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Monday, April 12, 2021

Is the world heading for a shortfall in global oil supply?

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By Dean Foreman, Chief Economist at American Petroleum Institute

Dean Foreman

It’s possible we could be headed for a shortfall in global oil supply as soon as next year – pretty remarkable considering where oil demand was last spring, with economies slowing under the weight of the pandemic.

Based on projected rising demand, the natural production decline from existing wells and decreases in drilling activity and industry investment – especially in the U.S. – the world’s oil needs could outpace production in 2022. An undersupply potentially could put upward pressure on costs, impacting consumers, manufacturers and, generally, any process that utilizes oil.

API’s outlook has maintained that global oil markets would improve in tandem with the economy, but uncertainties remain about the timing and extent to which the U.S. could participate in that recovery. As a primary source of U.S. petroleum data and analysis, API is able to shed some light on recent developments. Consider:

  • U.S. and global oil demand through mid-February 2021 nearly returned to pre-COVID-19 levels, mainly due to strong refining & petrochemical needs as well as seasonal winter heating fuel demand.
  • By all indications, global oil demand exceeded supply and supported prices since the third quarter of 2020.
  • Current official global oil demand projections through 2022 call for record, two-year demand growth that could require virtually all of the world’s oil spare production capacity.
  • Additionally, oil production declines naturally and that production must be replaced. Combine that expected decline with projected demand growth, and the world could require more than 14 mb/d of new production by 2022.
  • Global oil drilling activity and capital investments have remained historically weak, suggesting a potential supply gap.

In this context, the Biden administration’s early policies on domestic natural gas and oil could be perilous – including halting new federal natural gas and oil leasing, as well as possible moves on the regulatory front and other actions that could limit drilling or hydraulic fracturing. It also includes revoking the Keystone XL pipeline permit and concern that the administration will force the shutdown of the Dakota Access Pipeline, which is critical to Bakken oil production that ultimately serves mid-continent U.S. consumers.

Frankly, these policies could make it difficult for U.S. oil production to rebound even by the 1.0 mb/d that the U.S. Energy Information Administration (EIA) projects by 2022. In that case, it is possible that U.S. oil demand recovery could put upward pressure on oil prices and require more foreign oil imports that would ripple across the broader economy. A global backdrop that has increasingly appeared to be short of oil would only magnify the impacts of these policies and be felt by the majority of American households.

By the numbers, which appear to be compelling, let’s give some additional context.

First, 2021 kicked off with U.S. oil demand of 19.7 million barrels per day (mb/d) that rose to within 1.2% of its level in January 2020 and well within its five-year range by API estimates, which we discussed in this article. Before the polar vortex, weekly data through Feb. 12 suggested that U.S. petroleum demand rose further – to 20.7 mb/d with growth of 5.4% year-on-year (y/y).

Oil demand also appears to have recovered globally as well, for example, as China’s oil imports rose 18% m/m in January and India’s oil demand neared its pre-COVID levels. In fact, EIA currently projects that global oil demand rebounded to 96.7 mb/d in February to within 1.0% of its February 2020 level of 97.7 mb/d.

EIA currently projects that global oil demand could grow by 8.9 million barrels per day (mb/d) this year and the next (5.4 mb/d in 2021 and 3.5 mb/d in 2022). If these estimates prove to be accurate, it could represent the largest two-year global oil demand increase on record since 1950.

Again, the latest monthly and weekly U.S. oil demand data, along with the aforementioned international reports and EIA global oil forecast, suggest this oil demand recovery was on track to start 2021. Furthermore, global oil demand has continued to exceed supply since the third quarter of 2020, per EIA.

In addition to meeting demand growth, global oil production naturally declines and must be replaced. This often gets lost in the news flow, but it’s an essential detail, so let’s dig into the International Energy Agency’s (IEA) view, which calls for 5.4 mb/d of oil demand growth in 2021, same as EIA.

In its 2020 World Energy Outlook, IEA estimated that global oil production would decline by about 7% per year without investment in existing fields. With investments in existing fields, global production would still decline by about 4% per year, according to IEA.

Let’s translate this into something more relatable. Global oil production for February 2021 was estimated at 93.6 mb/d, which was less than global oil demand of 96.7 mb/d, per EIA. The decline of global production from existing fields therefore equates to a range of 3.7 mb/d to 6.6 mb/d, with and without investments in existing fields.

For 2022, global oil production is expected to increase to 100.8 mb/d in response to higher demand. The natural oil production decline range therefore equates to an additional 4.0 mb/d to 7.1 mb/d.

To keep track, the remaining oil demand growth to be supplied from February through December 2021 is 3.4 mb/d, plus another 3.5 mb/d of growth in 2022, per EIA. That’s a total of 6.9 mb/d of new demand through 2022, which combined with the replacement of natural production declines would require total new crude oil production of 14.7 mb/d to 20.5 mb/d by the end of 2022, respectively, with and without investments.

The key question is where this new production will come from. The most immediate source would be to bring oil spare production capacity back on stream. In January, EIA estimated that OPEC had 6.7 mb/d of crude oil spare production capacity, and the Russia and Caspian region’s production was 1.7 mb/d below its highest output of 15.0 mb/d in December 2018. Consequently, OPEC and Russia and Caspian producers might be able to raise their production by 8.4 mb/d – only about half of what’s needed.

If we accept this amount – which might be optimistic because OPEC historically has not produced 100% of its spare capacity – that would require the rest of the world to invest, drill and produce 6.3 mb/d to 12.1 mb/d of new oil by 2022.

Let’s look next at a couple of indicators for prospective global production, starting with drilling activity.

In the U.S. and Canada, which rely relatively mainly on shale oil production (rather than conventional oil production), there were 360 oil-directed rigs running in January 2021, compared with 793 rigs one year ago – a 55% decrease, according to Baker Hughes. Consequently, EIA projects U.S. oil production could remain flat this year and rise less than 1.0 mb/d in 2022 despite historically strong U.S. rig productivity. By contrast, outside of North America there were 513 rigs drilling for oil in January 2021, down 37% y/y from 808 oil-directed rigs in January 2020, per Baker Hughes. The near-term prospects for drilling activity therefore remain historically weak.

Drilling is not the only indicator of importance. Some major global oil developments, such as those in Brazil and Guyana, have been years in the making, and we can look at global capital expenditures being made by the industry as another measure of prospective oil production growth.

By and large, the industry was in a survival mode throughout 2020, reducing its capital expenditures to match with low cash flows through the 2020 COVID-19 recession. In fact, the industry’s quarterly capital expenditures over the latter half of 2020 were nearly half of their weakest levels during the Great Financial Crisis (2008-2009), adjusted for price inflation based on Bloomberg data.

As a result, the potential for oil supply to grow appears limited other than through the restoration of idled production capacity.

Now overlay this backdrop with the Biden administration’s proposed policies, which some say have already raised prices, and it’s fair to question whether the world has become so complacent about strong oil supply and/or pessimistic about the weakness of the 2020 COVID-19 recession that oil shortages are thought unlikely.

This is essentially a reversal of the classic phrase that one must “see something to believe it” – that people must believe it before they can see it. In fact, potential indications of a supply gap in oil market fundamentals are there, grounded by data – that is, an oil demand rebound, stronger prices, historically low drilling activity and investment, and potentially damaging U.S. energy policies.

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