The Fuse

Is An Oil Supply Crunch Looming?

by Nick Cunningham | January 24, 2019

The global oil and gas industry is poised to increase spending this year, albeit modestly, in a bid to boost supply after a punishing period of low oil prices. The industry has succeeded in cutting costs and speeding up project timelines, achievements that will help companies adapt to a market that may never return to the price highs seen prior to the 2014 meltdown.

The dramatic slimming down over the past half-decade by the oil and gas industry has led to a steep drop off in spending, exploration and final investment decisions (FIDs) on new projects. That has thinned out the pipeline of new projects set to come online in the years ahead, raising the possibility of a supply crunch in the early 2020s.

The global oil industry needs to come up with 35 million barrels per day (Mbd) of fresh supply between 2017 and 2025 in order to compensate for rising demand and natural decline from existing oil fields

Supply shortfall
The global oil industry needs to come up with 35 million barrels per day (Mbd) of fresh supply between 2017 and 2025 in order to compensate for rising demand and natural decline from existing oil fields, according to the International Energy Agency’s (IEA) 2018 World Energy Outlook. Projects that are already under development could add roughly 11 Mbd over that timeframe, the IEA said in November. Additionally, the IEA said U.S. shale liquids could add another 7 Mbd of new supply, although it would require a heroic effort to achieve – the rate of production growth over the ten-year period of 2015 to 2025 would slightly exceed the ramp up in Saudi Arabia between 1967 and 1977, making it the “fastest rate of growth ever seen,” the IEA said.

Even if that is achievable, there would still be a supply gap. Much of the remainder would, in theory, come from yet-to-be sanctioned conventional projects. The IEA says that if the oil industry announces FIDs on projects covering 16 billion barrels of oil reserves each year, it can come up with 13 Mbd of additional production by 2025. However, the problem is that the industry is not sanctioning projects at that rate. Instead, since 2014, only 8 billion barrels of oil reserves have been sanctioned on average each year. “The volumes of conventional crude oil receiving development approval would therefore need to double from today’s levels, alongside robust growth in other sources of production, if there is to be a smooth matching of supply and demand,” the IEA said.

If project approvals remain tepid, however, the gap could potentially be made up by leaning even harder on U.S. shale. The resource base theoretically exists to support 20 Mbd of U.S. liquids production by 2025, the IEA says. “However increasing production to this level would require a level of capital investment and a number of tight oil rigs that would far surpass the previous peaks in 2014,” the IEA warned. “It would also rely on building multiple new distribution pipelines to avoid bottlenecks that could prevent or slow the transport of oil away from production areas.”

“In other words, the U.S. needs to add one single Russia in seven years’ time in order to avoid a major tightening in the markets”

The IEA’s executive director Fatih Birol was more direct in an interview with CNBC in November. “In other words, the U.S. needs to add one single Russia in seven years’ time in order to avoid a major tightening in the markets,” he said, before adding, “It can happen but it would be a small miracle.”

The bottom line is that the damage to industry balance sheets stemming from the 2014 meltdown has forced a sharp cutback in new development, which sets the market up for a supply shortfall in the first half of the 2020s. A recent survey of industry executives finds that nearly three-quarters of respondents expect their companies to maintain or increase spending this year. However, capex in 2018 still was roughly 40 percent below the 2013 peak, according to Bank of America Merrill Lynch.

There is little sign that oil and gas companies are planning on returning to pre-2014 investment levels, particularly with heightened concern over cash flow and capital discipline. If the emerging supply gap won’t be closed by new sources of output, then demand will need to fall. In other words, the market is facing the possibility of a price spike in the years ahead.

There is little sign that oil and gas companies are planning on returning to pre-2014 investment levels, particularly with heightened concern over cash flow and capital discipline.

Lower breakevens
Not everyone agrees with this assessment. Significant cost declines have allowed new projects to move forward even in a lower price environment. For instance, in late 2016 BP and Chevron gave the final investment decision on the offshore Mad Dog phase 2 project. Originally, the project was expected to cost more than $20 billion, but a redesign following the price collapse resulted in a $9 billion cost estimate. Industry-wide, cost reductions have led to projects breaking even at much lower prices.

“Producers have also simplified and streamlined greenfield projects, driving breakevens below $40/bbl for a large majority of projects (ex US shale) coming online during 2019-24,” Bank of America Merrill Lynch said in a note on January 18. In addition to U.S. shale, the investment bank sees strong supply growth over the next few years from Brazil, Norway, Guyana and offshore Gulf of Mexico. “The aggregate capacity over the next six years is actually larger than 2013-18 when promising technical prospects are included.” After factoring in slower demand growth, new supplies may be sufficient.

The futures market offers some evidence to back up this story. Five-year Brent futures used to trade north of $90 per barrel, but are now in the low-$60s, which suggests that traders do not foresee a price spike on the horizon. Goldman Sachs has pushed a similar view, arguing that new Permian pipelines pave the way for another round of strong U.S. shale to grow in the next few years, which will allow OPEC to rebuild spare capacity. Goldman argues that long-dated WTI prices will fall towards $50 per barrel, a reflection of a market that is well-supplied in the years ahead.

There is a large gulf between the views of a looming supply crunch, as the IEA warns, and the “lower for longer” outlook represented by some major investment banks. Time will tell which is closer to the mark.

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