Oil Market Forecast

In some months, years happen, and this is one of those. The first major land war in Europe in 70 years is going to change a lot, but here we will only look at the impact on oil markets. Things are moving so quickly that this month’s Forecast contains much more opinion than normal, I’d almost hesitate to call it a forecast. However, we are going to spend some time looking at oil supply and demand, what may happen later this year, and what the implications are for how tight the market is. The last month has also seen a lot of discussion on boosting domestic oil production, and this month we look at US production potential and how the industry might respond to a period of very high oil prices.

A few key points:

Having converged last month, demand estimates from the three major reporting agencies began to diverge again. The IEA (1) cut their 2022 demand estimate by nearly 1 MMbbl /day from 100.6 MMbbl/day to 99.7 MMbbl/day, in response to a downward revision in their forecast of economic growth, driven by elevated commodity prices and Russian sanctions. This is an average cut of 1.3 MMbbl/day across the last three quarters of this year.

Both the EIA (2) and OPEC (3) held their demand estimate flat at 100.6 MMbbl/day for 2022, but with different messaging; the latest OPEC report acknowledging demand uncertainty. This uncertainty in outlook have contributed to the decision by OPEC+ to maintain their production schedule, rather than accelerate it in the face of a tightening market. There are further clouds on the horizon for demand, with Platts Analytics (4) reporting that China’s “zero-covid” and lockdowns in Shanghai and Shenzhen may cut oil demand by 650,000 bbl/day this month.

The concerns about high and volatile prices causing demand destruction are very real. While in the short run oil demand is relatively inelastic, in the medium term this isn’t the case. Following the 1970’s oil shocks, the US moved from oil fired power generation to alternative sources, resulting in a real, sustained drop in oil demand for several years. Prices over $100 per barrel may be far more effective at shifting consumers into electric vehicles than tax credits or tailpipe emissions restrictions. A lot will depend on how nations choose to respond; there are signs that some interest groups see an accelerated transition away from hydrocarbons as the solution, while others are more focused on hydrocarbon security of hydrocarbon supply.

If demand is cloudy, things on the supply side are a great deal more uncertain. Here we need to consider Russian supply, how OPEC+ will react and the US production response. Taking Russia first, while the US is the only country to have formally embargoed Russian oil, the actual impact is thought to be much larger. This is driven by a combination of reluctance to purchase Russian crude by international companies, witness the response to news that Shell had purchased a Russian cargo (5), together with difficulties in complying with sanctions, even though they were designed to facilitate continued trade in oil & gas.

Russia had been producing around 10 MMbbl/day, and has theoretical spare capacity, although it has struggled to keep with OPEC+ quote increases in recent months, so this spare capacity is questionable. It exports around 7 MMbbl/day of crude oil and oil products, with 4.8 MMbbl/day flowing to countries that are backing sanctions against Russia (6). The IEA (1) estimate that next month, 3 MMbbl/day of production will be taken off the market. There is not enough spare global capacity to fill that gap, never mind the 4.8 MMbbl/day that would be required for a complete embargo. The world needs Russian oil, at least for the foreseeable future. The question is what happens next.

Under one scenario, the war in Ukraine is resolved in the next few weeks, sanctions are relaxed and Russia production returns to the market. Even if the war resolves in the near term, I think this is unlikely. For one thing, energy security has become a concern again, and OECD nations are likely to either diversify their supply away from Russia, reduce their reliance on oil, or a combination of the two. President Biden has also called Vladimir Putin a war criminal publicly, it is hard to see Russia reintegrating itself into the global economy quickly.

In my view, the most likely scenario is that Russian oil is gradually redirected to buyers in countries that are not involved in Russian sanctions. Russian crude will be marketed at a discount, perhaps in Yuan or another currency. This will push other suppliers out of the market and they in turn will redirect their supply to sanctioning counties, to backfill Russian production. This would be a reallocation, rather than a reduction, of Russian supply, which will result in temporary dislocation, rather than a true supply shock. The oil market will become balkanized, with a dollar denominated, largely international market and another market of sanctioned nations – Russia, Iran and perhaps Venezuela. While this dislocation occurs the world will see tight supply, but there are actions that can be taken to mitigate those; world oil storage is still sitting at about the five-year average and the IEA can provide oil from member nations strategic reserve, as they did earlier this month with a coordinated 60 MMbbl release. How long will this dislocation last? If we assume 5% per month, around 250,000 bbl/day, the reallocation would be complete by 2023.

The second source of uncertainty is the OPEC+ response. Quotas were held steady at the latest OPEC+ meeting, with 400,000 bbl/day of supply returned to market, despite requests from the US and others to boost production. I don’t believe this is action was taken to profit from high prices, as the OPEC+ nations are as aware as anyone else as to the demand destruction that high prices bring. Rather, I think it is driven by a combination of factors – capacity to boost production, unwillingness to antagonize Russia, and uncertainty in outlook.

As noted in last month’s Forecast, OPEC+ has struggled to meet its quotas for the last few months. These rising production quotas have started to reveal the impact of years of underinvestment. There is also underlying volatility, with Libya, for example, which is not subject to OPEC+ quotas, losing a quarter of its production capacity in the last month due to an armed insurgency. It is not clear when this 330,000 bbl/day with return to market. Both Saudi Arabia and the UAE have spare production capacity, estimated at around 2.5 MMbbl/day, but it is not clear if that spare capacity can be placed on production for an extended period. Saudi Arabia has long held spare capacity for reservoir management, it would be prudent to discount those theoretical maximum production levels. In short, there may not be much additional capacity to bring to market.

Relationships are also important, since their price war in early 2020, Russia and Saudi Arabia have been remarkably successful in steering the industry through the covid price collapse and gradual recovery. They remain the world’s second and third largest producers and between the two balance the market, to try and create those stable, moderate prices that everyone benefits from. Saudi Arabia, and therefore OPEC+, will be very reluctant to damage that relationship.

Finally, there is uncertainty in outlook, both on the supply and demand side. The supply and demand picture, although more settled over the last few months, has whipsawed wildly since the emergence of covid. OPEC+ has remained remarkably consistent in its response to that uncertainty and the market has benefited from, with excess inventory worked off and prices recovering. It probably is prudent to wait and see.

Finally, we have to consider US supply response, with estimates ranging from flat production to an additional 1.2 MMbbl/day. My own forecast estimate is an additional 500,000 bbl/day. There has been a lot of debate over the last few weeks about boosting US production and as the breadth of the challenge becomes clearer, the low end of the scale looks more likely – see the US activity and investment section for a more detailed discussion on this.

Where does all of this leave supply and demand balance? A market that was already tight has gotten a lot tighter, see Figure 1, even with a projected drop in demand it looks like demand will outstrip supply by 1 – 2 MMbbl/day for the rest of the year.

Figure 1 - Supply and Demand Surplus Forecast

We now estimate global oil inventory drawdowns of 796 MMbbl in 2022, up from 321 MMbbl last month. This is still below the overall build of 1,072 MMbbl in 2020 but combined with stock draws of 321 MMbbl last year we are around the 5-year average now and stocks will fall below 2019 levels by year end.

Figure 2 - Global Storage Chart

We are starting to see further evidence of this with the IEA reporting that OECD stocks were 335 MMbbl below their 5-year average and sitting at an eight-year low.

As could be expected, oil prices have soared. Oil prices crossed the $100/barrel threshold for the first time since the 2014 price crash, with Brent Crude sitting at $115/barrel at the time of writing. The EIA revised their average 2022 Brent price up again by $22/bbl to $105/bbl, suggesting that they expect the market to remain tight for the rest of the year at least.

Both Brent and WTI are up again; at the time of writing both are at the top of their 12-month averages for most of their contract periods, although WTI is from 2028. Brent remains above $70/bbl out to 2030, with WTI above $65/bbl out to 2033.

Figure 3 - Brent Crude Oil Futures

Figure 4 - WTI Crude Oil Futures

After a sharp rise last month, the US land oil rig count seems to have leveled off adding and dropping rigs from week to week and sitting at around 510. This still puts it ahead of my most optimistic forecast for this point in the year and barring a sudden drop I expect it to stay that way for the month of March, see Figure 5.

Figure 5 - US Land Oil Rig Count

With calls this month to boost domestic oil production, from even the Biden Administration, there has been a much more detailed debate on the challenges facing the domestic industry and some more clarity on its production potential is starting to emerge. These challenges can be divided into four groups – lack of capital, oil field services capacity constraints, regulation and, for the first time, an acknowledgement that inventory is limited.

Starting with capital, as widely noted over the last few months, US shale has moved from a growth to a harvest model. Capital is rationed and existing producers are returning cash to investors. Consolidation is the order of the day, with existing operators spreading their G&A over more wells. As previously discussed in this forecast, this makes sense, after nearly a decade of very poor financial performance the industry has to show that it can generate attractive returns. Eventually, capital will return, but it isn’t returning yet and it isn’t clear where it will come from.

I attended an industry conference earlier this month, where the production of oil & gas was referred to, by a corporate CEO, as “the evil act”. For context, he ran a minerals company, and his sales pitch to investors was that they could profit from oil & gas, without participating in “the evil act”. The public equity markets have been reluctant to support oil & gas for years, and a more aggressive regulatory regime and a greater focus on ESG from fund managers is only going to make things harder. Private equity seems to be moving in the same direction, with Blackstone announcing that it would no longer invest in the industry (7), and Riverstone and Apollo Global Management also shifting focus. Without an influx of capital, new development will be restricted to existing producers re-investing out of cashflow, and this will not be enough to drive significant production growth.

The second constraint facing the industry is a lack of labor and equipment in the oil field services industry that drills and completes wells. In their podcast at the end of last year John and Richard Spears of Spears and Associates (8) expects the industry to hit capacity constraints, in terms of drilling rigs and frac spreads, this year. In their view bringing additional equipment online would require multiyear drilling programs, to cover capital costs, which the smaller operators who have been driving rig counts are unable to underwrite. Adding equipment would also take time. As we see the US oil land rig count hit the 500 mark, this may be the constraint the industry is starting to bump up against.

My view had been that regulatory constraints has not had much of an impact on activity levels, but Harold Hamm, the founder, Chairman and CEO of Continental Resources presented a different perspective in an article in the Wall Street Journal earlier this month (9). He identifies the Biden Administration’s push to restrict capital to the industry, impose restrictions on leasing Federal land for development and restricting pipeline infrastructure as things that prevent the industry from growing.

These restrictions feed into the fourth challenge facing the industry, that US shale is running out of inventory. At CERAWeek earlier this month, John Hess acknowledged that the Bakken was now in middle age, with perhaps a decade of inventory left (10). This constraint isn’t just limited to Hess’s position in the Bakken, with 80% of remaining economic drilling locations in the Permian Basin, according to Wood Mackenzie (11). This forces US shale firms to start exploring for new fields, either Shale oil fields or conventional ones, which requires capital and new acreage.

Where does this leave US production? At one end of the spectrum, Wood Mackenzie think that Permian production will grow by 240,000 bbl/day this year, but that will be offset by declines from other basins keeping US production flat on the whole (12). At the other end the IEA had predicted US production growth if 1.2 MMbbl/day. The historical relationship between oil price and US shale production is not the same as it was in the years before covid, for some of the reasons outlined above. Models that are based on that kind of historical relationship are likely to overestimate US output, something the EIA acknowledged last year. This suggests US production growth will be towards the lower end of the predicted range in future.

(1) Oil Market Report – March 2022, IEA, Paris.
(2) Short Term Energy Outlook (STEO), March 3rd, 2022, U.S. Energy Information Administration.
(3) “OPEC Monthly Oil Market Report”, Organization of the Petroleum Exporting Countries, March 15th, 2022.
(4) “Three big uncertainties cloud the oil market”, The Economist, March 20th, 2022.
(5) “Shell to stop all Russian oil and gas purchases, apologizing for buying shipment after Ukraine invasion”, Matt Clinch, CNBC, March 8th, 2022
(6) “Here’s where Russian oil flows”, The Washington Post, Steven Mufson, Aaron Steckelberg, Andrew Van Dam, and Naema Ahmed, March 8th, 2022.
(7) “Blackstone Swears off Oil & Gas as Private Equity’s retreat widens”, Bloomberg, February 22nd, 2022
(8) “The Drilldown: EP:214”, Spears & Associates, November 16th, 2021
(9) “Biden’s War on Oil Hits Consumers”, Harold Hamm, Wall Street Journal, March 13th, 2022
(10) “Frackers Say Bottlenecks Impede Output Boost as Oil Prices Soar”, Collin Eaton, Wall Street Journal, March 9th, 2022.
(11) “Oil Frackers Brace for the End of the US Shale Boom”, Collin Eaton, The Wall Street Journal, February 3rd, 2022.
(12) “Frackers Hold Back Production as Oil Nears $100 a Barrel”, Collin Eaton, The Wall Street Journal, February 18th, 2022.