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Is Another Oil Price Spike Likely Soon?

A number of analysts have been warning that the double-barreled price shock in 2020 which sent prices to historic lows (negative $37 a barrel, albeit only paper trades) drastically reduced upstream investment and delayed development of new oil production capacity, which could set the stage for a new oil price shock. Demand recovery coupled with slow production growth would cause a new spike, since upstream activity is significantly lagged to price moves given physical constraints.

The price drop was followed by a partial recovery to just over $50/barrel for WTI, half the pre-2015 price and well below prices in the past two decades. Regardless of the breakeven price for new supply, the physical constraints on upstream activity—finding skilled personnel and reactivating equipment, implies that a price shock is largely unavoidable.

As the figure below shows, the number of rigs active (outside of North America) has rarely increased by 10% per year, but last year’s drop was 25%. After the 1998 price collapse, it took roughly five years to surpass pre-collapse activity levels. And while the $100/barrel prices were largely due to political disruptions of supply, the price in 2000-2002 of $40 (about $55 adjusted for inflation) was elevated solely due to market tightness. So while the constant warnings of new price spikes often prove incorrect, such can occur after a price drop reduces investment.

But it is important to realize that investment plans change often, and companies regularly update plans as a year progresses and market conditions (i.e., prices) change. The figure below is from data no longer collected by the EIA, covering the major U.S. oil companies, and the rapidity with which expenditures can increase is obvious. Again, however, it depends on price and $50/barrel might not be enough to spur activity.

By the end of 2021, the world oil market will probably be close to equilibrium, that is, where increased demand allows OPEC+ to return to, at worst, the quota levels set in 2019. Should demand continue growing, more of it will be met by OPEC+ (in theory) and that, combined with minimal surplus capacity, should mean higher oil prices.

The biggest uncertainty centers around the ability of Iran and/or Venezuela to increase production and exports significantly, meaning less need for other OPEC+ members to invest but also less market tightness if non-OPEC+ production remains weak. Both could, in theory, meet much of the increased demand over the next 3-5 years, and while it is unlikely they will do so, the more they produce, the less likely another price spike would be. Indeed, it is also necessary that their supply remain curtailed in order for a price spike to occur.

The other wild card involves the prospects for U.S. shale oil supply. As the next figure shows, shale oil production has increased by more than 1.5 mb/d/yr, which is usually enough to meet the incremental global demand. This was true in 2019 when oil prices were about $60/barrel, but it’s not clear that this can be replicated at those price levels: capital is arguably for shale producers less available after the latest price bust reduced exuberance (rational and irrational) for the sector. Concerns about ESG and climate change policies are obviously not helping, although it hardly a given that their impact will be large.

Still, shale drilling—especially in the Permian—is starting to recover and at a rapid rate, as the following figure shows. At this rate, Permian drilling might recover to pre-crash levels in another year or more, by which time the oil market is unlikely to accommodate added production of 1 mb/d/yr. There are those who argue that Permian production has reached its peak, with the sweet spots largely exploited, implying more drilling will be needed in the future to maintain production let alone increase it. However, these warnings should be taken with a large dose of salt.

For OPEC+ and the industry in general, there appears to be much more demand risk than supply risk, or perhaps the supply risk is bearish for prices, given the large amount of shut-in capacity in OPEC+, Iran and Venezuela. The ultimate arbiter of long-term prices, though, is likely to be the level at which Permian (and shale more generally) can increase supply. The ability of U.S. shale producers to respond rapidly to higher prices should go a long way to reducing the odds of a price spike that is caused by simple market tightness, that is, absent another supply side shock.
Source: Forbes

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