The article below is an excerpt from our Q2 2022 commentary.

"The Kingdom has announced an increase in its production capacity level to 13 million bpd, after which the Kingdom will not have any additional capacity to increase production.”
~ Crown Prince Mohammed bin Salman, July 18th, 2022

Macron said that MBZ, as the UAE leader is known, “told me two things. ‘One, I am at maximum’ oil output levels, amounting to the UAE’s ‘complete commitment’ in this area,” Macron said. “Second, he told me the Saudis can increase a little bit, about 150,000 barrels a day or a little more,” he added. “They don’t have huge capacities” that can be activated in less than six months.
Bloomberg, June 27th, 2022

We are out of spare capacity.

Were Matthew Simmons alive today, he would certainly be taking a victory lap. The late investment banker turned author wrote Twilight In the Desert in 2005 in which he argued that Saudi Arabia had little remaining spare capacity. Simmons based his argument on dozens of Society of Petroleum Engineers (SPE) and industry white papers. At the time of its publication, Saudi crude production averaged 9.6 m b/d.

For years, Saudi Arabia maintained it could sustainably pump 12.2 m b/d. In May of 2020, at the start of the great price war with Russia, the Saudis managed to supply 11.5 mm b/d, although we believe this was sourced from a combination of production and inventory drawdowns. Other than this one month, supply has never exceeded 10.6 mm b/d.

The Saudis’ maximum productive capacity has been a closely guarded state secret that remains highly contentious to this day. The question has never been more relevant as demand is now approaching global pumping capability. Back in our Q2 2021 letter, we made a bold prediction that OPEC’s spare capacity was significantly lower than official published figures. Since then, the OPEC-10 countries have failed to produce even the amounts proscribed in the COVID-coerced quotas of April 2020. In June 2022, the OPEC-10 countries produced a full million barrels per day below their allocated quota – something we have never seen before. Even Saudi Arabia is now producing 60,000 b/d below its allotment.

As demand approaches pumping capability, the issue of Saudi Arabia’s capacity becomes more and more critical. Can the Saudis pump 12.2 mm barrel per day -- their stated claim? Is it reasonable to expect that at some point soon they can reach 13 mm b/d -- a goal they have again recently reiterated? Today the Saudis are pumping almost 10.8 mm barrels per day, and their 1.4 mm barrels of stated excess pumping capability is the largest within OPEC, but does this spare capacity really exist?

We have written about Saudi Arabia’s oil reserves multiple times over the last seven years, and most recently in 2019. In two extremely detailed pieces which appeared in our Q1 and Q2 letters of 2019, we focused on the mystery surrounding Aramco’s proved reserve figures. According to theories made famous by King Hubbert, Shell’s pioneering petroleum engineer during the 1950s and 1960s, an oil field will reach its peak production level once half of its total recoverable reserves have been produced. Many fields including the North Sea, Cantarell, Samotlor and US conventional production have all exhibited perfect “Hubbert Curves.” The key to understanding the Saudis’ production capability rests in understanding what their total recoverable reserves are. Once you have confidence in that figure, it is likely that production will plateau and decline once half of those recoverable reserves are produced. Saudi Aramco has not released an audited reserve report in over 50 years, and given the controversy surrounding their size, it was impossible to predict when half the total reserves have been produced.

Aramco issued bonds in 2019 and released an updated reserve report for the first time in 50 years. However, the report audited by the reputable Houston-based DeGolyer & MacNaughton raised more questions than it answered. For example, while Aramco listed 260 bn bbl of remaining reserves, the independent DeGolyer & MacNaughton audit confirmed only 160 bn bbl of remaining reserves. 45 bn barrels of reserves were contained in fields too small and remote to be independently verified, according to a disclosure in the Aramco bond prospectus, and an additional 55 bn barrel of reserves were expected to be produced after the concession was returned to the Saudi Government in 2077 -- these reserves were also not audited. Considering the huge controversy surrounding this 260 bn reserve figure, we clearly thought the Saudis would have wanted to put this issue to rest once and for all. We can only ask why DeGolyer & MacNaughton was unable to audit and confirm the full 260 bn bbl figure.

To date, Saudi Arabia has produced approximately 174 bn bbl of oil. Aramco has long maintained their remaining reserves total 260 bn bbl, suggesting total recoverable volumes of 455 bn bbl, of which only 40% have been produced and 60% remain. If this is correct, then Saudi Arabia can easily increase production to at least 13 m b/d for many years before production peaks.

However, as we discussed in our 2019 commentaries, remaining Saudi reserves are most likely only 185 bn bbl and not 260 bn bbl. If our modeling is correct, then total recoverable reserves are only 360bn bbl, of which almost 48% has now been produced. If the Saudis continue pumping 10 mm bb/d, total production will surpass 50% of recoverable within eighteen months.

If our calculations are correct, Saudi production is plateauing as we speak. Confirming our suspicions, Aramco released important data on the Ghawar field back in 2019. Ghawar, by far the world's largest oil field, has produced nearly 5.5 mm b/d since the early 1970s. Data in the 2019 prospectus admitted that Ghawar was now producing only 3.3 mm b/d -- down almost 35% from its peak. We visited the field in 2004 and in a letter to investors we estimated (using a “Hubbert Linearization”) that 50% of Ghawar’s reserves had already been produced. We projected that production would decline to 3.3 to 3.5 mm b/d by 2020. The data released in the 2019 prospectus confirmed exactly our 2005 analysis.

Assuming Ghawar has approximately 135 bn barrels of recoverable oil and that 62% of those reserves have now been produced, we calculate the field is now declining between 250,000 to 300,000 b/d per year. In just four years, Saudi Aramco will have to develop 1 mm b/d of new production, just to offset Ghawar’s declines.

Instead of being able to grow production to 13 mm b/d, it is now becoming ever more difficult for the Saudis to even sustain current pumping levels of 10.5 mm b/d.

Following the release of the Saudis reserve data in 2019, we concluded that only time would confirm the accuracy of our analysis regarding the true state of Saudis remaining spare capacity. That time is now.

On June 27th while attending the G7 summit, President Macron was overheard on a “hot microphone” pulling President Biden aside to tell him that he just spoke with Sheikh Mohammed Bin Zayed (MBZ) of UAE who claimed that neither the UAE nor Saudi Arabia had the ability to add material crude volumes to global markets.

This dramatic event received little attention apart from energy analysts, but its implications are huge. If indeed Saudi Arabia is at or near its maximum production -- as predicted in our 2019 analysis -- then the world is on the verge of running out of spare pumping capacity for the first time in history.

A few weeks after the G7 incident, President Biden traveled to Saudi Arabia to meet with Crown Prince Mohammed bin Salman (MBS) to discuss increasing crude production. Although the talks themselves were private, the messaging was clear that Saudi would not be materially increasing production to alleviate the ongoing energy crisis. Following the meeting, MBS made a dramatic announcement at a press conference. Between now and 2027, MBS stated that Aramco could increase its “productive capacity” from 12 to 13 m b/d, but following that, no expansions would be possible. Although in theory, this announcement increased Saudi’s spare capacity, the underlying tone emphasized Saudi’s limited ability to grow.

The energy community continues to believe both Saudi Arabia and the UAE have 2.4 mm b/d of spare pumping capability; however, President Macron and MBZ’s comments suggest that this excess pumping capability doesn’t exist. As we move into the seasonally strong second half of 2022, with Russia’s invasion of the Ukraine showing no signs of abating, the risk of a major crude price spike has increased as global demand approaches total global pumping capability.

These announcements could not come at a worse time for global energy markets. Oil demand is running very strong while supply continues to disappoint, leaving inventories at their lowest levels since 2007, just before the huge price spike. Normally, oil inventories build over the first six months of the year by 400,000 b/d and then draw by the same amount over the last six months. With data now mostly in, OECD inventories only built by half the normal rate during the first half of 2022. While this in and of itself suggests a notable deficit, what’s shocking and important to note is governments have released 700,000 b/d on average from their combined strategic petroleum reserves (SPR). Without the addition of these SPR releases, which started in March, OECD inventories, instead of building by their normal 400,000 b/d would have drawn by 500,000 b/d. Unsustainable SPR releases are the only thing keeping inventories from steeply declining and price from rising sharply. The world has now developed a very unfortunate addiction to SPR releases – one that will be painful to break.

The second half of 2022 will be crucial. As discussed, the second half is a period that normally sees inventory draw 400,000 b/d. Furthermore, as Russian oil sanctions loom, refiners and traders will look to buy more than they normally might, given the potential disruption. Lastly, SPR releases will eventually need to come to an end, leaving the market dramatically tighter. Both US and broader OECD inventories, even with SPR releases, remain at levels not seen 2007. Any buffers against unexpected supply disruptions have been removed.

Supply and demand trends also point to a dangerously tight second half. Demand is running very strong as lockdowns abate and the world resumes traveling. As we have discussed in past letters, the IEA continues to chronically underestimate demand. Over the past few months, they have been forced to revise historical 2021 demand higher by 1.1 m b/d – a record. Oddly, the IEA did not feel the need to revise 2022 demand higher. In fact, since first making their prediction for 2022 last summer, the IEA has revised demand lower by 300,000 b/d. By increasing demand in 2021 and reducing it in 2022, the IEA has cut its year-on-year growth estimates in half – something we are not at all observing in the market data we look at.

As actual data has trickled in for the first six months of the year, demand appears to be running far higher than the IEA’s expectations. Perhaps realizing this, the IEA has increased its first half figures while shunting even greater downward revisions into the second half of the year. Even after doing so, the IEA maintained a balancing item in the first half of 700,000 b/d – suggesting demand continues to run even stronger than reported.

Recent weekly data suggests gasoline demand in the US has finally weakened in response to higher prices. Quite frankly, our models tell us that some level of demand destruction is necessary to balance markets going forward. This will a trend we will watch closely, but as of now global demand remains very strong.

Turning to supply, it is difficult to see what will drive production growth over the next several months. With every major oil company having reported second quarter earnings, not a single large-capitalization producer met production expectations. Companies continue to prefer returning capital to shareholders in the form of dividends and buybacks over increasing activity. Labor and equipment shortages are now common throughout the industry and many of the previous workers have left the industry for good.

Shale per-well productivity remains flat over the past several months, suggesting the industry is no longer able to further “high-grade” the basins and making it difficult for companies to quickly boost production without more drilling.

The rig count has increased noticeably over the past several months, although this trend now seems to have flattened out (perhaps reflecting the bottlenecks mentioned above). Between October 2021 and June 2022, the US oil directed rig count increased by 40% to reach 600 rigs. Although a 40% increase in nine months is material, we should highlight several important points. First, the rig count today remains 100 rigs below the pre-COVID level, 300 rigs below the 2018 highs, and 1,000 rigs below the 2014 highs.

Second, the sharp reduction in drilled but uncompleted (DUC) inventory is finally having an impact. During the COVID pandemic, when prices fell to negative $37 per barrel, many oil companies chose not to complete their drilled wells. As prices recovered, these wells have been brought online adding to production growth. At the worst, there were two shale wells being completed for every well drilled. At the end of 2021, we predicted that the DUC inventory would cease being a source of excess incremental supply sometime in 2022 and that appears to have happened.

Over the past three months, the industry completed 1.05 wells for every well drilled compared with 1.4 wells in the three-month period ending October 2021. As a result, although the rig count and number of drilled wells have both grown by 40%, the number of completed wells has declined. Between the flat to down per-well productivity, the bottlenecks, and the DUCs going from tailwind to headwind, we believe the US shales will have a difficult time showing much growth going forward.

The second half of this year continues to be the most critical. Given the looming Russian sanctions due to take hold at the end of the year, the inability of OPEC+ to quickly add production, strong (and understated) demand, and difficulties in the shales, we believe we will see material inventory drawdowns between now and year end. Inventories are now so depleted that we are at risk of a major price spike, especially if global demand pushes through global pumping capability as some point this fall.

We leave you with this thought. Following the dual oil crises of the 1970s, the United States, among others, established their strategic petroleum reserves. The reserves were meant to protect against sudden unexpected supply disruptions, but they had a secondary feature as well. Having a strategic reserve made it difficult for aggressive states to threaten supply disruption as a weapon -- the so-called “oil sword.” The thinking went that for a bad actor to truly threaten the OECD countries, they would have to not only disrupt crude oil production but maintain that disruption for a long enough period to fully deplete the SPR. The former is frighteningly easy to do, while the second is much more challenging. For the past fifty years the strategy was successful and the “oil sword” remained sheathed.

Today, given their drawdowns, commercial and SPR inventories are at their most vulnerable point since the 1970s. Our modeling of supply and demand suggests that this tightness will only get worse from here. What is to stop a “bad actor” state from pursuing disruptive actions? Remember it was only three years ago that rebel forces attacked infrastructure in Saudi Arabia that knocked out almost 4 mm b/d of production processing capability for several months. Oil prices initially spiked 10%, however, because of a big global inventory cushion and the knowledge that large amounts of oil could be quickly released from the SPR, price quickly retreated. Today, with inventories the lowest they have been since 2007 and with an SPR that is becoming more and more depleted by the day, such an action would have an immeasurably greater impact.

We are running out of spare capacity -- a situation that has never existed in 160 years of oil market history. Upside pressure on oil prices is getting greater and greater. We remain extremely concerned about the second half of the year and are maintaining all our oil investments.

Intrigued? We invite you to revisit our entire Q2 2022 research letter, Why Resources During a Recession, available below.