why do strategic reserves still matter?

Any oil supply disruption will have a very severe impact on the transportation sector, delivery systems, and movements of goods, and have a huge negative impact on the global economy as a whole.

The IEA’s perspective is that we are aware that there is some legislation mandating DOE to sell parts of the SPR, but it will be undertaken with the supply that exceeds the required 90 days of import cover. I don’t think there will be a serious problem in terms of emergency preparedness. But strategic reserves remain important for our member countries—especially since the transportation system, cars and trucks, still dominantly depend on oil. Any oil supply disruption will have a very severe impact on the transportation sector, delivery systems, and movements of goods, and have a huge negative impact on the global economy as a whole. The oil stock programs for IEA member countries remain critical.

Let’s also speak about demand—as you just mentioned, oil is a monopolistic force in all transportation, and demand is growing. The United States has hit a new record this year in terms of vehicle miles travelled. What are the best ways to reduce oil demand in the medium to long term: Where are you the most optimistic?

First of all, we see that low oil prices have stimulated demand for pickup trucks and SUVs in the United States. But mileage and efficiency standards are continuing to improve as well, which is a strong force to mitigate the increase in transportation related oil demand. There are new types of vehicles like electric vehicles, plug-in hybrids, natural gas vehicles, hydrogen fuel cell vehicles are just now being commercialized—but there are many uncertainties about the impact of these vehicles on transportation systems. In WEO 2015, in the New Policies scenario we assumed that even though EVs will increase market share, they will continue to be a niche product—5 percent or less of the automobile market by 2040. But if we can achieve a more ambitious climate target, such as the 450 ppm scenario, then we would see electric vehicles representing over 40 percent of new vehicle sales by 2040.

There’s been some discussion of autonomous vehicles, and the ways they could impact demand. On one hand, they could dramatically increase vehicle miles travelled. On the other, they could enable efficiencies in terms of vehicle size and weight. Do you have any views on this?

Autonomous technology should enhance efficiency, because so much of the inefficiency in vehicles comes from the rather random ways that human beings are known to drive cars, with drastic acceleration and aggressive braking. If the transportation system as a whole can be automated and coordination with other vehicles is improved, individual transport can be managed in a much more efficient way. But it also makes travelling much easier, so some people who use public transit might transfer to autonomous vehicle technologies, which would increase fuel demand relative to public transit. That said, automation, of not only vehicles but also appliances, should help drive efficiency throughout the energy system.

Finally, what are the non-oil energy security risks we should be watching in the coming few years?

I see two main issues. One is natural gas—the EU commission is working hard on trying to secure non-Russia supplies, as well as stress testing the gas pipeline systems. Natural gas, because of its nature, is much harder to store than oil, thus we have to address gas security issues in a more comprehensive way. Instead of stockpiling, we have to look at supply diversity and fuel switching. We are now seeing increasing share of LNG in the global gas trade, and we’ll see much more trade in the Asia pacific region.

The other risk I see is electricity security: It’s not so much about geopolitical risk but technical questions, as more renewables come into the power system with solar photovoltaic and wind power becoming much cheaper. We will no doubt see strong growth of renewable power generation, which is variable and intermittent, so it’s important to ensure the appropriate market design and regulatory systems are in place to manage that risk. We have established a new advisory panel to address these issues in an informal way, as this is one of the high priority areas for IEA.