It was not so long ago that the shale industry was adding more supply to the global market than the global economy was able to absorb. Oil prices crashed in 2014 as a result and never came close to recovering to the levels we have seen in the 2010-2014 period. Before the COVID crisis slashed global oil demand this year, I did expect to see a significant rebound in global oil prices, in large part due to growing signs throughout last year that the shale boom was running out of steam.
Contrary to increasingly popular rhetoric, there was no evidence of peak oil demand occurring any time soon before the pandemic hit. As long as the global economy was expanding at a rate of 3% or more, the demand for oil was growing as well. Global supply growth prospects on the other hand were looking increasingly bleak, mostly due to the stall in shale production growth. Conventional oil supplies have stagnated for well over a decade.
It is assumed that the global economy will return to a trend of somewhat robust growth in the coming years, once the pandemic is brought under control. Shale supplies helped to fuel the last global recovery, by not only providing ample supplies but also keeping prices within a reasonable range. Although it should be noted that those prices proved to be inadequate in providing shale drillers with profits. The shale industry is unlikely to repeat that role this time around. It may in fact act as a brake on the expected recovery we are supposedly in for starting next year, as there is a real possibility that we may start to see a decline in shale oil production, even if oil prices will recover. The only way it can help fuel the global economic recovery this time around is if it will receive substantial financial support in some form.
Shale drilling decline predates the COVID crisis.
There is a somewhat distorted view in regards to when exactly shale drilling started to fade. 2019 was in fact a year of constant decline in shale drilling activities according to the Baker Hughes rig data.
Source: Trading Economics.
As the chart shows, the decline in rig activity throughout 2019 was a steady trend, despite oil prices averaging $57/barrel for the year, which was always cited as being a price level that can comfortably sustain the industry. The declining trend flatlined in the early months of 2020, but then drilling activities plunged in early spring as the COVID crisis started taking its toll on the global economy. The decline has now leveled off, and there have been modest gains in rig activity in the past few weeks. It is nowhere near enough however to bring drilling activities back to a level that will at the very least ensure steady shale production for the longer term.
Looking at the chart, we see that after the 2014 oil price collapse, we also experienced a dramatic decline in drilling activity in the US. As prices rebounded, there was a rebound in drilling, but it never recovered to the levels we saw before 2014. Despite that, we saw record gains in production growth in the years that followed the oil price recovery that started in 2016. The reasons for it were two-fold.
First of all, many of the rigs that were never brought back into action were the older, less profitable ones. Second, rigs that were brought back to drill in the shale patch were employed mostly in the first tier acreage of the fields. By then enough drilling had occurred for the industry to have a very good grasp in regards to where the best drilling spots were to be found. The combination of the two factors created a false but overwhelmingly dominant narrative about shale industry efficiency gains which is still assumed to be a dominant factor for the future.
It is important to understand the gravity of the decline in rig activity we are seeing and what it means for the shale industry. We will not see the same bump in production that we saw after the 2016 oil price bottom, as rig activity will never recover to previous levels. We cannot see any further drilling consolidation into prime acreage drilling, because there is no significant second-tier acreage that is being drilled. Also, the pad drilling innovation is all played out, while I am not sure how much the further deployment of longer laterals can provide in terms of shale economics. As for the current rate of drilling, production is on a declining trend, even as DUCs are being drawn down, meaning that the gap between how much drilling is taking place and what is needed just to keep production flat is significant.
Source: EIA.
Source: Opec.
I should note that a number of factors helped to distort what would have been a natural decline curve for the shale industry, including a move by shale producers to shut in production in response to low oil prices and an agreement between Saudi Arabia, Russia, and the US to temporarily cooperate on removing some supply from the market. Now that most distortions, including temporary production losses from hurricanes are starting to fade, we are still left with a deep decline in production, somewhere in the 2-2.5 mb/d range based on the latest weekly EIA provisional numbers.
Energy demand to surge next year, while shale will continue to struggle. Significant energy cost increase likely to happen by end of next year, unless the global economy will continue to struggle.
Even though global energy demand has been rebounding from the lows experienced in the second quarter, there is still a long way to go until we will reach energy demand levels at pre-crisis levels.
Data source: OPEC
In 2019, global oil demand averaged just under 100 mb/d. Even by the fourth quarter of 2021, demand will still be shy of the 2019 average by about 1-2 mb/d. Assuming that US shale production will not recover from current rates of production, it will mean that the shale factor alone will have the global supply/demand situation in balance. We should keep in mind that oil industry under-investment is now occurring all over the world, given the price shock that was inflicted by the virus crisis. By this time next year, most of the industry across the world will probably experience production constraints due to underinvestment. In other words, there will be a lack of new wells in existing fields meant to make up for natural decline from old fields. There will be a lack of projects such as water injection wells meant to stimulate falling production.
It is important to highlight the lack of new global conventional oil & gas discoveries that have not been adequate in terms of replacing yearly production volumes year after year for most of this century so far.
Source: Statista
The world is currently producing about 25 billion conventional barrels of oil per year. The total tally of recoverable discoveries in the 2011-2018 period as presented in the chart above is 64 billion barrels. Given that about 200 billion barrels were produced during the same period, it means that about 136 billion barrels more were produced than were discovered, for an average of about 14 billion barrels per year. Looking at just the years since 2015, the average becomes about 19 billion barrels per year that are produced each year and not replaced by new discoveries. Given these facts, it stands to reason that we may see a permanent decline in global conventional oil production capacity any time now.
A tightening supply/demand situation for oil and other crucial commodities, combined with loose monetary policy around the world can combine to trigger a bull market in commodities.
A tightening supply/demand situation would ordinarily be nothing to fret about. It happens all the time and any small deviation from a balanced market can lead to oil prices either plunging or spiking. The resulting price changes tend to signal to the industry to either increase or decrease upstream CAPEX, which leads to a classical market readjustment. OPEC has been careful most of the time to either increase short-term production by employing its limited spare capacity or cut production slightly in order to prevent prices from cratering.
We saw what happened back in 2007-2008 when Saudi Arabia failed to come up with the spare capacity needed to cover the widening gap between global supplies which stagnated and growing demand. In the end, oil prices spiked towards $150/barrel and the near-collapse of the global financial system was the factor that finally put an end to the oil price spike.
That last oil price spike which set an all-time record for oil prices came in the late stages of a recovery, within the context of tightening monetary policy. If there will be a supply shortage starting perhaps as early as this time next year, it will come within the context of a global economy that is stuck in a low-interest debt trap. In other words, there will be very little that central banks will be able to do in order to help slam the brakes on out of control commodity price spikes.
All the extra money that has been printed in order to help keep us economically afloat this year will be sloshing around within the financial system and it will chase anything that will show any sign of scarcity, therefore we can expect to see a super spike in oil, and perhaps other commodities, which will help ignite inflation throughout the economy.
Higher oil prices will not help to stimulate an increase in conventional oil production capacity, but there are people who hope that in the event of an oil price spike the shale industry will respond by increasing its drilling activities substantially, which would, in theory, start providing the market with additional barrels within months. The reality however is that the shale industry is being decimated by the current crisis. A report by CNBC suggested that as much as $300 billion in shale assets were set to be written down in the second quarter of this year. In other words, with WTI oil prices averaging just under $28/barrel for the quarter, $300 billion worth of shale assets were deemed to be worthless.
What this means is that shale companies cannot be considered to be credit-worthy if we are to assume a volatile oil price environment in the coming years, where perhaps we might have oil price spikes, which will be followed by a dramatic crash in prices. If the viability of these companies is not seen as a given, then it is safe to assume that it will be hard for them to come up with the cash needed to drill.
Even if cash were to be made available to shale drillers by the market, we are now increasingly dealing with a situation where prime drilling acreage is considered to be scarce and oversaturated with existing wells. Second-tier acreage is still plentiful, and at a certain oil price point it could be considered viable, but I doubt too many companies want to risk exposing themselves to the risk of assuming the risk of drilling such wells based on the assumption of a sustained increase in oil prices. A shale well can take years to pay back all drilling costs and second tier acreage tends to be especially hard to profit from, while an oil price spike can easily give way to a crash in prices.
I do believe that at some point we could see a non-market intervention meant to stimulate shale production, in the interest of avoiding a potential economic catastrophe caused by global oil shortages. This however depends very much on the political trend that will be set by the upcoming election in the US. The government could alternatively find ways to funnel money to the shale industry through the voluntary participation of the private sector.
In other words, work with financial institutions to get funds to the shale industry when an increase in oil prices occurs, in order to prevent a derailment of the global economy. The government would of course offset the resulting losses to financial institutions through concessions on taxes, regulations, or other concessions.
As crazy it may seem for such things to be even contemplated, the reality is that there may be no other way to ensure that an oil price spike will not derail the coming global economic recovery. During the 2008-2019 period, WTI oil prices averaged just under $74/barrel, and yet the industry ended up spending about $280 billion more money than it made in the shale patch, based on some estimates. The fact that some investors and institutions will be left holding the bag was something I have been saying since 2015, starting with a series of articles I wrote which looked at the shale well economics of a number of companies, entitled “Economics Of A Shale Well.” I wrote some articles about shale profitability before that, but none were as detailed and revealing about the true nature of shale.
As I pointed out then, there were plenty of shale projects which did not seem to be profitable, assuming a long-term price of $70/barrel. It turns out that I was right, which is why I continue to be baffled by the huge sums of money that continued to flow into the industry, far beyond the point when I thought it should have been plain to see that it was a money pit. It left me wondering whether there was more to it than just misguided investors and institutions pouring money into a money-losing industry. Regardless of whether it was the case or not in the past, it seems increasingly clear that we will need to see some targeted, non-profit-driven flows of money into this industry if we are to see some supply relief whenever demand does pick up again.
It remains to be seen whether that will happen or not. Currently, political winds are shifting in the opposite direction, where the prospects of an oil price spike are seen as an opportunity to further promote a shift away from oil. There is of course always a chance that government actors will funnel funds to the shale industry if need be through more stealthy avenues, even as they continue to maintain a position that is officially hostile towards the shale patch. If such an intervention will not occur, the economics of shale drilling will not produce the relief from supply shortages that we may start to experience as soon as a year from now, if the global economy will experience a strong rebound. If this is the case, the global economic rebound will be very short-lived.
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