Stop Expecting Oil and the Economy to Recover

Global oil markets are on the cusp of something.

Nafeez Ahmed says that the oil age is coming to an end.

The oil industry is on the cusp of a process of almost total decimation that will begin over the next 30 years, and continue through to the next century.

Nafeez Ahmed, Director Institute for Policy Research & Development

Goehring and Rozencwajg say there’s not nearly enough oil to meet demand and that a global energy crisis is imminent.

“We are on the cusp of a global energy crisis…Global energy markets in general and oil markets in particular are slipping into a structural deficit as we speak. We believe that energy will be the most important investment theme of the next several years and the biggest unintended consequence of the coronavirus.”

Goehring and Rozencwajg

They are both partly right but miss the larger point namely, that it is unlikely that either oil supply or demand will ever return to 2018 levels.

World Oil Growth is Dependent on U.S. Tight Oil

U.S. oil production fell -2.72 mmb/d (-21%) from 12.7 to 10 mmb/d from March to May as oil prices collapsed (Figure 1). It recovered to 11.36 mmb/d in June as shut-in wells were re-activated. EIA expects output to average 11.2 mmb/d in the second half of 2020 and 11.1 mmb/d in 2021.

That is impossible.

Figure 1. U.S. oil production fell -2.72 mmb/d (-21%) from 12.7 to 10 mmb/d from March to May.
It recovered to 11.36 mmb/d in June as shut-in wells were re-activated.
Output expected to average 11.2 mmb/d in 2H 2020 and 11.1 mmb/d in 2021.
Source: EIA 914 and Labyrinth Consulting Services, Inc.

During the last oil-price collapse in 2015 and 2016, U.S. output decreased 1.12 mmb/d over a period of eighteen months. This time, a much larger decline has taken place over a period of just a few months.

Goehring and Rozencwajg are correct that tight oil is crucial to world supply growth and that the best parts of those plays are fully or nearly full developed.

U.S. tight oil accounted for 83% of growth in world production over the decade 2009 to 2019 (Figure 2). Deep water and oil sands were the other growth area at 23% while conventional production declined 9% over the same period.

World crude and condensate production fell an astonishing 10.8 mmb/d from 82.5 to 71.7 mmb/d from April to June of this year. About 30% of that decline was from U.S. output and a little more than half of the U.S. decline was from tight oil.

Figure 2. U.S. oil production fell -2.74 mmb/d (-21%) from 12.7 to 10 mmb/d from March to May.
It recovered to 11 mmb/d in June as shut-in wells were re-activated.
Output expected to be flat through 2021 from 10.5 to 11 mmb/d.
Source: EIA 914 and Labyrinth Consulting Services, Inc.

Tight Oil Rig Count and Oil Production

Rig count is a good way to predict future oil production as long as the proper leads and lags are incorporated.

It takes a month or two between increased oil price and a signed rig contract. It takes another 5 or 6 months to drill and complete all the wells on a drilling pad. It then takes another 5 or 6 months from first production before new wells offset declining output from older wells. Add it all together and it takes at least a year between an upward price signal and enough new production to maintain or increase output.

Twelve-month lagged tight oil horizontal production reached 7.28 mmb/d when the rig count was 613 (Figure 3). That corresponded to 12.9 mmb/d of U.S. oil production (tight oil is about 53% of total U.S. output). The EIA forecasts about 11 mmb/d of output through 2021. Approximately 450 rigs are needed to maintain that level but the July tight oil rig count was 147, about one-third of the number needed to maintain 11 mmb/d.

Figure 3. Tight oil output may decline to 3.5 mmb/d & U.S. to 6.5 mmb/d in Q3 2021
Tight oil rig count is 147, 32% of 450 rigs needed to maintain
5.5 mmb/d tight oil/11 mmb/d total U.S. output.
Source: EIA, Baker Hughes and Labyrinth Consulting Services, Inc.

It is, therefore, inevitable that production will fall. The considerable lags and leads mean that production decline cannot be expected to reverse until well into 2021 assuming that large numbers of rigs are added immediately. That won’t happen because of constrained budgets and low oil prices. Based on rig count analysis, U.S. oil production will probably be about 6 mmb/d by mid-2021 or less than half of peak November 2019 levels.

This is why EIA’s production forecast is impossible. It does not acknowledge that production cannot be maintained without drilling new wells to offset legacy well declines.

What about DUCs (drilled, uncompleted wells)? The DUCs drilled before 2015 will never be completed because they were questionably commercial at $100/barrel oil prices. Many remaining DUCs are part of the 12-month delay from well spud-to-production. Nor is completing DUCs free. Completion accounts for roughly half of total well cost.

Supply and Demand: Two Parts of a Single Whole

Goehring and Rozencwajg believe that we are on the cusp of a global energy crisis because of the depletion of U.S. tight oil plays. They are right but are not paying enough attention to demand. Ahmed believes the oil industry is dying a slow death because of decreasing demand. He is right about lower demand but is not paying enough attention to supply.

Supply and demand are two parts of a single whole.

World liquids supply has fallen 9.5 mmb/d in the first half of 2020. Demand has fallen almost 19 mmb/d for a supply-demand surplus of almost 9.5 mmb/d (Figure 4). That is precisely why oil prices remain range-bound in the $40 range. A big drop in supply only results in an energy crisis if demand recovers to 2019 levels.

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Figure 4. OPEC-EIA* expects a supply-demand deficit for 2H 2020 through 1Q 2021
but a supply-demand surplus for the last 3 quarters of 2021.
-9.1 mmb/d demand growth and -6.1 mmb/d supply growth in 2020.
Source: OPEC, EIA and Labyrinth Consulting Services, Inc.

The integrated OPEC-EIA data shown in Figure 4 indicates a V-shaped demand recovery in the third quarter of 2020 with a lagging recovery in supply. I don’t believe that either forecast is likely but let’s put that aside for now so we can understand the best-case outcome.

A huge supply surplus in the first half of the year is expected to give way to a smaller yet significant supply deficit in the second half. A 2.25 to 2.50 mmb/d supply deficit in the second half of the year is not an energy crisis but it does suggest higher oil prices are ahead.

The OPEC-EIA model suggests approximate market balance in early 2021 followed by a substantial surplus during the rest of the year. That is hardly a death knell for the oil industry but it does suggest lower oil prices are ahead.

Where is the crisis for either supply or demand?

To be fair, I’m sure that Goehring and Rozencwajg, and Ahmed would say that they are thinking farther into the future. Their models assume some version of business-as-usual but I don’t think there is anything usual about the either the present or the future. The world has changed but paradigms change slowly.

Stop Expecting Oil to Recover

Many believe that oil markets are recovering and will return to normal sooner than later. I’m not sure that normal applies to oil markets but let’s look at the facts.

August average WTI price of $42.88 is less than the 2003 average inflation-adjusted price of $43.54 and, of course, every one of the sixteen succeeding years (Figure 5). That is hardly an impressive recovery.

Figure 5. August 2020 WTI price of $42.88 has recovered almost to 2003 CPI-adjusted price of $43.54
but is lower than average price of each of 16 successive years.
Source: U.S. Bureau of Labor Statistics, EIA and Labyrinth Consulting Services, Inc.

Figure 6 shows U.S. supply, demand and supply-demand balance. Supply has been trending lower since late 2018 except for the early 2020 spike that resulted from shutting in production with collapsing consumption and limited storage.

Although demand has recovered from early May low levels it appears to be turning downward now and is, in any case, far below levels for the last 12 months. Again, not a great recovery.

Figure 6. U.S. oil supply is falling and demand is flattening and beginning to decline.
Supply and demand may remain in balance
as long as supply and demand move in tandem.
Source: OPEC, EIA and Labyrinth Consulting Services, Inc.

U.S. refined product consumption has recovered only to 62% of its 5-year average (Figure 7). Gasoline has recovered to 81% of 5-year average and diesel to 84% of 5-year average. Kerosene Jet has only recovered to 34% of 5-year average.

Figure 7. U.S. refined product consumption has recovered to 62% of the 5-year average.
Gasoline has recovered to 81% of 5-year average and diesel to 84% of 5-year average.
Kerosene Jet has only recovered to 34% of 5-year average.
Source: OPEC, EIA and Labyrinth Consulting Services, Inc.

The recovery is not going all that well but history tells us that is what we should expect. It took 4 1/2 years after the 2008 Financial Collapse for U.S. refined product use to recover (Figure 8). The magnitude of the 2020 consumption collapse is far greater than in 2008 so why should this recovery be any faster?

Figure 8. We should stop expecting oil consumption to return to normal.
It took 4.5 years after 2008 Financial Collapse for U.S. refined product use to recover.
The magnitude of the 2020 consumption collapse is far greater than in 2008.
Source: OPEC, EIA and Labyrinth Consulting Services, Inc.

In fact, the only thing that justifies calling what is happening today a recovery is the presumption that things can’t get any worse than they were in April. That presumption is probably wrong.

The Great Simplification

Energy is the economy. Money is a call on energy. Debt is a lien on future energy.

What is happening to oil markets and to the global economy is not because of a virus. The virus greatly accelerated what was already happening. Things won’t go back to normal when the virus ends.

The expansion of energy and debt have been leading toward some sort of reckoning for at least the last fifty years. That day of reckoning has been brought forward by coronavirus economic closures.

Oil prices had averaged $25 per barrel from the end of World War II until 1974 when average prices doubled (Figure 9). From 1979 through 1986, oil price soared to an average of $86 per barrel. These massive economic dislocations resulted in use of debt to maintain economic growth.

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Figure 9. High oil prices resulting from oil shocks of 1974-1986 led to widespread use of debt to maintain economic growth.
Source: EIA, Bureau of Labor Statistics and Labyrinth Consulting Services, Inc.

Excessive debt was the leading cause for the Financial Collapse of 2008. The crisis was resolved with more debt and monetary policies that ushered in the present era of central bank primacy in the world financial system.

Quantitative easing, near-zero interest rates and high oil prices led to the first wave of the tight oil boom. Over-investment resulted in over-supply and price collapse in 2014. By February 2016, WTI price reached $33 and investors rushed in to support the second wave of the tight oil boom.

WTI reached $72 by mid-2018 but by then, investors had begun to abandon tight oil as well as oil companies in general. The coronavirus economic closure brought monthly average prices to $17 in April, 2020—the lowest month on record. Unlike early 2016, investors weren’t writing any checks this time.

U.S. production may be 50% lower by mid-2021 than at year-end 2019. The implications for U.S. geopolitical power and balance of payments are staggering. It seems likely that the economy will weaken as government support for the unemployed decreases

I doubt that we are on the cusp of either a global energy crisis or the end of the oil age. It is more likely that both supply and demand will fall in tandem as the global economy contracts.

These observations are at odds with the mainstream view that both supply and demand are recovering. Some might concede that I am correct for the present but that things will improve and return to normal although it may some time.

Figure 10 shows credit growth and credit impulse for the United States from 1960 through the first quarter of 2020. Credit impulse is the change in flow of credit (debt) relative to economic activity (GDP).

Spikes in credit impulse correlate well with the oil-price shocks of the 1970s and 1980s. The extraordinary U.S. comparative inventory drawdown of early 2017 through the second quarter of 2018 also corresponds to credit impulse anomalies.

Figure 10. First quarter 2020 increase in U.S. credit impulse* was greatest on record
First quarter credit growth was greatest since 1984.
Source: EIA, Bureau of Labor Statistics and Labyrinth Consulting Services, Inc.

The chief feature of Figure 10, however, is that the magnitude of the first quarter 2020 credit impulse was more than twice as large as any previous increase. Moreover, GDP growth was either neutral or positive during previous spikes but was negative (-10%) for the first quarter of 2020. Also, oil prices were increasing during earlier periods but prices were decreasing in early 2020.

Ilya Prigogine was a chemist who won the 1977 Nobel Prize for his work on dissipative structures and self-organization. Dissipative structures are physical systems that release considerable heat as they consume ever-greater energy to support their growth and increasing complexity. A crisis occurs when growth can no longer be supported by available energy resources. The system either collapses or spontaneously re-organizes itself into a simpler form that uses less energy.

Empires, organizations and economies are dissipative structures. So is the human brain.

My friend Nate Hagens has applied some of Prigogine’s ideas to his own research about world energy, economics and ecology. He believes that we are on the cusp of something quite different from the scenarios suggested by Ahmed, and Goehring and Rozencwajg.

Hagens predicted a global economic decline in the 2020s and publicly expressed that opinion before the Covid pandemic. The main reason for decline, he stated, was too much debt undertaken to continue consuming and growing the economy. The virus has accelerated its timing and may result in contraction greater than the 30% drop during the Great Depression.

The Great Simplification will occur when the credit-supported part of the economy is removed. Economic activity will contract and less energy will be needed because it will be increasingly unaffordable to many parts of the population. People will be forced to adjust living standards downward and self-organize around energy with greater emphasis on local supply chains and regional economies.

I expect that the mix of energy sources will be similar initially. That will probably change as declines to meet the decreased carrying capacity of a society deprived of fossil energy productivity. Then, I imagine the world will move increasingly toward lower productivity energy sources like wind and solar. A viable economy may very well be created based heavily on wind and solar. It will, however, support a much poorer world than we have known for many decades in the world’s advanced economies.

Most ideas and analyses about future trends in energy and the economy fail to recognize that they are the two aspects of the same thing. That is why they are so far off the mark. This basic misalignment is painfully obvious because the energy sector represents only 2.5% of the S&P 500 valuation but underlies probably 95% of U.S. GDP.

That is what Hagens calls energy blindness.

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