There Is An Oil Supply Glut Now, But The Party Won't Last Forever

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Includes: AOIL, BGR, BNO, CRAK, DBO, DDG, DIG, DRIP, DTO, DUG, DWT, ERX, ERY, FENY, FIF, FTXN, FXN, GUSH, IEO, IYE, JHME, NANR, NDP, NRGD, NRGO, NRGU, NRGZ, OIH, OIL, OILD, OILK, OILU, OILX, OLEM, OLO, PXE, PXJ, RIG, RYE, SCO, SZO, UCO, USAI, USL, USO, USOD, USOI, USOU, UWT, VDE, WTID, WTIU, XLE, XOP, YGRN
by: Rob Pinkerton
Summary

There is widespread disagreement about almost everything regarding the future of oil supply.

However, a world oil supply crunch may be coming in the next few years.

The long-term problem for shale oil isn't just low prices - it's low reserves.

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There is a world oil supply glut at the moment, mainly due to the recent significant increase in shale oil production. However, I am going to reveal here my thesis as to why I think there is a good chance that the very success of shale oil may have sown the seeds of destruction as far as future oil supply goes.

Shale Oil Production

Just a short time ago, no forecasting body was projecting how quickly a U.S. shale oil surge would not just change the U.S. outlook but also transform energy markets around the world and basically devastate the offshore oil industry. The share prices of many of the offshore service companies are now at multi-year lows, and more than one has been made bankrupt or is facing bankruptcy in the near future.

Let’s start by looking at the EIA forecast for future shale oil production that was made in 2015, as shown in the figure below:

We can see that in 2015, even the most optimistic forecast was not predicting an average production rate of 8.5 million bbl/day that is on track to occur this year. This is a massive increase on 6.44 million bbl/day from last year.

The consensus now seems to be that US shale oil production is here to stay and yearly production will reach about 10 million bbl/day by 2030, and it will be a major contributor to world oil production into the foreseeable future. But how realistic is this scenario?

Let’s first look at the proved oil reserves of US shale oil. At the end of 2017, the EIA stated that proved reserves of shale oil amounted to 20 billion barrels. Note that proved reserves is the amount that can be economically recovered and is dependent on the oil price. That means that when the oil price is high, the amount of proved reserves automatically increases, and vice versa.

With past and predicted future yearly shale oil production, the following table shows what the cumulative shale production would be since the 2017 date:

Year

Average Shale Oil Production Rate (million bbl/day)

Total Production for the year (billion bbl)

Cumulative Production (billion bbl)

2018

6.44

2.35

2.35

2019

8.5**

3.1

5.45

2020

8.65*

3.16

8.61

2021

8.80*

3.21

11.82

2022

8.95*

3.27

15.09

2023

9.1*

3.32

18.41

2024

9.25*

3.38

21.79

*Estimate
**EIA estimate

So, looking at the above table, it can be readily seen that by 2024 the party will be well and truly over when basically all of the proved reserves of shale oil will be depleted.

But we could also ask the question: If the table shows that shale oil production can be profitable until 2024, then how come 15 out of 20 shale drillers are presently making a loss? I suggest that the reason is that when figures are published on proved reserves, it is not mentioned what the oil price was assumed to be. And it was probably far higher than the oil price is now. So, with this in mind, the drop dead date for shale oil production could come earlier (a lot earlier). Also note that loss-making shale oil drillers are at present finding difficulty in obtaining finances to continue production. Before it was "drill baby drill". Now it is "show us the money".

It may also surprise you that (ex-US) world proved oil reserves is about 1500 billion bbl. That is 75 times that of US shale oil reserves. So this reinforces my view that shale oil may have won the sprint but is not going to win the marathon.

Drivers of Increased World Oil Production

So, if there is a shortfall in shale oil production in the near future (9 million bbl/day from shale is a lot to lose), then where is the lost capacity to be made up? Possible drivers of increased world oil (and/or energy) production are as follows:

  1. OPEC spare capacity (2.8 million bbl/day)
  2. Regime change in Iran (Unlikely)
  3. A Democrat president in 2020 bringing accommodation between the US and Iran (Bookmakers’ odds = 110)
  4. Regime change in Venezuela (Possible)
  5. Startup of world (ex-US) shale oil production (Very, very unlikely).
  6. New discoveries and development of offshore oil reserves (The main hope)
  7. New discoveries of US shale oil reserves (Indeterminate)
  8. Increased development of renewables (Don’t think so)

The first thing to note is that OPEC spare capacity will not be enough to replace all of the shale oil production if it is lost.

Note that Venezuela has more oil reserves than Saudi Arabia, and the only reason that production is so low is due to political policies that have been present for many years now. Theoretically, the country could produce at least as much as Saudi. So, it goes without saying that if foreign investment were to return to Venezuela, it could make a huge difference, but it would take a few years to build up production.

Also, a startup of ex-US shale production around the world is unlikely, because only the US has the infrastructure necessary to make shale oil profitable. And, of course, it is barely profitable there. But you might say: What about Vaca Muerta in Argentina? Well, development work on this shale field only started when the Argentine government agreed to to subsidize the development costs and and buy the natural gas at 3 times the market price. But it hasn’t come even close to replicating the U.S. shale revolution. After billions of US dollars in investment, only 77,000 bbl oil/day is being produced. Only 4% of the total capacity has been developed, and the lack of infrastructure has begun to be a real problem for any future expansion.

At present, renewable energy, which is from hydro, sunlight, wind, rain, tides, waves, geothermal heat and bioenergy, amounts to 10% of the world’s energy consumption. There are many problems associated with renewables. For example, the sun doesn’t always shine, the wind doesn’t always blow. Plus, there is the question of where the energy storage is going to come from. It is basically not a cheap source of energy. A lot could be said about this, but unfortunately, I do not have the space here for a complete discussion. But the present view is that renewables can really only supplement energy from fossil fuels and not replace them. Anyway, the IEA expects renewables to grow by 4% per year over the next 5 years, and that’s not going to make up for the potential shortfall in oil/energy here.

Oil field depletion and increases in yearly world demand should also be bought into the equation. We all know that shale oil wells deplete at the rate of about 70% in the first year, and continuous drilling is required to keep things going, but conventional oil wells also deplete - at an average rate of 6-7%/year. Note that non-OPEC production minus US shale oil production is about 54 million bbl/day. So, if no new wells are bought on-line, then we are losing between 3.2 million and 3.8 million bbl/day every year. (I am assuming that OPEC can look after themselves on this front.) The annual increase in world demand can be anything from 1.1 million to 1.7 million bbl/day per year. So, we need non-OPEC new developments bringing an extra 4.3-5.5 million bbl/day every year just to stand still.

Since most of the potential future world reserves still lie in offshore fields, it is most likely that there will be a move back to this space in the future, but we don’t know exactly when this will occur. And unfortunately, it won’t be just a question of turning the faucets back on. From discovery to first oil, there is a lead time of about 3-4 years for shallow water fields, and it can be up to 6-7 years for deepwater. There will also be the question of what effect the lack of investment has had in this area over the past few years. A lot of offshore service companies have gone out of business, and many professionals have lost their jobs since the 2014 oil price collapse and will never be seen again. It just so happens that offshore oil discovery and field development uses advanced technology, and if there is a resurgence of development activity, it is not really known where the required skilled personnel are going to come from.

Please note that I have neglected a few things here (including shale gas production) for the sake of simplicity. We all know that natural gas prices in the US are very low at the moment, and the conclusions will still be the same.

Conclusion

So, the conclusion is that there are too many variables to predict exactly what world oil production or what the oil price will be at any time in the future, but at the current and projected rate of shale oil production, all of the proved reserves of will be depleted by at least 2024. With US shale oil production out of the picture, there may be a significant shortfall in world oil production. Since most of the potential future world reserves still lie in offshore fields, it is most likely that offshore production would have to come back to take up the slack. Though, the lack of investment in this area in the last few years may make things a bit difficult here.

However, it is unlikely that shale oil production would stay elevated and suddenly stop in 2024. More likely, there will be a slowdown in production before that date and at least a pickup in offshore exploration & production activity beginning in the not-too-distant future. Indeed, the end of the shale revolution might already be in sight with a substantial decrease in new investment in the light of bankruptcies that are now occurring. The high level of debt has caused 28 frackers to file for bankruptcy this year, and the number is expected to rise when about $137 billion of debt will mature between 2020 and 2022. And any increase in the oil price from now on may not be able to fully compensate for the massive debt here.

Moreover, there is a good chance, for reasons that I’ve already stated, that offshore may not be able to respond quickly enough to fully compensate, at least in the short term, for a significant decrease in shale oil production; bringing with it, of course, an appreciation in the oil price.

So, you could ask: When is it time to buy offshore oil stocks? The answer would seem to be now, while offshore stocks have been beaten down so much and there are faint signs of a recovery. With any increase in oil price, the first thing we should notice is an increase in offshore exploration activity. I came back into the market and bought Transocean (RIG) when it had just about reached an all-time low recently. This was because I thought that the selling had been overdone. RIG still has a satisfactory balance sheet, but it may be wise to keep close tabs on things here.

Disclosure: I am/we are long RIG. 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.

Additional disclosure: I am not a financial adviser, and the views expressed here are my own only.