Top Down: The Five Forces That Will Define the Oil Market – to 2023
Near-term oil market analyses emphasise decline rates and pessimistic outlooks leading to looming supply gaps.
However, a top-down view shows the opposite: the four major supply blocs – OPEC, Russia, US, IOCs – will all likely achieve near-term growth strategies, even as the more ponderous forces of declining demand start to dominate. Changing everything after 2023.
The Recent Failure of Bottoms-Up
It’s easy to get lost forecasting the oil business.
Bottoms-up analysis of oil supply over the past few years has been pessimistic, suggesting geologic decline rates of oil-fields is a harbinger of major supply gaps (and price spikes) to come.
The key assumption is that with ever-growing demand for oil, but major downturns in oil-field investments due to the price collapse in 2014-15, decline rates will start to bite, and force supply shortages.
In the event, however, OPEC and Russia have had to curtail supply to avoid a global glut, even though oil liquids demand has grown decently by around 1.5million barrels per day.
The supply pessimists are unbowed.
They now point out that, yes, supply has continued in non-OPEC countries due to prior investments paying off – but that pipeline will soon dry up, and field decline rates will kick-in to create a supply gap after all.
In fact, according to the FT this month, OPEC is practically banking on this scenario, to keep oil prices supported
And in an extreme variant of this analysis, BP’s latest Energy Outlook shows this chart in support of how average field decline rates of 3% pa would leave a supply gap of over 20 million barrels per day by 2025 (albeit with a scorched earth strategy of zero investment beginning right now).
Where are all the declines?
If these analyses are right, this is eye-popping headline news.
It leaves us, the world’s consumers, having to create two new Saudi Arabias (or USAs, or Russias) worth of oil production (net) within the next few years, or we miss demand by a mile.
This sudden supply chasm would be far worse than 2005-15, when prices gradually rose to $150/bbl: gasoline prices would spike above $5 gallon, air travel would be prohibitively expensive, and reduced trucking and shipping of goods would force GDP into a downward spiral: especially in the US which is a highly fossil-fuel dependent economy.
Because such an increase in supply is not feasible in that timeframe. you would therefore expect oil prices to be moving sharply upwards, and GDP forecasts revised downwards – right now – without the help of OPEC and Russia’s production cuts.
However, oil has not only needed OPEC and Russia’s restraint but also the collapse of Venezuela’s output and the geo-political uncertainty surrounding Iran’s export future to underpin its current $60-70/bbl value – still 40% down from 2015.
And even if oil prices may take some time to react, you might expect capital markets to be pricing in major vertical movement in oil stocks, especially those hyper-investing in production growth such as Exxon.
But in fact not the case. Most oil stocks are becalmed, and have been for several years, and Exxon stocks have bombed in the last few months as investors spurn its growth narrative.
So – what gives ? Perhaps decline rates don’t matter as much as other factors after all.
Oil-field by oil-field bottoms-up analysis may be falling foul of what scientist Daniel Dennett called greedy reductionism – overlooking bigger scale factors by over-emphasising the micro ones.
Or in his words: “trying to skip whole layers or levels of theory in (a) rush to fasten everything securely and neatly to the foundation”
So – let’s try a top down, simpler analysis rather than using complex models or forecasts with diverse variables built up from smaller parts.
Plus – one other thing – what we also need to do is focus on Crude Oil.
Supply and demand forecasts often conflate crude oil, the gooey black stuff, with a range of other associated, but quite distinct, chemicals: Natural Gas Liquids (NGLs), condensates, (slightly heavier gas fractions associated with crude oil production), and biofuels.
This chemistry lesson is important. It gets to the heart of why “oil” supply and demand issues may be getting confused.
Crude oil is what is required, via refining, to make critical transport fuels for passenger cars, commercial vehicles, planes and shipping. The associated gases and condensates are a by-product, which are used directly for the production of plastics and fertilisers -distinct products and markets in their own right. Likewise, biofuels form a separate supply chain.
With the risk of stating the obvious, to understand the dynamics of the oil business, we need to focus on crude oil.
The Five Forces: Four Strategies and a Technology
The world produces (and consumes), to a good approximation, 75 million barrels a day of crude oil.
The top line number you will see in most websites and reviews, however, is close to 95 million barrels a day (b/d) of “oil” or oil liquids – but this is not the crude oil number; it’s crude oil plus another 20 million barrels a day of those other lighter, gaseous hydrocarbons and other fuels.
With this simplification we can divide crude oil demand and supply into five major categories: demand, and the four main sources of supply.
Crude demand, and its growth, is dominated by world road transport.
Many commentaries suggest that air and marine transport, and petrochemicals are the new core of “oil demand”. This is not the case for crude oil demand: 65% of crude oil is used in road transportation (via gasoline and diesel), and it remains the major growth market for crude.
The growth in world vehicle sales, and the advances of electrification (and supporting policies) into road transport are therefore the vital determinants of future crude oil demand. Their ultimate direction is clear: it is a decline in oil demand. Only the timing remains in dispute.
On the supply side, four strategies dominate.
70% of crude oil is produced by just three supply entities: OPEC, Russia and the US.
OPEC (32 million barrels per day), Russia (10 m b/d) and the US (10 m b/d) generate roughly 52 million b/d of crude oil.
The fourth segment, rest of the world supply, contributes the remaining 30%, 23 million barrels per day of crude.
Each of the three large producers do not produce oil in an arithmetic, geologic way, driven by bottom-up individual well economic performance. They are working to macro-strategies, because their vast resources of crude and / or financial depth allow them to do so.
OPEC is attempting to control output by political will and maneuvering, Russia is restraining production to support OPEC pricing, and the US is in a high-growth, new technology / price-hedging paradigm that is developing increasing volumes of crude oil each year from mammoth shale basins.
As a consequence, these major producers aim to deliver more oil today than they are currently achieving.
Their near-term strategies are to increase their latent production, even if currently OPEC and Russia are restraining output, and the US is still ramping up.
This leaves rest of world production as a residual between this controlled production and actual demand.
However, the Rest of World supply segment does not behave as a passive remainder – it follows the global growth aspirations of the world’s largest oil and gas corporations.
It is therefore a hard residual production segment, not a soft one, resistant to the moves of the major blocs.
The Five Forces
Source OPEC and dollarsperbbl estimate
So – key point – applying a bottoms-up 3%pa decline rate to global “oil” production is a misleading straw-man: in fact, every one of the four major supply segments has the ability, and aspiration, to increase production, irrespective of geology, even politics, over the next 5 years (and perhaps beyond).
Moreover, if an average decline rate is to apply at all, it would only be to the rest of world 23 millon b/d – so in BP’s chart instead of a 20 million barrel/day gap by 2025, the gap at worst would be 3 million b/d.
But the decline rate does not apply even here, as this segment is pursuing growth across most of its output with many locked-in projects in construction.
For example both BP and ENI who operate globally largely outside OPEC, have specifically noted they will increase production – net of decline rates – by about 1-2% pa over the next 3-4 years.
So – here is a first approximation of what the global future of crude oil supply – demand looks like over the next five years using just three simple assumptions based on the above – a base scenario:
• Demand for crude oil grows at 1% pa (roughly current rates)
• OPEC, Russia and US supply at the rate they currently project for this year: OPEC staying at 32mb/d, the US and Russia 11mb/d each.
• Residual (rest of world) supply grows at 1% pa, net of decline rates, as described.
Note: Current, Base Estimate for 2023, and Bull / Bear Scenarios for Crude oil supply- demand balance: dollarsperbbl estimates
This leaves a gap of approximately 1 million b/d by 2023 – easily covered if OPEC were to chose to open taps just half-way back to 2016 levels.
This may be a clue as to why markets are somewhat sanguine (albeit edgy) about oil price and skeptical about expansive high-cost non-OPEC/Russia investments.
However – not so fast: plausible scenarios appear on either side of this knife-edge supply-demand picture.
The Bull Case : Here demand increases by 1.5% pa, OPEC supply faces continued supply crises in its ranks, and Russia and the US cannot supply above 11 mb/d. The rest of world production stays flat as decline rates negate on-stream production perhaps because of project delays that make it unable to respond to the supply gap: a deficit of 4mb/d opens up, spiking prices.
The Bear Case: demand due to eg EV growth or policy development peaks in the period and falls back to 2018 levels; OPEC and Russia discipline cracks, and US growth stays robust; rest of world production stays to plan, up 1%pa. In this case a sudden OPEC pull-back or even coordinated decline across the residual production would have a limited impact on the supply surplus of 5 mb/d. Prices would collapse.
Of course in each of these states of the world, there would be various corrective actions – but it does not take detailed scenario planning to observe the core forces shaping the oil market today.
Shifts in either of the main producing blocs will overwhelm actions elsewhere.
And structural changes in demand will force moves too, with OPEC likely to act first due to its governance structure. Russia and the US will first pursue their internal aims, and the resilient Rest of World bloc will still focus on growth targets.
World oil prices (and oil stock movements) may be just as simple as watching the developments in these five forces.
It remains difficult to make a call on the outcome: but the forces working on the Base and Bear scenario seem individually more likely and aligned than those in the Bull case.
But. But – Perhaps after a long stroll, we have just happened back on an oil market truism: the industry remains in tension, ready to make fools of us all, because it is largely shaped, right now, by the moves of three huge supply blocs, and less by the rational precision of geologies.
Until 2023: One Force to Bind Them All
Of course, things change.
This all only holds until demand asserts itself (clearly) as the dominant force – when transportation electrifies at the margin and quickly beyond.
Oil is huge and dominant in the transportation corner of the energy world. But in a Darwinian twist it is almost completely dependent on the segment: it is a niche into which it has adapted so well it now has no escape into other areas of energy production.
In 2017, for example, US gasoline demand at 9.32 million b/d was precisely flat, and vehicle sales were down 1.9%. The US consumes over 40% of global gasoline – this peak in the world’s largest market (by far) of consumer gasoline signals the risk to come.
As electricity encroaches on oil’s energy niche at increasing pace, shrinking crude demand will become the dominant narrative of world oil.
As noted in several posts (eg here), and to be specific, we expect electricity to remove all marginal oil growth in transportation by 2023, forcing crude oil’s business trajectory into terminal decline.
Given that, the shape of the post-2023 oil market, is, as they say, another story entirely.
And the subject of an upcoming post.
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