The article below is an excerpt from our Q4 2021 commentary.
“The world has already passed ‘peak oil’ demand, according to Carbon Brief analysis of the latest energy outlook from oil major BP.”
Carbon Brief, September 2020
“IEA Boosts 2022 Crude Demand Forecast, Says Consumption Could Reach Record Level”
Natural Gas Intelligence, February 2022
“Some analysts have said that by the middle of the year unused capacity could be depleted.”
Reuters, January 2022
How could so many people get it so wrong for so long?
As we go to print, the International Energy Agency (IEA) has just announced the largest set of upward demand revisions in its history. For several years, we have discussed how the IEA chronically underestimates demand; these revisions suggest we were right. Despite the significance of the shift, most people were not even aware it took place. After a full decade of investor apathy (or outright hostility), it is difficult to change people’s minds.
What follows is a study of unintended consequences and the impacts of massive capital distortions. For nearly a decade, the energy industry has underinvested in its upstream business; it was naïve to think this wouldn’t have any impact.
Oil prices stand at eight-year highs, and we believe they are heading higher. How high could crude rally in this cycle? We would not be surprised if prices ultimately spiked to between $150 and $200 per barrel. Natural gas prices reached $300 per oil-equivalent barrel in Q4, and the fundamentals in the oil markets are as bullish, if not even more so.
Volatility will likely increase as well. Global inventories are at their lowest seasonal levels ever, leaving us extremely vulnerable to any supply disruption, just as geopolitical turmoil seems to be accelerating. OECD inventories peaked in the summer of 2020 at the height of COVID lockdowns at 4.8 bn barrels – 245 mm barrels more than normal for that time of the year. Inventories are currently down to 4.1 bn bbl – 327 mm barrels less than normal for this time of year. Relative to seasonal averages, oil inventories have never been lower in our dataset going back to 1995.
The headlines make it seem as though the current situation was entirely unforeseeable, but our readers know otherwise. In fact, most astonishing to us is how the current deficit unfolded in slow-motion over two years, receiving no attention from either investors or policymakers along the way. Oil prices have been rising steadily since April 2020 with only minimal short-term pullbacks. Nearly that entire time, the market has remained at near-record “backwardation” (future prices below spot prices); a key clue that physical markets were extremely tight. Inventories have been sharply and steadily declining for nearly two years. We estimate the oil market has been in outright deficit now since 2020 by over 1 mm b/d – the most pronounced and most sustained deficit in history. The fundamentals that led to the current deficit (strong demand and lack of capital spending) have been in place for over a decade.
Why were so few people prepared? Even now we do not think most investors understand the gravity of the situation. Things are about to go from bad to worse, yet the energy weighting of the S&P 500 is lower today than it was when COVID was first spreading in the beginning of 2020. Energy stocks make up 3.4% of the S&P 500 compared with 11% in 2014 (the last time oil prices were this high) and the record-high 33% set in 1980.
Whether you look at absolute prices, the backwardation, producer stock prices or inventory levels, all the normal market signals are screaming for more oil. This in turn requires more upstream capital spending. Unfortunately, ESG pressures are serving as a block, preventing capital from entering the oil market and preventing it from balancing. There is little relief in sight. Capital spending at the 100 largest energy companies in the S&P 500 topped out at $228 bn in 2014 and had already fallen by a third to $155 bn in 2019. The COVID-19 pandemic drove capital spending budgets lower by another 40% in a single year to $91 bn in 2020. With oil prices nearing $100 per barrel, energy capital spending is only expected to reach $98 bn in 2022 and $110 bn in 2023 – half the levels in 2014 the last time oil was above $90 per barrel. Companies talk about how they are listening to their investors and not investing capital in their upstream business. Clearly the market is not acting as though there is an acute oil shortage.
Today’s situation is the result of years of vehement rhetoric against the energy industry. Pundits have declared how oil stocks are the new tobacco stocks without the slightest understanding of complex global energy markets. Unfortunately, no one bothered to provide an equivalent Surgeon General’s report this time around.
Making matters worse, the agencies charged with providing reliable timely oil market data have done anything but. As we have discussed in our letters for years, the IEA chronically underestimates global oil demand, mostly from the non-OECD world. Their estimates of supply and demand rarely reconcile with observed inventory behavior, often by 1 m b/d or more. We refer to this discrepancy as the “missing barrels,” and we have explained that we instead believe they represent under-estimated emerging market demand. The IEA’s February 2022 Oil Market Report proves our analysis was correct.
In their report, the IEA revised non-OECD demand higher by nearly 1 m b/d every year going back to 2018. Beginning in 2010, the IEA has now underestimated global oil demand in 10 of 12 years (leaving aside 2020) by nearly 1 mm b/d each year on average. This is a systematic problem with their methodology and yet few people openly acknowledge the ongoing errors. As recently as 18 months ago, conventional wisdom held that 2019 would mark the all-time peak in global oil demand. Instead, 2022 demand will likely surpass the previous record with no signs of slowing down anytime soon. The IEA now expects global demand will reach nearly 102 m b/d in Q3 of 2022, three months earlier than even we had predicted. Given the IEA’s propensity to underestimate demand, the final number could come in even higher. Gasoline and diesel demand are setting new records around the world and even aviation fuel is back to pre-pandemic levels despite travel restrictions still in force (notably in Asia).
Many of our clients want to know about oil demand destruction. They want to know what oil price will impair global economic activity. This is a very difficult question to answer, but both history and theory can point us in the right direction. We have done a lot of work on the history of energy. Throughout most of human history, energy was provided by biomass with an EROEI of 10:1. This relatively low energy efficiency did not leave any surplus energy for growth. Neither GDP nor population grew until commercial coal deposits were developed in the seventeenth century (please see our video here to learn more). If an EROEI of 10:1 resulted in de minimis economic growth, what can we use this 10:1 number to infer about how high oil prices can go today? An EROEI of 10:1 means that 10% of all energy goes to sustain the energy supply. If energy is a good proxy for general economic activity, then an economy should stagnate once 10% of its GDP goes towards producing (and by extension consuming) energy. Evidence backs this up. Many academic studies suggest an economy will fall into recession once energy takes up 10% of total GDP – an empirical result that agrees with our theory.
In 2008, energy prices were approximately 10% of GDP right before the global financial crisis. If oil represents about half of all energy consumed, this means an economy will stall when oil represent about 5% of GDP. In 2008, the US consumed 18.8 m b/d. At $120 per barrel that equated to $823 bn or 5.6% of the $14.7 tr US GDP. The economy fell into recession shortly thereafter. In 2012-14, oil consumption never exceeded 3.5% of US GDP and prices stayed between $90 and $100 per barrel with no impact on either demand or economic activity.
Today, oil represents less than 3.3% of US GDP and would have to rise to $140 per barrel before approaching the critical 5% threshold. Why do we focus only on the US? Demand is the most elastic in wealthy countries with high energy intensities and the least elastic in developing countries that need energy to fuel their ongoing development. In 2008, prices spiked as high as $145 per barrel albeit temporarily. In this cycle, we believe oil prices will at some point reach, and potentially significantly exceed the previous $145 per barrel peak before we begin to see evidence of demand destruction.
Misconceptions abound on the supply side as well. Last year, analysts believed energy companies must forgo any further upstream spending lest they risk stranding their assets and impairing their capital. Now, Larry Fink and others admit that perhaps a dearth of capital spending may have negatively impacted global oil supply – an understatement if ever we have heard one. Even OPEC+ spare capacity, long seen as the bearish Sword of Damocles hanging over oil markets, is now being called into question -- something we have argued for a long time. In fact the only bright spot in 2021 oil supply was again the US shales.
We admit we were wrong about shale growth last year. We expected US production to be relatively flat but instead total liquids (including NGLs) grew by 1.4 m b/d between January 1st and December 31st 2021, driven mostly by the shales. In retrospect, we failed to appreciate the huge impact of drilled but uncompleted wells (DUCs). After prices collapsed in 2020 many shale producers postponed completing newly drilled wells to save costs. As prices recovered, they tapped into their inventory of DUCs. Last year, the average energy company completed two wells for every well drilled. Clearly this boosted production but DUC liquidation cannot go on forever. Our models tell us the aggregate impact of accelerated DUC completions boosted production by 1.3 mm b/d in December 2021 and that without the DUCs, supply would have been flat.
Most of the DUCs have been developed and are now in production. From a peak of 9,000 wells in the autumn of 2020, DUCs fell by half and today stand at 4,500. At the current rates, DUCs will be back to “normal” levels by March. Production will falter unless drilling activity picks up sharply from here, and permitting data tells us this will not happen. Remember, public company capital spending is only expected to rise 8% in 2022. Cost inflation is rampant in the oil patch and so current budgets do not leave much room for any increased drilling at all.
Before a company drills a well, it must apply for a permit several months beforehand. A pickup in permitting activity so far has been weak, suggesting an increase in drilling activity is not imminent. The most recent data for December 2021 shows new well permits unchanged from the six-month average. Therefore, drilling will likely not accelerate much from here before DUC inventories normalize in March. We will continue to monitor this closely, but as of now we believe shale growth will begin to stall sometime in Q2.
The IEA expects US liquids production (including NGLs) to grow by 750,000 b/d between January 31st and Q4 of 2022. Instead, our models suggest that at current rig counts and assuming one completion for every well drilled, production will only grow by 200,000 b/d from here. Please note that production did grow last year, and so even if production were flat from January 1st to December 31st 2022, year-on-year growth would still average 1.1 mm b/d because last year production ended above its year-long average level. Nevertheless, we think that incremental growth will be hard to come by going forward unless activity picks up measurably.
Production from the rest of the non-OPEC+ world continues to disappoint, just as we predicted it would. Over the last four months, the IEA has revised its non-OPEC+ ex-US estimates lower by nearly 300,000 b/d for 2022, very much in keeping with our models. Going forward this non-OPEC/non-US block will offer little in the way of new production. According to the IEA data, only Brazil is expected to grow production between January 31st and 4Q22 by more than 100,000 b/d. The only other source of expected growth is global biofuels, which given our concerns around agricultural output we expect will be revised lower.
Given our outlook for demand and non-OPEC+ supply, we continue to believe the call on OPEC+ crude will exceed its pumping capability in Q4. The IEA now makes the distinction between “spare capacity” and “rapidly available” spare capacity – which immediately calls into question the ability of the cartel to produce at the higher level. Our models tell us that only Saudi Arabia and the UAE have any material true spare capacity available. Iraq has 300,000 b/d of potential spare capacity, but it is contingent on improving security conditions. The most generous estimates assume Iran could increase production 1.3 m b/d from here contingent on a nuclear deal, which seems to be moving forward. As we wrote about in our introduction, we believe Russia has little room to grow production from here.
Another problem is depletion in the rest of the OPEC+ world. In January 2022, 10 of the 16 countries subject to production quotas were producing below their allotted limit. In aggregate, these countries missed their target by over 1.0 m b/d. Low prices have had an impact on OPEC+ reserves as well. No one has modeled ongoing OPEC+ disappointments which could further tighten balances.
Assuming Iranian volumes come back, Iraq boosts production and no other countries suffer unexpected outages (all very generous assumptions), we still estimate that OPEC+ spare capacity only amounts to 2.8 m b/d. Based upon our models, all of this capacity will be needed by the end of this year.
As far as we can tell we were among the first investors (along with Mike Rothman at Cornerstone Analytics) to make this call when we wrote about it in [3Q21] While more analysts agree with us today, few of them have thought through the implications. The truth is no one knows what will happen when we run out of spare pumping capacity potentially this year. During the two oil crises of the 1970s, OPEC maintained significant spare capacity. Even when prices ran to $145 in 2008, OPEC’s spare pumping capability was substantial. Never in the history of world oil markets have we been in this situation--- we are about to enter unchartered territory.
Ultimately, the oil market deficit will resolve once capital spending is allowed to increase to help offset declines and encourage production growth. Looking over the past decade, the cumulative E&P capital spending shortfall is likely in the hundreds of billions of dollars. Until this investment can be restored, the market deficit will likely remain acute.
We have argued for years that negative rhetoric and anemic spending would bring about an energy crisis, and we think that is now upon us.
Interested in reading more on this topic? Download our full Q4 2021 letter, The Distortions of Cheap Energy.