After more than a century, it appears that the age of oil is drawing to a close.
The entire world is rapidly embracing renewables.
Governments everywhere have pledged trillions of dollars toward the transition to clean energy.
China, India, Britain, Korea, Japan, and now even the United States are moving in the same direction: away from hydrocarbons.
While that doesn’t sound very bullish for the price of oil, in the short and medium-term, I’m growing convinced that it actually is…
Suddenly, Nobody Wants to Spend Money Drilling Oil Wells
The world’s oil producers are slashing spending across the board.
Those spending reductions are going to have a big impact on medium-term oil supply.
The moment an oil producer puts a new oil well into production, the rate at which it produces immediately starts declining.
So for oil producers, these production declines create a never-ending treadmill. Producers have to constantly spend money on drilling just to stay in the same place.
To grow production, they need to spend even more.
According to Exxon Mobil (NYSE: XOM), global production from existing oil wells declines at a rate of 7% per year.
On a base of 100 million barrels per day (bpd) of production, that means the world will lose 7 million bpd of production over the next 365 days.
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That means to just keep production flat at 100 million bpd, the oil industry needs to add 7 million bpd of new production.
Without sufficient spending on new wells, global production will fall.
Historically, spending enough on new wells to offset declines hasn’t been a problem.
The oil industry has always notoriously borrowed aggressively and burned through every penny of its cash chasing production growth above all else – often creating no value for shareholders.
But now things are different for two reasons…
- Investors have indicated to oil companies (especially shale producers) that borrowing recklessly and burning through cash is no longer acceptable.The market wants to see these companies spend less, improve their balance sheets and return cash to shareholders instead.Oil executives who would like to keep their cushy jobs have received that message, and growth spending has been cut to the bone.
- With the long-term future of oil in doubt, the largest oil producers are no longer willing to spend billions exploring and developing the megaprojects that are so crucial to maintaining supply. These companies can’t spend billions developing long-term oil projects if they don’t believe there is going to be long-term demand for that oil. I recently wrote about how oil majors Royal Dutch Shell (NYSE: RDS-A), BP (NYSE: BP), and Total (NYSE: TOT) have all announced plans to intentionally reduce production.
Without these big boys growing new production, oil supply is set to suffer in both the near and long term.
Demand Will Fall Eventually, but Not Yet
Prices are always determined by the relationship between supply and demand.
If supply exceeds demand, prices fall.
If demand exceeds supply, prices rise.
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While huge spending cuts are set to hit short- and medium-term oil supply, demand is not projected to fall until far out in the future.
In China and India, where billions of people live, oil demand is expected to continue growing for a while.
Eventually, the transition to renewables will cause global oil demand to peak. But it can’t happen overnight.
Reuters recently provided a recap of when oil market analysts are forecasting global demand to peak.
- Bernstein Energy projected it would peak between 2025 and 2030.
- Rystad Energy was more specific, pointing to 2028.
- The International Energy Agency believes it will happen within 10 years.
- Goldman Sachs thinks it will happen after 2030.
Meanwhile, spending cuts are going to hit oil supply much sooner.
Last week in its investor update, the French oil major Total warned that it sees a big oil supply shortfall coming by 2025.
By big, I mean a shortfall of 10 million bpd.
That is a massive shortage.
If Total is correct and the oil market is headed toward a situation where it is undersupplied by this much, the price of oil is going to surge.
So while the age of oil might be ending, it isn’t going to end without a bang.
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Good investing,
Jody