The New Paradigm in Global Oil Markets
Limited supply and critically low inventories threaten to take the price of crude oil considerably higher for the foreseeable future.
The global oil market is built on thousands of moving parts that overlap with each other in strange ways. However, when you look beyond the daily price fluctuations, which have been particularly extreme since Russia’s invasion of Ukraine, the macro outlook is clear: as demand for oil continues to rise globally, the world remains considerably undersupplied.
1) OPEC’s Imaginary Spare Capacity
The belief in OPEC’s large spare capacity is critical to the stability of the global market. When oil markets get too hot, politicians and traders assume OPEC can simply turn on the spigots to keep the world economy stable and prevent the demand destruction that would likely arrive with $150+ WTI. Such assumptions prompted US President Joe Biden’s trip to Saudi Arabia at the beginning of July. Unfortunately for the President, the signs of OPEC’s dwindling spare capacity have been flashing red for months now.
Back in November of 2021, Saudi Aramco warned that the post-Covid demand boom was running up against an undersupplied oil market, which he correctly predicted would begin to drain global inventories. Then in March, Saudi Aramco’s Chief Executive noted that the globe’s spare capacity cushion was historically “thin.” Just last month, the CEO of Shell noted that OPEC’s spare capacity is likely a lot smaller than analysts assume. These warnings from the most important players in the global energy market are also being reflected in the data.
Saudi Arabia’s onshore global oil inventories are sitting at a 20-year low. After climbing from around 150 million barrels in 2002 to over 325 million barrels in 2016, Saudi Arabia’s onshore inventories have fallen below 140 million for the first time since 2000. Meanwhile, the country’s crude production has been steadily falling since its 2018 peak of 10.38 million bpd. Simultaneously, OPEC+ has been continuously missing its production quotas by increasingly large margins. Since the beginning of 2021, OPEC+ has missed 17 out of 17 monthly production quotas by an average of 1.05 million bpd. In June alone, OPEC+ missed its production quota by a staggering 2.84 million bpd. So why is this happening?
The common perception is that Russia, after being hit with considerable sanctions from the US and EU, has reduced its oil production considerably. This picture is incomplete, however. With India and China as committed buyers, Russia has been substantially ramping up production since its low in April. As of May, Russian production has recovered to 10.55 million bpd. While crude production was 7 percent below pre-invasion levels, Russian oil exports have actually surpassed 2019 highs. In fact, the amount of Russia’s flagship Urals crude oil sitting in vessels at sea reached a record of 62 million barrels. In sum, Russia’s underproduction accounted for just 30 percent of OPEC+’s historic production miss. So what accounts for the other 70 percent?
Since the oil price crash of 2014, oil field services (OFS) companies have been underspending on the capital equipment and talent necessary to service the globe’s growing demand for energy. In the six years from 2010 to 2015, US OFS companies spent $79.9 billion on capital investment. From 2015 to 2021, the same companies spent just $33.2 billion. This 58 percent decline in CAPEX by the operators of the world’s oil market has created an exceedingly tight market for the field services OPEC+ countries need to ramp production. To attract the capital investment required to service the world’s growing demand for energy, oil prices will likely need to stay elevated for a long time.
Even though each member of OPEC+ has localized incentives to meet their quota, if not exceed it, the world’s largest oil producers have been constrained by declining well productivity and an evisceration of the services supply chain. Thus, OPEC+ will continue to miss its quotas for the foreseeable future.
2) North American Capacity Limits
Currently, the futures market for WTI is in backwardation, meaning oil producers can only hedge future barrels at levels considerably below spot prices. While the current price of $96 WTI is sufficiently above the marginal cost of production for even high-cost E&Ps to make money, the futures market's insufficient guarantee of future profitability is constraining the appetite of oil producers to make large upfront capital investments in long-term wells. At the same time, historic volatility in oil markets has introduced levels of risk that will likely dampen the appetite for increased long-term investment. Such investment is also becoming increasingly difficult to finance as America’s largest capital providers swear off oil and gas. Thus, despite oil prices resting considerably above their 5-year average, US crude oil production actually declined by 57,000 bpd in May.
The regions that analysts expected to keep US production growth strong are showing signs of weakness as well. Production in the Eagle Ford is approximately 300,000 bpd below its 2019 average, despite considerable rig count increases over the past few months. Meanwhile, severe labor shortages, high costs of capital, and supply chain issues have hampered growth for shale producers in the Permian Basin. Longer-term questions also remain about the runway for American crude production. Currently, the US exploits about 9 percent of its oil reserves, compared to about 4 percent for Russia and less than 2 percent for Canada. The US production boom that began in 2010 was largely driven by over-investment in high decline shale assets, some of which saw remarkable 80 percent declines in just two years.
To bring the oil market into balance, US and Canadian producers would need to ramp up production to record levels. However, not only is the service capacity not sufficient to facilitate such a ramp-up, but most E&Ps are promising to return capital to shareholders before budgeting long-term capital investments. In a volatile energy market and changing regulatory landscape, the appetite to invest with a decades-long time horizon is small. Thus, considerable investments in expanding US production are unlikely to arrive until the futures market leaves backwardation and begins to reflect the current global supply deficit of oil.
3) Inventories
As global oil production consistently disappoints to the downside for reasons discussed above, oil inventories are being drained at an alarming rate. Since November of 2021, over 300 million barrels of oil have been released from the SPR. The unprecedented dumping of over 1 million bpd has created substantial downward pressure on oil prices. When the release reaches its legal limit, likely around October, an already tight oil market could become even tighter. Simultaneously, the government will have to start refilling the SPR and become a net buyer of crude.
Commercial crude inventories in the US are also rapidly depleting. After a record build in 2020, commercial crude inventories (excluding SPR) have declined by over 250 million barrels. When factoring in the SPR, US oil inventories are at a 20-year low. The US is not alone, however. Saudi Arabia’s inventories of crude have steadily declined since 2016 to 20-year lows. Oil inventories in the EU are now at record lows as high natural gas prices prompt more power plants to switch to crude. Globally, crude inventories are at historically tight levels. As inventories continue to be depleted, countries will be forced to ramp up their buying in oil markets.
The only country building inventories at the moment is China. In June, Chinese oil imports hit a five-year low as lockdowns continued in Shanghai. The large reduction in local demand for gasoline in China has allowed commercial inventories to grow by about 1.19 million bpd for the first five months of 2022. However, this trend is likely to reverse as China heads into an election year while undertaking a massive initiative to vaccinate the elderly population. Currently, Chinese oil demand is about 1.5-2.0 million bpd below pre-Covid levels. Without factoring in any potential for demand growth, a Chinese reopening will put significant pressure on domestic inventories and, subsequently, on the tight global oil market.
The global inventory picture looks dire. The SPR is set to stop dumping oil onto the market before winter, just as European demand for crude could spike. With global production unlikely to rise substantially to meet demand, the draining of historically low inventories will ultimately translate to considerably higher crude prices in the medium term.
4) Geopolitics
With fuel and food inflation spreading throughout the globe, political unrest threatens to hit supply in an already tight oil market. In the past few months, there have been protests in Iran, Iraq, Libya, and Venezuela. Just last week, Halliburton employees in Libya were told to immediately evacuate the country just as the Libyan government was promising to reach 2 million bpd. Simultaneously, protestors stormed the Iraqi parliament, a dangerous situation that could destabilize Iraq’s government and consequently hamper their crude production. Finally, the Biden administration made it clear that a new Iran deal is off the table, and proposed sanctions against companies that they believe are helping Iran export its crude on the global market.
None of these trends threaten to substantially alter the global supply/demand balance for oil. However, the broader trend towards instability brought on by high commodity prices threatens to spark localized supply disruptions throughout the world.
Another important factor that could reduce the export capacity of oil-producing nations is domestic consumption. When oil prices rise, particularly for long periods of time, the national incomes of oil-rich countries usually rise along with them. This leads to increased local demand for gasoline and refined products, but not necessarily an increase in oil production. As more oil is purchased by refiners for domestic use, less oil gets exported onto the global market. Countries like Iran, Saudi Arabia, and Iraq will likely see rapid growth in domestic consumption demand as national incomes reach new records. This dynamic is important to consider in the likely scenario of sustained high crude prices.
A price cap on Russian oil could also considerably alter dynamics in global crude markets. Currently, the US is in serious discussions to roll a price cap out by winter. While policymakers assume that such a cap would reduce global prices by increasing Russia’s oil discount, such a policy may do the opposite. If Russian oil is capped at an absurdly low figure, like $40/bbl, Russia may simply take some of its crude exports offline. If a considerable part of Russia’s 10 million bpd production was halted, WTI would likely shoot past $200/bbl.
Conclusion
The tight physical oil market is showing no signs of slowing down. This month alone, Saudi Aramco raised prices to Asian consumers by a remarkable $9/bbl while Russia began tapering its 30 percent discount. Meanwhile, global inventories are being drained at record rates, and crude production has stalled thanks to years of underinvestment. With no SPR left to drain and no OPEC+ spare capacity to lean on, the price of WTI will readjust substantially higher throughout 2022 and into 2023. Few analysts anticipate a world with $150+ WTI, though this might be the only scenario that attracts much-needed capital back to the sector.