Guest blog by S. A. Shelley: In Part 1 of this blog on Oil Supply, l examined the supply-demand history of oil over the past decade, which has set the stage for the dramatic changes in the industry that are just beginning. In this blog I'll explore some of the likely consequences and will venture to predict some of the dramatic events to come and some of the likely irreversible impacts recent events will have on the world oil industry.
For the last few years, OPEC+ has been trying to curtail supply to more closely match demand. In theory this should work but in practice it hasn't. While the Saudis were trying to rebalance markets by cutting supply, their actions had no effect when OPEC+ partners such as Russia had their own agenda (see Fig. 1).
Russia has an advantage over the Saudis in that Russian pipelines link to Europe and China. The Saudis have an advantage over Russia in that they can produce and sell at much lower prices than the Russians. However, pumping like madmen (sorry, madpeople) won’t help at all, especially with steady demand decline and, in this year, with the additional demand shocks due to COVID-19 and the resulting recession.
Storing Oil Afloat Will Not Help
One of the first questions that popped up in the industry when the supply war broke out is: "who has tankers and storage available?" In 2016, there was approximately 1 billion barrels of oil in storage in tankers around the world. More recently, tanker rate have surged with the supply war as traders and producers charter tankers to carry to market and store this cheap bounty.
What will happen to oil prices when the cheap oil going into storage now gets released by traders when storage costs start to diminish profits? Once all available oil storage capacity is filled, the real price war will start. Woe to the trader who thinks that oil prices will recover in 6 months (Figs 2a and 2b), and woe to oil prices when traders start to dump oil from storage before they start losing money.
Will Shale Continue to Supply Oil to the World?
Some people curse tight oil while others are very grateful for it. Tight oil (shale oil) has been the number one reason for the tremendous increase in domestic oil production in the United States.
Global conventional crude oil plateaued in January 2005. This would prove to be a decisive turning point for the industrial ecosystem. Since then, unconventional oil sources like tight oil (fracked oil shale) and oil sands have made up the demand shortfall, where U.S. shale (tight oil, fracking with horizontal drilling) contributed 71.4% of new global oil supply since 2005.
But, and it's a big but, nobody is certain whether tight oil can indefinitely continue to produce at its current levels or how much more production can be squeezed out of the Permian basin in West Texas. The following figure is taken from the same Finnish report.
Tight oil supply may soon peak for the Permian basin in West Texas, and other tight oil formations may need to kick in to keep production levels high, but at what cost per well?
What Will be the Effect of Low Oil Prices on Shale or Oilsands?
Now that the oil supply war has started, and oil is being flooded on to the markets, oil prices have crashed to levels at which shale oil producers will find it difficult to remain solvent. But, while this may have been a tactical objective of the Russkies and Saudis, it will not be a strategic win. In the short term, yes, oil producers in West Texas and other shale basins will be under financial stress, and there will be some bankruptcies, consolidations and production cutbacks. Overlooked in Riyadh or Moscow is that for the long run, those shale (and oil sand) resources still remain. So, in the future, two things will develop:
If oil prices rise, then the flexible shale oil producers will come back onstream quickly. If oil prices remain low for a long time, the U.S will thrive with cheap oil form overseas. The worst thing for the Russians and Saudis, if they truly intended to knock shale oil out of the market, is that they will need to wait at least 2 or more years to do that because wells already drilled are just now coming on line, and their decline is at least 2 years out. If the oil supply war lasts for longer, then it is likely that some oil dependent nation states will fail (I'm looking at you Russia and most of the big OPEC producers). Furthermore, for how long will Russia and China continue to prop up Venezuela? Every ruble or yuan sent to Venezuela is a ruble or yuan thrown away.
Oil will also still come from Canada because the marginal cost of heavy oil production in Canada is around $25 / bbl, and Canadian producers have been very adept at staying afloat while WCS oil was selling at between $20 to $30 / bbl (and most recently at around $9 /bbl). On top of that, Canadian producers have been producing against a hostile government and an internationally funded campaign of climate wonks (extremists). The Canadian economy is not as diverse or resilient as the American, but as long as American thrives, Canada will survive and it could thrive a bit if the massive discount on WCS were overcome with access to deepwater ports.
Is Big Oil Still a Fiscally Sustainable Business?
Investors were already questioning the value of big oil before this oil supply war started. In the last quarter of 2019, most, if not all, major oil companies had significantly lower earnings. "A tipping point for the future of fossil fuels may have been reached this year as financial markets massively down-rated traditional energy companies, with their slumping share prices destroying "staggering" amounts of shareholder wealth."
A more careful financial analysis reveals that it is quite likely that most oil firms are now burning through financial reserves faster than they can replenish them. In essence we've got the technology to produce oil almost anywhere, even on Mars (if Musk would let us), but while oil companies historically worried about replacing produced reserves with new discoveries, now oil companies seem worried about supporting dividends with diminishing cash flows, while new reserve discovery and development appears to have becomes a secondary objective. Persistent oversupply yields low prices and low profits, which in turn leaves less cash available for capex investment in future production.
On top of the investors moving away from oil companies and projects, in some areas of the world the pressure to stop new investments or developments is unrelenting and growing: "Opening a new fossil fuel basin in the middle of our ocean was always madness," she said. "Moving to net zero emissions by 2050 means we must reduce pollution now, not give the green light to new polluting projects."
There still is plenty of conventional oil supply (including tight oil and oil sands already in production) to meet existing global demand and some near term demand growth (highly unlikely) for some time. Yet, big oil companies are still executing large projects with ambitious production targets in new frontiers but with higher risk of increasing pressure on oil prices, which could then result in additional and earlier than planned write-downs or large, expensive stranded assets. Something has to change to keep the oil businesses functioning because operating in a business-as-usual mode while trying to negotiate production cuts to support prices wasn't enough now and isn't going to be enough in the long run. Expecting oil demand to remain level, let alone rise, also isn't a viable strategy anymore.
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