The Fuse

It’s Déjà Vu All Over Again: OPEC, Petroleum Investment, and the Threat to U.S. Consumers and Energy Security

by Jonathan Chanis | October 10, 2017

The dilemma for OPEC, and particularly Saudi Arabia, has always been to establish an oil price high enough to satisfy revenue needs, but low enough to dissuade both other producers from investing in production capacity and consumers from becoming more fuel efficient. While the energy markets and much of the world now focus on OPEC production cutbacks and on the “successful rebalancing” of prices in the $50-$60 range, many miss the fact that the intermediate term outlook is increasingly positive for OPEC and negative for the U.S. consumers and U.S. energy security. Over the decades, through a deliberate strategy of periodically driving down prices and disrupting the investment plans of companies outside OPEC, Saudi Arabia and other OPEC members undermine non-OPEC necessary capacity additions and attempt to create future undersupply and higher prices. The oil market saw such manipulation as recently as 2014-16, when OPEC drove crude prices below $30 per barrel. Unless a sizeable number of mega ($5 billion plus) oil development projects are initiated over the next 12-18 months, oil prices are likely to be much higher in the 2020s than they are today.

Over the decades, through a deliberate strategy of periodically driving down prices and disrupting investment plans, Saudi Arabia and other OPEC members undermine non-OPEC investment plans and attempt to create future undersupply and higher prices.

The petroleum (and natural gas) business is unique because of the nature of its investment cycle. The tremendous funding required, the time necessary for project completion, the delayed information feedback loop due to this long lead-time, corruption and resource nationalism in many producer countries, and the centrality of oil for economic and military security all complicate the oil investment process. No other industry must contend on such a scale with all these difficulties.

Since the rise of OPEC in the 1960s, petroleum investment has experienced roughly five phases. During the late 1960 and early 1970s, global oil demand almost doubled with consumption rising from 30.7 million barrels per day (mbd) in 1965, to 55.6 mbd in 1973. The leading oil companies (“the Seven Sisters”) were slow to respond because of a number of reasons, particularly the threat of nationalization by many resource holders. As a result, investment on exploration and production languished. With the quadrupling of prices after 1973, companies began to massively invest in production capacity. By 1981, the world had excess production capacity and prices and investment collapsed. In 2000, prices broke out of their $10-$20 range and began a dramatic rise. Except for 2009 (the post-financial crisis year), investment steadily increased from this point. By 2014, according to the IEA, global upstream spending exceeded $700 billion. The results of this boom in spending were predictable. Similar to the 1973-1981 period, the industry created huge production overcapacity. By the middle of 2014, oil prices collapsed and investment followed shortly thereafter.

In its most simplified form, the petroleum cycle works like this: High prices induce high investment; high investment creates higher production that leads to low prices; low prices stop investment; low investment leads to insufficient supply, which in turn creates high prices, which brings back high investment, and so on. But a key to these extreme shortages and surpluses is OPEC’s role in structurally either undersupplying the market or mismanaging its investment function.

Supply gap in the intermediate term

The investment cycle is important because prices tend to follow it with a lag of 5-7 years.

The investment cycle is important because prices tend to follow it with a lag of 5-7 years. The investment cycle will not tell us if prices in 2022 will be $50 or $55, but it will tell us if prices will be closer to $25 or $100. If anything, the introduction of U.S. short-cycle oil through hydraulic fracturing now creates a false sense of security and inadvertently aids OPEC because it makes it easy and profitable for many companies to defer these longer cycle mega investment projects. The fear or reality of OPEC driving down prices and ruining billions of dollars of investments naturally makes companies hesitant to invest. But without these investments in large greenfield conventional projects, the natural decline curve of existing fields eventually will outpace U.S. shale oil production growth.

While figures for non-shale decline rates are difficult to cite with precision, we do know that without continual investment in both new conventional production capacity and development drilling of existing fields, the “observed decline rate” (or the measured production decline rate of oil production) is approximately 5-7 percent per year. Some analysts today even say the rate is closer to 8 percent. This decline rate means that the industry needs to bring on almost 4-5 million barrels per day (mbd) each year just to keep production stable. And this does not even consider the amount also necessary to meet incremental annual demand increases of approximately 1 mbd each year. Hence, by 2022, the world will need new production of approximately 40 million barrels. Even with the most optimistic forecasts for U.S. shale oil production of over 10 mbd, the bulk of this gap will be unmet without substantial new conventional investment. Moreover, a good portion of the U.S. shale increases will simply replace declines in the other U.S. oil provinces such as the Gulf of Mexico, Alaskan North Slope, and California.

By 2022, the world will need new production of approximately 40 million barrels.

In 2014, global oil and gas development spending was over $700 billion. According to the International Energy Agency (IEA), in 2015 and 2016, it declined by 44 percent.  The IEA also expects inflation adjusted upstream spending in 2017 to increase 3 percent, to just over $400 billion. However, a disproportionate amount of this spending will be in U.S. short-cycle oil and other brownfield incremental projects, not major new development. This amount of spending is insufficient to close the impending supply gap. It will narrow the supply gap in the 2020s, but it will not close it. And even if the remaining gap is only 1-2 mbd, it can, and probably would, have an outsized impact on prices. Persistent shortfalls of even one million barrels per day, or 1 percent, would have an enormous price effect. OPEC’s efforts to keep the market undersupplied, its refusal to open most of its acreage to private oil companies, and its general lack of competency in balancing investment with demand have made the markets more volatile and less secure for energy consumers. The famous 1973 Foreign Affairs article heralding the impending oil supply crisis was titled: “This Time the Wolf Is Here.” Well, it is slightly too early to say the wolf is once again at the door, but he is certainly circling the house.