Oil: This Time Is Different, Right?

Summary

• Global upstream Capex is increasing but remains a third below levels required to help rebalance acute oil market tightness.
• Producers, especially US independents, have not bought into the post-Covid price rally, keeping spending subdued (-50% vs 2014 peak).
• Mismatches between the speed of energy transition and supply-side underinvestment will result in sustained market volatility.
• Oil at $100 will become the norm, barring a severe recession.

Introduction

The first flickers of higher spending by oil and gas companies in response to the surge in energy prices over the last year are emerging (Table 1). But the market is far from achieving a long-term rebalancing of spending that will be sufficient to bring supply back in line with demand. With demand now back at pre-Covid-19 levels, spare oil production capacity has been largely exhausted, sending benchmark prices and spreads soaring as the market screams for more prompt supply. Indeed, it is unclear if companies can or will respond to these price signals in the way they previously have.

Western operators in particular are struggling to meet fossil fuel demand while also diverting more capital to alternative energy sources due to pressure from investors. Many investors have not yet abandoned their focus on a value-driven business model even though the looming prospect of an energy sector–induced recession following Russia’s invasion of Ukraine is starting to turn the tide. Management teams will remain cautious as the rally in the shares of many energy companies largely reflects short-term tactical investment flow rather than a structural shift in attitudes towards the energy sector. The appetite from long-only investors remains subdued. And until that capital returns in force, overhauled business models for public operators have a sustained focus on dividends, buybacks and returns at the expense of output growth.

Increase in Capital Due, But Too Little

Upstream operators are set to raise spending by 13% y/y (up by $44 billion to $391 billion) after regaining their footing following a brutal 2020 and a tepid 2021. Of this increase, $15 billion will go to North American assets (+14% y/y) and the remaining $29 billion to the rest of the world (+12% y/y to $274 billion). In total, this level of capital spending is still 34% below the 2010–14 average of almost $600 billion (or 54% below in 2014 dollars) and will mean supply fails to keep pace with demand growth. Furthermore, inflation – reported to be as high as 15% in the US shale space – is eroding the industry’s ability to translate spending increases into more supply.

The spending uplift this year is a start. But it remains short of a new golden period for oil and gas investment. We believe Capex needs to move into and stay in a $550–600 billion range to sustainably service 100 mb/d of demand. Additionally, we note a larger bias towards gas assets today versus previous cycles. Over 1999–2014, spending rose six-fold (in 2014 dollars) from a trough of $122 billion to a peak of $669 billion. However, between 2014 and 2020, spending by the oil and gas industry halved, and we are in the eighth year of sub-par investment. This has eroded productive capacity across the board.

It is less a question of capital scarcity than one of market signals. Without a rise in the back end of the oil curve (we think an $80–90 range on a sustainable basis is required), long-term investors will struggle to gain the confidence required to deploy more capital. The key factor behind this behaviour has been an excessive focus on short-termism (a by-product of loose monetary policy), culminating in weak cash generation and returns on capital. This led to many investors rejecting oil companies and remains the case today, with energy a paltry 4% of the S&P versus 14% at its peak in 2008. These investors have more recently been joined by another cohort of ESG-driven investors who refuse to invest in oil companies regardless of returns.

Sustainable long-term returns require structurally higher oil prices. This is paradoxically compatible with ESG investing as it makes renewables more competitive. However, if the push to renewables is sustained, higher oil prices will beget higher oil prices. From the market standpoint, this is where the real challenge originates.

The response from international energy companies (IECs) and public shale operators has so far been to divert capital from short-cycle barrels. This is stage one in a multi-step process. Next, conventional investment must rise to fill the gap shale filled for many years.

Too little…

Using the spending of North American independents as a guide, investment in shale rose from $84 billion in 2010 to $135 billion in 2014 in what is often described as the most staggering technological innovation the oil industry has ever seen. US liquids regularly grew at 1 mb/d y/y and surpassed 2 mb/d at points during in 2014 and 2018. For a while, investors could not get enough of this business model. Pitches based on single well IRRs that were strong through a range of oil prices led to cash being made readily available, allowing operators to drill at will. During the shale boom, modest upward price signals were met with outsized drilling and activity. In turn, large supply volumes were added to the market, often tipping liquids balances into a surplus.

These periodic surpluses lulled the market into a false sense of security and supported projections of perpetual shale growth in a supposed era of supply abundance. The failure of shale firms to generate returns through the cycle led to severe investor disappointment. However, the rapid growth in US production masked the sharp decline in investment in conventional supply in the last decade, which the Covid pandemic amplified. Only now, just as the vision of a long-term shale boom has ended, is this underinvestment becoming apparent.

When a renewed focus on returns met with Covid, the result was a market stripped of productive capacity. US oil output collapsed by nearly 2 mb/d in 2020 following a 34% decline in North American upstream Capex, and the flipside of short-cycle growth—steep declines—became apparent. The shale industry’s muted Capex responsiveness to the 2021 recovery reflected new priorities of increasing shareholder returns following a decade of negative cash generation.

…Too Late

Boosting short-term spend will not yield energy at the flick of a switch. The average size of conventional oil discoveries has been falling since the late 1980s, meaning new developments will also be smaller.  

Ultimately, shale has exaggerated the misunderstanding of the importance of pricing on investment. During the shale boom, short-cycle pricing dictated investment flow in the sector. However, oil and gas remains a long-cycle industry where average costs are much higher. Long periods of prices being insufficient to generate reasonable returns will lead to underinvestment. That theme is coming home to roost.

Moreover, investing in long-cycle conventional upstream projects consists of balancing through cycle economics with above-ground risk factors. Sanctioning big projects today will mean supply only comes to the market later in the decade when concerns around peak demand and transition pressures will be stronger.

Cheap, Clean, Safe and Secure

In general, society feels good when energy supply meets four basic criteria: cheap, clean, safe and secure. Shale caused an atypical 10-year window when these four factors appeared to be met, but the world was lulled into a false sense of security. History tells us that it is very rare to achieve all four at the same time.

Barring a severe recession, $100 oil will become the norm not only between 2022 and 2024, but into the 2030s unless investment picks up. That may be just what is required to shift investors’ attitudes towards upstream investment. But several recent energy crises have proven it is tricky to balance the price companies need to justify new investment and the price society can tolerate.

Moreover, the war in Ukraine pushes the required spend towards the upper end of the $550–600 billion range we estimate is required to meet demand since low-cost Russian assets will be off limits to many investors. The war will force a redistribution of capital towards market-oriented provinces such as Canada, Norway, Guyana and Brazil. But there is a catch. If capital is merely shifted and not also increased, there is little hope to boost total supply. These countries may be able to deliver clean, safe and secure barrels, but they will not be cheap.

The energy transition will play out over decades, yet tectonic shifts have already occurred on the supply side. Mismatches between the speed of energy transition (and demand destruction) and the speed and scale of supply-side underinvestment will result in more market volatility. The larger the imbalance, the higher prices will go, leading to more serious economic disruptions. After all, energy is the main input of the economy and everything else, from technology to consumer staples to materials, depends on it. We are learning this the hard way.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)