Notable authorities such as the EIA, the IEA , OPEC and BP forecast growth of demand for oil in their base case scenarios through the end of their forecast periods. These same organizations failed to predict, and even to fully recognize after the fact, the start of declining demand in the United States and the OECD when those occurred more than a decade ago. Royal Dutch Shell broke ranks from other industry players last fall when its chief executive officer opined that global demand could reach a maximum in the next five to fifteen years. Given the nature of the demand plateau and the historical failure of authorities to predict its advent, it is time for the oil industry to begin planning and watching for the turn.
Global demand growth has been slowing over the last decades, and it is forecast to grow at around 1% or less into the future. The actual year-to-year figures, though, are volatile. Large-scale movements like increasing efficiency, decreasing costs of alternatives, and effects of policy changes can be slow to unfold, difficult to see and very difficult to predict. If today’s optimistic outlook persists, then the industry is likely to be caught by surprise when demand shifts. Oil prices will not be inherently lower during the very long future decline of oil, but the nature of the cycles will change, especially the first cycle in which demand fails to grow.
Before that happens, oil prices seem set up for boom. The extraordinarily low oil prices of recent years caused investments in future supply to be cut too much. Though current and futures prices have sustained a reasonably consistent band since last summer, worldwide reinvestment has not stepped back up. At this point, an effective floor seems to have been established in the minds of the industry. Outside of the US there is widespread effort, if unevenly shared, to increase prices. Investment confidence has improved somewhat from independent producers, but many countries seem to lack the ability to respond and timely. Indeed, they seem unable in some cases even to spend appropriate maintenance capital. The IEA has warned that the lack of investment is likely to lead to a shortage in the early 2020s, but it doesn’t take an econometric model to see that.
Markedly higher prices, should they arrive, could provide the last push on top of underlying decay. Producers may rush into development even as users back out of use. If supply increases while demand plateaus or declines in absolute terms, then the oil industry will see the worst down cycle in memory.
In past cycles, demand maintained its growth, more slowly in higher prices then stimulated anew with lower prices. In the end, though, demand will stop moving up at all. Factors unrelated to price will dominate, and demand will, at best, hold a virtual plateau. What is more, OPEC is likely to continue their management of the market to their own advantage.
When demand does turn, there will be only one path to balance—decreased supply. That is, marginally economic production must be plugged, and investment must slack off so much that the underlying decline of existing production can pull down the total supply figure to meet demand and to work off accumulated inventory builds. For OPEC which has some of the lowest production costs in the world, this turning point creates an opportunity to gain market share and to solidify pricing power. It benefits key and leading members of OPEC to allow a deep and long depression of prices—long enough to allow the world to recognize that demand has turned, to plug high-cost production and to redirect large portions of investments.
The underlying decline of existing production is in aggregate 5 to 6% per year with normal levels of maintenance capital. If demand were growing 1 to 2% or more each year as it has in the past, then each year’s investments have replaced 6 to 8% of total demand. If demand instead declines 1% per year, then investments must replace only 4 to 5% of total demand each year, and that total demand benchmark will itself decline, eventually return to levels markedly lower than today.
The industry may overshoot again on the down side, and cycles may continue even as demand lies flat or falls. This and subsequent gluts will, like the peak demand glut, be resolved by drops in production. Booms will be shorter, and the busts may be longer. On the other hand, having ceased better control of the market, OPEC may try to establish and maintain a reliable and modest long term price to abate the decline in demand.
In any event, the nature of the business will change. The public markets will no longer value companies for their growth stories in oil. Growth for energy companies will come instead from natural gas, which will be a global commodity by that time, or from alternative energy sources. Those who stick with liquid hydrocarbons will be treated like the natural gas companies of recent years—out of favor and focused on margins.
The planning and decisions of our business require drawing conclusions about the future of oil prices. Often the best we can do is to watch alertly as existing and novel trends unfold. Widespread awareness of the possibility of plateau demand can affect planning and thus, perhaps, change the way that we experience the transition to a world of declining demand.
These are the pieces I see on the board and how they may move. Of course, lots can happen between now and then. In fact, my next hypothesis is about how supply interruptions and risk premiums can up-end the game board in the near term. Click HERE to subscribe to my intermittent newsletter.
In the meantime, what do you think?