Global Oil Supply
Oil supply is driven by OPEC, geopolitics and new technology. Oil demand is driven by consumption (driving, transportation), where China and other Emerging Markets make up a large percentage of incremental growth.
Oil and Gas Price Equilibrium Overview
The US$ price of oil itself has been in the news lately, and is driven by the global supply-demand dynamic. Demand growth is driven by the need for transportation and that is highly correlated with economic growth (movement of goods and services). Currently, there is no scalable substitute for gasoline as a fuel for transportation. If China’s economy is growing rapidly, oil demand can be expected to grow faster. Incremental oil demand growth tends to be from emerging markets as they industrialize and their needs align with those of developed markets.
On the supply side, we need to think of individual oil projects as finite. As such, the aggregation of producing projects will make up total production and accordingly supply. Macro forecasters will look at oil production by country, perceived supply curtailments (war, terrorism, political effects, unexpected maintenance) and when projects (particularly million barrel per day of production plus projects) start to decline. A major supply shock that is commonly discussed is an OPEC production cut, given OPEC’s share of global production. We will discuss the feasibility of this in a later article.
The last part of the equation is storage. When there is an oversupply of oil, oil can be stored in tankers and batteries. If tanker volumes start to become too high, that puts pressure on the oil price. When inventory volumes see drawdowns and storage levels fall, that will support the oil price. However, a lot of expectations are priced into the price of oil (and oil futures), so if there is a drawdown and expectations were for a larger drawdown, this could cause a selloff.
Oil and Gas Supply Side
Oil supply is a function of oil production and inventory levels.
Oil production supply growth is dependent on a variety of factors. Historically, oil and gas projects had varying lead times and would be sanctioned based on long-term oil price forecasts that ensured an appropriate return on capital for stakeholders in the projects.
For instance, a large oil sands project in Alberta would take a considerable amount of time for resource estimation, various stages of engineering and infrastructure planning. From proposal to actual production, the process may take over 5 years.
The time frame differs as oil is located across a range of geologies, and as such production and cash flow profiles differ across different basins whether shale, conventional, shallow water, deep water, mining or thermal production.
Given the profiles of oil and gas megaprojects, a certain amount of oil supply can be reasonably forecast over the medium term (short term accuracy may be marred by various factors, including unplanned shut downs for technical, regulatory or geopolitical reasons).
OPEC Policy and Oil Prices
However, OPEC nations have a large amount of oil where production can be brought on or off very quickly (major oil projects in the oil sands cannot, as they have extremely high fixed costs to start up and may be worth running at a loss per barrel for some period until oil prices recover). OPEC producers will often have spare capacity that they can choose to utilize if prices are acceptable to them.
OPEC members base production decisions on national interest, which is primarily dictated by revenue but will consider foreign policy goals as well. Previously, given OPEC’s considerable ownership of the world’s total oil reserves, the OPEC’s influence on the supply curve was considerable.
Here is an expository post on OPEC decision making.
Shale Oil Production and Technology
Shale production has since changed this. Shale return forecasts are precise and production can be brought online in a matter of weeks. In addition to this, technology for the hydraulic fracturing methods used in shale drilling are improving at a rapid pace, continuously pushing down the breakeven price for production.
Only the US has successfully achieved widespread commercial shale production, but the US alone has changed the supply paradigm as any cut from OPEC will result in an opportunistic increase in production in the US as investment hurdles are met at every higher oil price. This brings the world to a more stable equilibrium function.
However, shale oil reserves are enormous globally, with large deposits in China (Sichuan) and Argentina (Vaca Muerta) that have not been commercialized yet. Should shale production become a global phenomenon, the supply curve could change drastically over the next decade (via a large shift to the right).
Oil and Gas Regulation – Environment and Production Sharing
Environmentalist resistance has been one of the largest impediments to oil and gas production growth in Canada (and less so the US). North America has seen numerous pipeline projects delayed or cancelled due to strong social pressure (Northern Gateway, Keystone XL – although this has been revived under Donald Trump). Without a reasonable transport option, even the cheapest oil to extract is not economical as there is no sale realized. As such, what a government sanctions is key in production growth, although this is very long-term (regulatory body decisions and construction both have extremely long lead times).
Capital is mobile and oil and gas companies look at how much the government takes. Most developed countries have royalty regimes where the risks and rewards of development lie with the oil producer. However, in most OPEC countries, producers are subject to a production sharing agreement (PSA) whereby production is split with the country after costs are recovered. Profits after that are taxed after as well.
This impacts economics and adds a layer of cost – more generous extraction rules will increase supply and vice versa.
Oil Inventory Levels
Oil is stored in oil batteries and tankers at sea. Oil is stored by a variety of stakeholders, from refineries who want to keep a reserve of throughput, to governments keeping a strategic amount of oil for national security (the US and China have by far the biggest storages, with the geography of China’s holdings not very transparent), to physical arbitrageurs looking to capture financial profits.
When inventory levels fall, this pushes oil prices up as it means that demand is exceeding supply where consumers of oil must draw on inventory levels.
In looking at oil inventory data, # of days of oil supply in inventory levels is a good relative indicator for whether there will be pressure on the oil price. Also, storage availability is a downside risk. If storage capacity approaches, oil prices will fall as this will mean that oil producers may have difficulties storing excess oil cheaply. Tanker prices for overseas movement are also an indicator of oil demand.