A new oil reality


If you do not believe in a “lower for longer” oil price scenario, what would need to happen for oil prices once more to reach over 100 USD per barrel some time in the future? What disruptions to oil supply might support higher than 70 USD per barrel prices? What drivers for demand might support growth going forwards? The factors that might cause either of these effects and their likelihood are discussed in the present article.

Supply disruptions

We believe there are three key factors that carry the potential to cause significant supply disruptions: geo-political unrest, deferrals of CAPEX and coordinated production cuts from OPEC.

First, let’s take a closer look at geopolitical risks. In the last 5 years, much has changed in oil-rich parts of the world, like the Middle East given the Arab Spring uprisings and ISIS challenging for territorial and political dominance. Other geographies like West Africa have also been affected, with for example Boko Haram on the march in Nigeria. However, evidence shows that concerns over possible major supply disruptions are overstated. For instance, the rise of ISIS in Iraq has coincided with a period of exceptional growth in oil output for the country, now at slightly above 4.55 million barrels per day making the country OPEC’s second-largest producer (with oil output having an average annual growth rate of 10.3% between 2010 and 2015). Nigerian output in the same period was more or less flat (a gain of 0.63%) despite Boko Haram causing mayhem and reports claiming that the group is stealing large amounts of oil directly from supply.

Only Syria and Libya have seen a major decline in production. In the case of Syria, a nation embroiled in a full-scale civil war, there has been a massive reduction in oil production; from 400,000 barrels a day on average in 2008-2010 to less than 30,000 barrels a day last year. For Libya, the major changes occurred before oil prices collapsed, and they were somewhat detached from oil price developments; from over 1.6 million barrels of Libyan crude production a day pre-Arab Spring uprising to almost zero by the end of 2011 – then back to 1.4 million barrels a day after the civil war in 2013-14, and now down to ~0.5 million barrels a day given deteriorating security conditions.

Another development with the potential to lower the future supply and thus increase oil price levels, is CAPEX deferrals. Wood Mackenzie estimates that investments of approximately 380 billion USD have been postponed due to the collapsing oil price, resulting in as much as 3 million barrels per day in reduced supply by 2024.

Although this level of potential supply deficit could become a significant constraint, we find plenty of other suppliers ready to leap in to fill that gap. Iran claims that in a post-sanction scenario they will immediately increase the crude output from 2.8 million barrels a day to 3.6 million barrels a day already by 2017, with an additional 1 million barrels per day by 2020 if all investment plans materialise.

Additionally, given favorable price signals (potentially starting in May 2016 with prices hitting the 50 USD per barrel mark once more), US LTO can also step in to fill a possible supply gap. We performed a bottom-up analysis of the effect of redeployment of the idled unconventional drilling rigs today onshore in the US, with new rigs coming up only after all idled rigs have been redeployed. We modelled their production curves with conservative productivities for each LTO-rich play, not including the learning curve the last 18-24 months1. In addition, we used historic decline rates for wells as well as base production.

Our bottom up analyses show that US shale plays have the potential to increase production by as much as 6.4 million barrels per day by 2020 by reemploying idle rigs and further rig fleet expansion, and by a further 2.8 million barrels per day by 2025. Actual volumes produced will be contingent on a continuous positive price signal, i.e. levels above 50 USD per barrel on a sustained basis (however, given current shale breakeven levels, 60-70 USD per barrel is more than enough to enable production across all LTO-rich basins). These volumes would more than compensate the 3 million+ barrels per day of potential supply deficit due to delayed FID of projects – and then some.

The final element that could tip the balance on the supply side is OPEC production-planning. The group’s ability today to influence market prices by adjusting outputs looks weaker than ever with two blocs forming to battle it out over OPEC’s strategic direction. On the one hand, there is Saudi Arabia and its allies on the Arabian Peninsula, who are standing firm in an attempt to drive American LTO players and other hig-cost producers out of business, and more importantly, maintaining their market share of the crude market over the cycle. On the other hand, there are several OPEC member states that are struggling today under the burden of fiscal pressure such as Venezuela or Ecuador, or those that have conflicting agendas, like post-sanction Iran that is aiming to increase production until the country recovers a similar market share to the position held pre-sanctions. Therefore, agreement on production cuts will be hard to realise, especially without full support of all OPEC members, including Iran (which did not send representatives to the last OPEC meeting in Doha last April), in addition to outside support from i.e. Russia. Finally, with onshore OPEC oil production at the lowest breakeven among large oil producing countries, the real question becomes for how long will their economies, so heavily reliant on oil revenues, be able to manage in a low oil price scenario before concerted action needs to take place.