Creating space for an Oil Crisis

This article is derived from the research of Goehring & Rozencwajg Globally, we are on the brink of an energy crisis. Like most crises, the fundamental reasons for the energy crisis have been lurking in the background for several years but required a catalyst to bring them to the forefront and the eye of the public as well as the average investor. The pending energy crisis is rooted in the underlying reduction of US shales and the continuing disappointments in non-OPEC supply from the rest of the world. The catalyst for the energy crisis is the coronavirus.

The first phase of the crisis that saw prices go negative is now in the past, and the next phase, which should take prices much higher, is still in very early stages. In general, global energy markets, and oil markets specifically, are moving into a structural shortfall as we speak. During the coming years, investment in the energy market will be the most important theme in investment terms and the most significant unintentional consequence of the coronavirus.

Investors are now focussed on how quickly supply can be brought back to meet the recovering demand. Though most investors believe that production can be brought back online easily, the models of Goehring & Rozencwajg tell a different story. It is most likely that OPEC+ production will rebound; however, non-OPEC+ production will find it much more difficult to recover. Models indicate that non-OPEC+ production is about to decline, instead of recovering from the current dramatically low levels.

To date, the decrease in non-OPEC+ production has come entirely from proactively shutting in production. The oil wells were mostly old and only slightly economic before oil prices collapsed in early 2020. In the future, production will be impacted by a different and also longer-lasting force. The low oil prices led to producers to limiting almost all new drilling activity. As of 13 March 2020, 680 rigs were drilling in the United States. The US oil rig count fell by 75% to 180 rigs in less than four months afterwards, the lowest level on record.

Typically, shale wells benefit from strong initial production levels but suffer from sharp ensuing declines. Basin production falls quickly unless new wells are constantly drilled and completed to offset the base declines. Given that the US shale production was already declining in November 2019 (when the rig count was above 700), the current rig count of 373 all but guarantee that production will collapse in the future.

The lower oil prices led to a significant decline in drilling in the rest of the world as well. Between February and June 2020, the non-US oil rig count declined by 40%, also the lowest count on record. The last decade saw this group’s production slowly and steadily decline, as a dearth of new projects has not been enough to offset legacy field depletion. By laying down half their rigs, this group ensured that future production would be substantially impacted.

Analysts continue to focus on what has already happened (the shutting-in of existing production), instead of focussing on what is yet to come. The unprecedented drilling decline is only starting to impact production now. In the future, supply will decrease dramatically, leaving the market in an unprecedented deficit starting now.

See below the move in Brent Crude Oil, back up to $60 a barrel from the lows of around $20 we saw in Apr/May 2020.