Why oil prices are going up (and will continue to do so)

“a few pictures say more than a thousand words”

Oil prices have been going up over the last few months, from below 30 dollars per barrel in February to the current levels of around 50 dollars per barrel. Many short term issues of a different nature play a role here, ranging from market psychology to supply interruptions such as the Alberta wildfires. But I would argue that in the background there is a persistent upward trend, caused by the simplest of explanations: supply and demand are starting to approach a balanced situation.

On predicting future oil supply and demand no individual can produce anything close to the comprehensive analyses of organizations like the IEA or the major consultancy firms. But one can try to highlight a few processes that hopefully give some insight into the way that supply is responding to changes in the oil price.

 

Increased field decline of conventional oil fields is kicking in

Much of the publicity on the way that oil supply is responding to lower prices has focused on unconventional shale oil in the US. And indeed the rapid advance of US shale oil has been a key factor in the creation of oversupply. But for the response of supply to low prices the over 50 million barrel/day production from conventional (non-OPEC) fields plays a much bigger role. Small changes in the average decline rate of these fields result in large changes for oil supply in absolute numbers.

The figure below is taken from a recent (June 2016) Rystad Energy study and shows the average decline rate for mature non-OPEC oil fields. Up to 2015 these figures are actuals; for 2016 this is a prediction with limited uncertainty and for later years uncertainty increases.

Oil price rise paper fig1

Due to higher amounts of activity, the average decline rate in the 2010-2014 high oil price world was about 3 % only (without any activity this decline rate would have been about 8 – 9 %). Reduced activity in the subsequent low oil price world resulted in higher decline rates of about 5 – 6 %. In absolute terms: for 2016 this amounts to a supply decrease of 3.3 million barrels/day.

First of all: the fast response of existing field decline rates is due to the nature of the activities involved: workovers and infill drilling can be planned and executed in a relatively short time frame.

Secondly, the effects of reduced infill drilling in conventional fields will be felt for years to come; a conventional well not drilled in 2015 is still likely to result in lower production in 2020 and beyond.

Thirdly, decline rates are much less of an issue for OPEC fields. Production in a country like Saudi Arabia is capped by political decisions or infrastructure capacity rather than geology (hence their much higher reserves to production ratios).

So why do decline rates of conventional non-OPEC fields receive so little attention? I think this is simply because field decline has so far been masked by new fields coming on stream. For 2016, the added production from new fields amounted to about 3.0 million barrel per day, roughly compensating for the decline of existing fields. Many projects are still coming on line (especially in deepwater) that have been sanctioned in the 2010 – 2014 high oil price world.

New oil compensating for field decline is not sustainable, however. Hardly any new major developments have been sanctioned in 2015 and the first half of 2016. Over the coming years new oil from projects currently being built is gradually decreasing from 3.0 million barrels per day in 2016 to a much lower level in the early 2020’s (exactly how low will depend on when the sanctioning of new developments will resume). For 2017, a similar level of field decline (compared to 2016) is already expected to outstrip new developments by about 1.2 million barrels / day.

 

The reduction in US shale oil production is kicking in, finally

I have chosen to include a figure from a Seeking Alpha paper rather than the well known EIA figures that only give production up to the present day. Obviously the prediction beyond mid 2016 depends on future oil price (the predicted further decline is in the middle of the range for a number of forecasts from different organizations).

Oil price rise paper fig2

The time it takes for US shale oil production to respond to the low oil price oil world is much longer than often assumed. It took close to a year before peak production was reached; it took close to another year before a steady reduction (per month) of up to 100,000 barrels / day was reached. US shale oil can not take on the role of a short term swing producer (as Saudi Arabia used to do). It cannot do so timewise (it takes two years to fully respond); it cannot do so volumewise (changes in US shale oil production being too small a fraction of changes in global supply). It does play an important role, as part of a complex global oil supply system.

A shakeout is taking place in the US shale oil world with increased focus on the best plays and the best sweetspots within these plays. The Permian is emerging as the dominant play in shale oil, in the same way as the Marcellus has emerged as the dominant play in shale gas.

 

50 dollar per barrel is too low to be sustainable

The major international consultancy firms cover all parts of the energy business. Rystad Energy, a small independent Norwegian consultancy firm, primarily focuses on one part of the business only: maintaining a state of the art database of all oil fields (plus potential developments with timelines and oil prices needed for project sanction) on a global basis. This enables them to model future oil supply for different price scenarios. In this important niche they have become a world leader.

The figure below gives some these scenarios. These integrated models combine shale oil production, conventional field decline and new conventional developments (as well as more secondary processes such as exploration, end of field life and project delays). The gradual decrease of global oil supply in a constant 50 dollar per barrel scenario is primarily due to the combination of the continuation of significant mature field decline and the gradual decrease of oil from new developments over the coming years.

Oil price rise paper fig3

Unless more dramatic cost reductions materialize, these models imply that a long term price of the order of 70 – 90 dollar per barrel is needed to generate sufficient supply, anywhere near expected demand. The reason is simple: it is at this price level that many projects, of a different nature (onshore, shallow offshore, deepwater and shale oil), become sufficiently profitable to go ahead. Lower prices will eventually result in undersupply; higher prices will eventually result in oversupply (regardless of oil demand continuing to increase at its current rate or reaching a plateau).

 

Oil demand: India is taking over the role of China as a growth engine

In the meantime oil demand continues to stubbornly grow each year, at a rate of about 1.5 million barrels / day. So far any increase in efficiencies or renewables is more than offset by increasing demand in non-OECD countries. The populations of China and India (about 1.4 billion and 1.3 billion respectively) are so large that what happens in these countries simply matters most.

As the growth in Chinese oil demand abates it seems that India is taking over China’s role as the key country for oil demand growth in Asia. A recent study of the Oxford Institute for Energy Studies paints a breathtaking picture of a country where manufacturing and car ownership (and hence oil demand) are about to explode. Last year India’s oil demand grew by 0.3 billion barrels / year (compared to an average of about 0.1 – 0.15 billion barrels / year over the last decade). India is now in the position where China was about 15 years ago.

Oil price rise paper fig4

Even if India’s phase of rapid economic growth would be characterized by a greater focus on renewables this would be more of an issue for coal and gas than for oil.

One day the energy transition will take off in earnest and peak oil demand will be reached. But it will come at a slower rate than the response of oil supply to changes in oil price or changes in oil demand. The energy transition will lead to a reduction in volumes but not (necessarily) to a reduction in price. For an oil company volumes matter. But price matters much, much more.

 

 

 

 

 

 

 

 

 

 

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2 Responses to Why oil prices are going up (and will continue to do so)

  1. Pingback: Toenemende daling van olieproductie in bestaande (producerende) velden vanwege sterk verminderde investeringen | Paradoxnl's Blog

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