Elevated Risk Of Oil Price Spike Within A Year

by: Zoltan Ban
Summary

The shale industry, which helped keep the global supply/demand situation inclined towards the over-supply side, is now showing more and more signs of stagnation.

The Saudi news in regards to the steep decline in Ghawar's production capacity suggests spare capacity may be very limited.

Sanctions on Iran are in effect causing most global spare capacity to become concentrated in the hands of Iran.

In the event of supply shortfalls going forward, there may be no relief available for the market, which could cause a major oil price spike, ending with demand destruction, thus global recession.

Those who followed my work on Seeking Alpha closely might have noticed that in the past few years, I expressed my belief that an oil price spike will be the main trigger for the next global economic downturn. Other problems will contribute to a new recession but will not trigger a downturn on their own. This was a very tough argument to make back in 2016, in the immediate aftermath of the oil price slide, after which there was a widespread consensus that oil prices will remain low for the foreseeable future. There still seems to be widespread belief in oil prices remaining relatively tame for the foreseeable future, but if we look closely at what we learned in the past few weeks and months, I think it is rather clear that there is now a significant chance of a severe oil price spike within the next year or so.

US rig count declining this year, despite rising oil prices.

The first factor I want to look at is the curious case of the US rig count decline, even as oil prices have seen a dramatic increase since the beginning of the year.

Baker Hughes rig count

Source: Investing.com.

From the end of last year to the latest Baker Hughes rig count last Friday of April, the rig count declined by almost 10%, while the WTI spot price increased by about 40% since the beginning of the year. It remains to be seen whether this trend of declining rig activity, even as oil prices remain relatively firm or even continue to improve will last. If it will, I think we will need to revise current expectations in regards to US shale production gains in the near future.

As I pointed out in a recent article, the EIA is already forecasting a seemingly permanent downshift in US shale oil production gains.

EIA shale oil production forecast

Data source: EIA.

As the chart shows, we most likely saw the last of the great quarterly leaps in US shale production in the last quarter. Going forward, we will see less-impressive quarterly gains, punctuated by the regular occurrence of quarters which will experience outright stagnation. Given what we see in regards to rig counts, even this forecast of moderating production growth may have to be revised down. We may even be looking at the prospect of US production entering a period of decline within a year unless the current trend of declining drilling activity will reverse itself soon.

In the same above-mentioned article, I pointed to the fact that the slowdown in drilling and shale production most likely has to do with approaching over-saturation of the limited prime acreage in all shale fields. While I do believe that most solid shale companies are still sitting on a few years' worth of prime acreage, I also think that at this point, more and more companies are realizing that there is no rush to drill themselves into second-tier acreage. In fact, there may be some advantages in being among the last to still have some of that prime acreage available, while others deplete themselves into inferior acreage much faster.

Saudi Arabia's giant field entered decline.

If we think back to the last oil price super-spike back in 2007-2008, Saudi Arabia was called upon to help stop the spike by ramping up production. As we now know, it failed to do so, revealing the probability that it has been overstating its spare production capacity. Since then, it did invest in capacity expansion at some of its existing giant fields, which amounts to perhaps about 3.5 mb/d. We should keep in mind that these are not new fields coming on-line because Saudi Arabia has not had much success finding new giant fields for a very long time. Without taking into account capacity declines at some of its old and increasingly depleted fields, the addition of new capacity should have brought Saudi Arabia to a total capacity of about 13 mb/d.

We recently learned, however, that its largest field, Ghawar, which has been responsible for yielding about half of all the oil that Saudi Arabia produced cumulatively thus far is in a dramatic state of decline. Until recently, most people thought that it should still be producing or at least have the capacity to produce about 5 mb/d. As it turns out, that capacity is now down to 3.8 mb/d, as confirmed by a recent audit of Aramco. We can also safely assume that a number of other giant fields, which have been producing for many decades now are also facing production decline, therefore, Saudi Arabia has the sustained capacity to produce about 11 mb/d. This capacity is still declining as time goes by and will only be stemmed by further capacity expansion projects, which at this point is increasingly hard to do, given limited geological opportunities.

While it may be frowned upon to brag in our society, I should point out that what we are now officially learning about Saudi Arabia has been a view I held and expressed for years now. In fact, I pointed out in a 2016 article entitled "OPEC Emperor's Clothes" that its Ghawar field was already in decline back then, and its overall ability to produce oil beyond levels it was pumping at back then was limited. Given what we now know, Ghawar probably started declining perhaps just a few years before I wrote that article. I brought this up because I want to highlight the fact that if one pays attention to details, it is possible to get a decent picture of a situation, even when faced with a country like Saudi Arabia, which prefers secrecy over disclosure, especially when dealing with its oil industry.

Geopolitical risk of sanctions and other disturbances.

The Trump administration announced just a little while ago that it will not renew the waivers for countries to continue buying Iranian oil. It is not yet certain just how much more oil will be taken off the market with this move, but Saudi Arabia, as well as a number of other OPEC members, are expected to make up for whatever supply shortfall this may cause. On the surface, this may seem reassuring, but we should keep in mind that it also means a reduction in already limited spare capacity, meaning that the market will not have any backup in case of any unforeseen supply disruptions.

As far as unforeseen disruptions go, there are plenty of potential flash-points around the world, which could cause a supply shortfall. There is Venezuela, which is now in the news, but also Libya, Nigeria, Algeria, which are all oil exporters that are experiencing some form of instability. There can also be unforeseen outages, such as pipeline issues, natural disasters, and so on. We could also have some unexpected surprises in terms of natural field decline rates around the world, which might collectively and cumulatively cause a shortfall in supply, while demand might perhaps turn out to be slightly more robust than expected.

We could face such shortfalls, while the current sanctions situation is in effect causing most spare capacity to become concentrated in the hands of the country that is being targeted by sanctions. In other words, most spare production is set to become concentrated in Iran. That could lead to an uncomfortable situation, where the US may be forced to choose between relaxing the sanctions or facing together with the rest of the world an oil price spike, which would most likely trigger the next economic downturn. Alternatively, oil importing countries would have to choose between facing US sanctions or defying the US in order to get what would most likely end up being discounted Iranian oil. Neither outcome, which will lead to more Iranian oil on the market is likely to come to pass because it would be a hit to American credibility in regards to its ability to enforce such sanctions. If most current trends will continue, we might be looking at such an outcome within about a year, where we will enter an oil price spike driven recession, even as Iran will continue to helplessly sit on significant spare capacity.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.