Why oil prices are going up – and will continue to go up

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Platform moored in Mossel Bay, South Africa, June 2015, after production was halted due to fall in oil prices (photo Tim Abbott)

Platform moored in Mossel Bay, South Africa, June 2015, after production was halted due to fall in oil prices (photo Tim Abbott)

Oil prices are going up as oil supply and demand are approaching a more balanced situation, writes geophysicist Jilles van den Beukel. And they will continue to go up as supply is expected to fall below demand in the 2018-2020 period. The key factor in supply reduction is that cost cutting is leading to higher decline rates of mature conventional fields. So far this decline has been compensated by new oil field developments, but the current severe investment cuts will gradually reduce the flow of “new oil” to a mere trickle by the early 2020’s. In the meantime demand is still growing, despite the expansion of renewables and higher efficiencies.

Oil prices have been going up over the last few months, from below $30 per barrel in February to the current levels of around $50. Many short term issues of a different nature play a role here, ranging from market psychology to supply interruptions such as those caused by the Alberta wildfires. But I would argue that in the background there is a persistent upward trend, caused by the simplest of explanations: supply and demand are getting more into balance again.

When predicting future oil supply and demand no individual can produce anything close to the comprehensive analyses of organizations like the IEA or the major consultancy firms. But one can try to highlight processes that give some insight into the way that supply is responding to changes in the oil price.

Increased field decline of conventional oil fields kicking in

Much of the publicity on the way that oil supply is responding to lower prices has focused on unconventional shale oil in the US. And indeed the rapid advance of US shale oil has been a key factor in the creation of ‘oversupply’. But actually the response of the more than 50 million barrels/day (mbpd) production from conventional (non-OPEC) fields plays a much bigger role. Small changes in the average decline rate of these fields result in large changes for oil supply in absolute numbers.

The figure below is taken from a recent study (June 2016) from Rystad Energy. It shows the average decline rate for mature non-OPEC oil fields. Up to 2015 these figures are actuals; for 2016 this is a prediction with limited uncertainty and for later years uncertainty increases.

Jilles oil price figure 1

Due to higher activity, the average decline rate in the 2010-2014 high oil price world was only about 3% (without any activity it would have been about 8-9%). Reduced activity in the subsequent low oil price environment resulted in higher decline rates of about 5-6%. In absolute terms: for 2016 this amounts to a supply decrease of 3.3 mbpd (on total global oil production of some 90 mbpd).

There are several important points to be noted about these decline rates. First of all, the fast response of field decline rates to price levels is due to the nature of the activities involved: workovers and infill drilling can be planned and executed in a relatively short time frame.

Secondly, the effects of this reduced infill drilling in conventional fields will be felt for years to come: a conventional well not drilled in 2015 is still likely to result in lower production in 2020 and beyond.

Thirdly, decline rates are much less of an issue for OPEC fields. Production in a country like Saudi Arabia is capped by political decisions or infrastructure capacity rather than geology (they have much higher reserves-to-production ratios).

So why do decline rates of conventional non-OPEC fields receive so little attention? I think it is because field decline has so far been masked by new fields coming on stream. For 2016, the added production from new fields amounted to about 3.0 mbpd, roughly compensating for the decline of existing fields. Many projects are still coming on line (especially in deepwater) that have been sanctioned in the 2010-2014 high oil price environment.

New oil compensating for field decline is not sustainable, however. Hardly any new major developments have been sanctioned in 2015 and the first half of 2016. Over the coming years new oil from projects currently being developed will gradually decrease from 3.0 mbpd in 2016 to a much lower level in the early 2020’s (exactly how low will depend on when the sanctioning of new developments will resume). For 2017, a similar level of field decline (compared to 2016) is already expected to outstrip new developments by about 1.2 mbpd.

Reduction in US shale oil production is kicking in, finally

At the same time, we are finally seeing a reduction in US shale oil production in response to the price decline, as can be seen in the figure below.

I have chosen to use data from a Seeking Alpha paper rather than the well known EIA figures that only give production up to the present day. Obviously the prediction beyond mid 2016 depends on future oil prices (the predicted further decline is in the middle of the range for a number of forecasts from different organizations).

Jilles oil price figure 2

The time it takes for US shale oil production to respond to the low oil price oil world is much longer than often assumed. It took close to a year before peak production was reached: it took close to another year before a steady reduction (per month) of up to 100,000 bpd was reached.

This shows that US shale oil cannot take on the role of short term swing producer (as Saudi Arabia used to do). It cannot do so timewise (it takes two years to fully respond) and it cannot do so volume-wise (changes in US shale oil production being too small compared to global supply). It does play an important role, as part of a complex global oil supply system.

A shake-out is taking place in the US shale oil sector with increased focus on the best plays and the best sweet spots within these plays. The Permian is emerging as the dominant play in shale oil, in the same way as the Marcellus has emerged as the dominant play in shale gas.

$50 per barrel is too low to be sustainable

The major international consultancy firms cover all parts of the energy business. Rystad Energy, a small independent Norwegian consultancy firm, primarily focuses on one part of the business only: maintaining a state of the art database of all oil fields (plus potential developments with timelines and oil prices needed for project sanction) on a global basis. This enables them to model future oil supply for different price scenarios. In this important niche they have become a world leader.

The figure below gives some of these scenarios. These integrated models combine shale oil production, conventional field decline and new conventional developments (as well as more secondary processes such as exploration, end of field life and project delays). The gradual decrease of global oil supply in a constant 50 dollar per barrel scenario is primarily due to the combination of the continuation of significant mature field decline and the gradual decrease of oil from new developments over the coming years.

Jilles oil price figure 3

Unless more dramatic cost reductions materialize, these models imply that a long term price of the order of $70-90 per barrel is needed to generate sufficient supply anywhere near expected demand. The reason is simple: it is at this price level that many projects, of a different nature (onshore, shallow offshore, deepwater and shale oil), become sufficiently profitable to go ahead. Lower prices will eventually result in undersupply; higher prices will eventually result in oversupply (regardless of oil demand continuing to increase at its current rate or reaching a plateau).

Oil demand: India taking over from China as a growth engine

In the meantime oil demand continues to stubbornly grow each year, at a rate of about 1.5 mbpd. So far any increase in efficiencies or renewables is more than offset by increasing demand in non-OECD countries. The populations of China and India (about 1.4 billion and 1.3 billion respectively) are so large that what happens in these countries simply matters most.

As the growth in Chinese oil demand abates it seems that India is taking over China’s role as the key country for oil demand growth in Asia. A recent study of the Oxford Institute for Energy Studies paints a breathtaking picture of a country where manufacturing and car ownership (and hence oil demand) are about to explode. Last year India’s oil demand grew by 0.3 billion barrels/year (compared to an average of about 0.1-0.15 billion barrels/year over the last decade). India is now in the position where China was about 15 years ago.

Even if India’s phase of rapid economic growth would be characterized by a greater focus on renewables this would be more of an issue for coal and gas than for oil.

Jilles oil price figure 4

One day the energy transition will take off in earnest and peak oil demand will be reached. But it will come at a slower rate than the response of oil supply to changes in oil price or changes in oil demand. The energy transition will lead to a reduction in volumes but not (necessarily) to a reduction in price. For an oil company volumes matter. But price matters much, much more.

Editor’s Note

Jilles van den Beukel worked as a geologist, geophysicist and project manager for Shell in many parts of the world. This paper was first published on his blog JillesonEnergy.

Comments

  1. onesecond says

    Our only hope is that the EV revolution becomes unstoppable on an exponential basis or this planet is doomed.

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