OPEC, the International Energy Agency (IEA) and a host of Big Oil executives are sounding the alarm about a looming supply gap and potential price spike sometime after 2020. The reason: a sharp plunge in upstream investment in the years following the 2014 oil price collapse.
History is on their side, as traditionally prolonged periods of low prices have prompted sharp cuts to industry capital expenditures and lower production, eventually leading to higher prices. Such is the cyclical nature of the oil business. But these dire forecasts today are misguided. There are many reasons to believe that past cycles don’t apply to today’s markets, mainly because a thriving U.S. shale industry did not exist as recently as a decade ago.
Shale is hardly the ideal swing producer. But functioning at its best, it should help avoid a return to $100 a barrel prices and keep them around or below $70 a barrel, even with the sharp drop in capital expenditures (capex) in recent years on deepwater, oil sands and other “mega-projects” by international oil companies. These multi-billion dollar schemes typically take several years from project sanctioning to first oil, and OPEC, the IEA and others are worried that low capex rates since 2014 will come back to haunt the industry after 2020.
Upon closer examination, however, these fears appear exaggerated — even self-serving for OPEC. After all, supply gap fears bolster oil prices, which boost the cartel’s revenues. The IEA, meanwhile, is the consumer watchdog for the world’s largest developed economies. It can’t risk getting caught with its pants down if there’s a supply issue on the horizon. Better to play it safe.
So what exactly is the challenge? Essentially, the global industry was spending more than $700 billion a year on upstream oil and gas projects before prices tanked in 2014. The industry cut upstream capex by 25% in both 2015 and 2016. Capex was flat in 2017, and early data points to only a modest increase in 2018, says the IEA, which believes this points to “trouble for the future.” Upstream capex has been running closer to $400 billion a year since 2015, leading some like consultancy Wood McKenzieto fret over a $1 trillion global oil investment gap post-price crash.
Under this scenario, OPEC wouldn’t be in a position to save the day. Of course, OPEC and some non-OPEC partners, led by Russia, have been holding back about 1.8 million barrels a day of production since the start of 2017 to rebalance oversupplied oil markets and bolster prices, but the return of this output would not be enough to resolve the medium- and long-term supply deficits foreseen. OPEC itself has few levers to pull. Within the cartel, only Saudi Arabia holds any meaningful spare capacity, estimated at 2.5 million barrels a day. Political, security and commercial issues continue to plague members like Venezuela, Iran, Iraq, Nigeria and Libya, where the production outlook ranges from dubious to bleak.
Fortunately, there are flaws in the supply gap theory. While investment plunged sharply, so too did industry costs. Projects of all shapes and sizes have become cheaper, so producers have been getting more bang for their buck. Over the past 18 months, the deepwater industry has made a gradual recovery, with final investment decisions returning on big projects in the Gulf of Mexico, North Sea, West Africa and Brazil. The realignment of costs with lower prices has been substantial. Project costs for BP’s Mad Dog 2 deepwater project in the U.S. Gulf fell from more than $20 billion to $9 billion. At Statoil’s Johan Sverdrup Arctic project, the company has been able to reduce breakeven costs from $60 a barrel to below $20 a barrel.
But it is the U.S. shale sector that will do the most to avert any great supply deficit. Indeed, it has been shale’s potential that has made the international oil companies (IOCs) hesitant about sanctioning new expensive mega-projects in recent years. As they watched shale drive down its breakeven costs dramatically and become increasingly competitive on the global stage, IOCs were forced to rethink many long-cycle mega-project opportunities in their portfolios. Today, only the best ones with the lowest break-even points are moving forward.
However, together with shale, and Saudi Arabia, this should be enough to satisfy growing global demand. The IEA reckons global demand will be 6.8 million barrels a day higher in 2023 than today. The U.S. is expected to add 3.7 million barrels a day to output and reach 17 million barrels a day in total liquids production by then, but the IEA concedes this could be too conservative if prices exceed those on today’s future curve. Others are far more bullish, saying U.S. production growth will be closer to 5 million barrels a day over the same timeframe – even if oil prices average just $50 a barrel.
If there are any concerns about underinvestment, they should be focused on the U.S. oil services industry. Without sufficient capacity among the blue-collar crowd in the field, the U.S. shale sector can’t reach its full potential. This corner of the industry was hit hardest by the downturn. Now as frackers seek to ramp up drilling and output, they increasingly face restraints due to a scarcity of labor and critical materials, like sand that remain in short supply.
It will take time for the service sector to get back on its feet, including charging higher fees to their producer customers in order to make the necessary investments in the equipment and personnel to keep the shale boom going.
For the IEA, OPEC or anyone else concerned about a future supply crunch, the service sector is the space that deserves the most attention in the coming years.