Friday, March 17, 2017

Why Oil Forecasting Is So Difficult Now: Short-cycle vs. Long-cycle vs. "Peak Demand"

Oil experts are deeply divided in their views on the future of what is still the world's key commodity. This divergence was on display at last week's CERA Conference in Houston, which brought together industry executives, consultants, media, and government officials from around the world. Although I didn't attend in person, the organizers provided extensive streaming coverage of keynote talks and interviews with thought leaders.

From OPEC oil ministers and the head of the International Energy Agency, we heard that the world could be headed for another supply crunch within a few years, due to low investment following 2014's oil-price collapse. I've mentioned this concern before.

By contrast, the major oil companies seemed more cautious. Low oil prices caught many of them with big, expensive projects underway--too far along to stop but undermined by prices now far below the assumptions on which they were justified. Cash flow seems to be a higher priority than growth. "Peak demand", when global oil consumption stops growing and might begin shrinking, could also arrive within ten years or so, at least according to Shell's CEO, further disrupting markets.

Renewables were discussed frequently, but shale was arguably the star of the segments I watched. Big companies touted their shift toward shale assets that can be brought into production quickly, while independent E&P (exploration and production) companies highlighted both the upside and limitations of focusing on the core, or most productive, cost-effective portions of various shale regions.

With these large, and to some extent mutually contradictory trends in play, any kind of straight-line extrapolation from current or past conditions of price, supply, or demand seems sure to be swamped by uncertainties. Rather than putting my thumb on the scales for one view or another, my best service just now is improving our understanding of these risks and why they look so uncertain.

On the supply side, the relationship between short-cycle and long-cycle investments is especially interesting and a source of great uncertainty. Short-cycle supply, mainly from shale or "tight oil" wells that can be drilled and brought on-stream quickly and for only a few million dollars each--but that also tail off quickly--was the main factor in the drop from over $100 per barrel to less than $40 just a couple of years ago. It now provides many of the lowest-risk, most attractive opportunities available to the oil and gas industry. Yet the more short-cycle oil is developed, the longer the recovery of long-cycle investment is likely to be delayed, because shale is effectively putting a low ceiling on oil prices and will consume ongoing cash flow to sustain it.

Long-cycle oil, which still accounts for over 90% of global supply, is an entirely different domain. It consists mainly of large conventional oil fields that were developed years ago and continue to pump oil with relatively little continuing investment. It also includes new, big-ticket projects in places like the deep waters of the Gulf of Mexico and offshore Brazil, that add to growth but importantly offset the natural decline rates--often 4%-10% annually--that eat into the output of older oil fields every year.

Hundreds of billions of dollars of planned investment in long-cycle projects was deferred or canceled since 2014. Because such projects take years--sometimes decades--to develop from discovery to production, this investment drought implies a hole in future production. That shortfall hasn't appeared yet, because projects like BP's Thunder Horse expansion that were begun when oil was still over $100 are still periodically starting up. The impact of the long-cycle gap might also shrink or vanish entirely if enough short-cycle oil is developed in the meantime.

We might never notice this impending gap, if demand growth slowed sharply from its recent rate of more than 1 million barrels per day per year, or even started to fall. Not so long ago, few could imagine oil demand falling without hitting a wall on supply--so-called "Peak Oil"--but now it's almost harder to envision oil demand continuing to expand in light of competition from renewables, substitution from electric vehicles, and constraints imposed by climate policies intended to comply with the Paris Agreement.

The big uncertainties for these changes are time and scale. The Solar Energy Industries Association (SEIA) forecasts US solar power growing from 42 Gigawatts (GW) last year to nearly 120 GW by the end of 2022. However, that would leave solar generating just 4% of US electricity, even if electricity demand didn't grow at all in the interim. Nor does solar power compete with oil, except in the few remaining places--mainly in the Middle East--where lots of oil is burned to produced electricity, or when it powers electric cars.

With regard to EVs, Tesla's goal of producing 500,000 cars per year by the end of next year is impressively big. However, even if those Teslas replaced only conventional cars of average fuel economy, all of which were then scrapped--unlikely on both counts--they would reduce US gasoline demand by less than 0.2%. It would take more than six times as many EVs to offset last year's growth in US gasoline demand of 1.3%. Only as EV sales ramp up and conventional cars are retired in large numbers would they start to make a serious dent in oil demand. How long will it take to reach that point, and how much would a big jump in oil prices within the next few years nudge it along?

Until recently, most of the speculation that the transition away from oil and other fossil fuels could happen faster came from outside the industry. Lately, though, respected voices in the industry--or at least closer to it--have begun to raise the possibility that the shift to renewables and EVs might accelerate, affecting demand sooner than expected.

To be clear, I am still convinced that constraints on how fast capital stock turns over--vehicle fleets, HVAC, factory equipment, etc.--impose a speed limit on any large-scale transition like this. However, careful examination of the last 20 years of oil prices provides ample proof that smaller-scale shifts can have large impacts. From the Asian Economic Crisis of the late 1990s, to the massive price spike of 2006-8, followed by the financial crisis, the Arab Spring, and the shale boom, we can see that supply/demand imbalances of no more than about 2-3 million barrels per day--say 3-4% of production or consumption--were sufficient to drive oil prices as low as $10 and as high as $145 per barrel.

When we combine the big, new trends outlined above with normal uncertainties about the economy and then factor in the extreme sensitivity of oil markets to relatively modest surpluses and shortfalls, predicting the likely path for oil looks very daunting. The factors driving it may be changing, but accurate oil forecasting remains as challenging as ever. That same realization stimulated interest in scenario planning more than 40 years ago, focused on the insights available from considering multiple possible futures, rather than just one.