Fears of a looming oil supply gap are overdone

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The ability of the shale industry to respond quickly to market conditions should allay concern

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Leaders from both the International Energy Agency and OPEC predict a looming oil supply gap emerging by 2020, implying much higher prices ahead, blaming a steep drop in capital spending since 2014, the limited number of new discoveries, and a steepening of global production declines.

But the fear or hope of an emerging supply gap is exaggerated and misleading. Like OPEC and the IEA, we believe that the oil market is rebalancing rapidly this year, but we differ in the medium-term. This year oil markets should see growing inventory draws of crude oil, petroleum products and natural gas liquids (NGLs), with demand growth plus OPEC and Russian output cuts and declines in legacy non-OPEC production resulting in supply shortfalls.

These draws have been postponed by the sloppy management of negotiations by producers last year when, in the midst of negotiations to fairly share production cuts, Russia and OPEC increased production by 1.5-million barrels a day.

Much of that oil reached China and the US this past quarter along with a drawdown of floating storage that became unprofitable. But the cuts are real and inventory draws are finally accelerating. Prices rose following the announced cuts buttressed by huge investor financial flows into paper oil, and as a result near-record hedging by producers stimulated a drilling response, and not only in the US.

They way the market has responded is a reminder not to underestimate shale. The unconventional oil revolution looks unstoppable. US shale production looks likely to rise by more than 5m barrels a day by 2022. Shale costs have fallen 35 per cent since 2014 and are beginning to rise again. But shale cost inflation is limited to well completion, not drilling, and productivity gains look to be rising even faster.

Estimated ultimate recovery levels have doubled over the last few years and such bottlenecks as delivering fracking sands are being overcome. And don’t ignore either deep water or oil sands, which could each contribute more than 1m b/d of growth by 2022. Deep and difficult water costs have fallen 20-25 per cent and appear to have another 20-25 per cent to go. BP’s Mad Dog2 deep-water Gulf of Mexico project costs have fallen to $9bn from $19bn all-in since 2014 and Statoil’s Johan Sverdrup Arctic project’s all-in costs, once thought to require $60 a barrel have come in at $25.

Costs in oil sands have seen a drop of 20-30 per cent and while some projects might require higher prices, lower costs and new takeaway pipelines to Canadian Pacific and US Gulf Coasts are raising expected net back values to Alberta. Unconventional oil alone seems capable of meeting most global oil demand growth going forward.

While the bull case points to accelerating oil demand growth, the new world oil order points to a declining energy intensity of GDP growth, even in emerging markets. While gasoline and jet fuel demand growth remain robust, oil’s monopoly as a transport fuel is ebbing and an increasing amount of global demand is being met by LPGs from the gas stream, not oil. An end of the output cuts and new unconventional and conventional production presage market weakness post-2017.

Most scenarios through 2022 now show US supply meeting the bulk of demand growth nearly every year at hedgeable prices above $50. Combined Russian, non-conventional and Opec production growth should more than adequately meet the balance, given huge and growing capital efficiencies. Don’t overestimate declines.

The view that in five years the world needs to replace around 30-million barrels a day of lost oil stems from applying a 5-6 per cent decline to 100m barrels of daily production. In reality only some 40m of non-OPEC oil is subject to worrisome decline, meaning only some 10m b/d of oil requires replacement over five years and technology and capital efficiency put that easily within reach.

The bull case also anticipates a new era of price stability, whereas the new norm points to higher volatility. Producers look incapable of sustainable market management given the response of short-cycle shale. Prices since 2014 have mostly fluctuated within a $20-25 range annually.

Citi expects an average Brent price of $65 come the fourth quarter, meaning spot prices could reach $70 and a supply outage from Venezuela or Nigeria, or Libya could push higher. But over the next five years expect average oil prices to settle into a $40-$65 range.

 

Edward Morse is global head of commodities research at Citigroup

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