Perhaps nothing will influence the medium to long term prospects of Ukraine more than the oil price. If prices rise to $140 / barrel, as Pierre Andurand, the world’s best known oil trader, suggests, then the EU / US embargoes and price caps on Russia oil will prove politically untenable, and Russia’s financial resources will be all but unlimited.

In my last Ukraine-related post, I looked at demand and assessed Andurand's claim that oil demand could rise by a hefty 4 million barrels per day (mbpd) this year.

In this post, we look at the oil supply. What is the outlook for growth? Will it be able to keep pace with demand, or are prices set to rise towards $140 / barrel?

The Historical Context

As the graph below shows, until 2005, the global oil supply was growing at a solid pace, with gains coming principally from OPEC and post-communist Russia. During this time, US oil production was declining, as it had been for many years, by about 0.1 mbpd on 9 mbpd of total petroleum liquids output. The decline was slow, but perceptible and inexorable.

In 2005, all that changed. Russia and OPEC were no longer willing or able to add supply in the medium term, and the US could only watch its own resources decline. For four years, from 2005 until 2009, the oil supply barely budged. This culminated in the oil price spike of 2008, when the US benchmark WTI oil price hit an all-time record of $147 / barrel. Two months later, the global economy was consumed by the Great Financial Crisis.

The financial crisis morphed into the Great Recession. Oil producers scrambled to cut production in the hopes of propping up plummeting oil prices. This ultimately proved successful, and by 2010, the global economy was growing again. Oil production recovered with economic activity.

Nevertheless, the oil supply was once again unable to keep pace with the recovery of the global economy, and by 2011, the European Brent benchmark had soared to $110 / barrel. It would remain in this range for the next three and one half years, through June 2014. During this period, the US struggled with 'secular stagnation', and Europe entered yet another recession, even worse than the one it had just exited. The economic stresses of high oil prices were evident.

Salvation came from an unlikely source: the US. Although US oil reserves are among the smallest of the major producers, they are efficiently exploited, and US innovation and entrepreneurship are unmatched. US oilmen discovered that they could extract natural gas from rock -- shales -- and then applied that knowledge to extract oil using horizontal drilling and hydraulic fracturing -- 'fracking'. Fracking was wildly successful. From 2008 to 2022, the US added 11.7 mbpd to the oil supply (comprising crude oil and condensates from oil wells and natural gas liquids (NGLs) from gas wells). To put it in context, US shale production growth since 2005 exceeds the total production of Russia or Saudi Arabia. By itself, US shale liquids (crude + NGLs) would be the world's second biggest producer after the United States.

In fact, US shales have provided more than 80% of the incremental world oil supply since 2005. US shales, along with Canadian shales and oil sands, have provided effectively all of the net incremental oil supply since 2005. In the last seven years, US shales have carried the global oil system single-handedly.

Of course, other countries also added production. The Russians contributed modestly, and the Brazilians a bit more. But one group contributed effectively nothing: OPEC.

The OPEC supply of petroleum liquids (crude oil + natural gas liquids) was essentially the same in 2022 as it had been in 2005. OPEC has added nothing to the global oil supply in seventeen years. Indeed, Saudi Arabia is pumping about as much today as it was in 1979, before the second oil shock. It is true that OPEC was pumping 3 mbpd more in 2016 than it is today, and that OPEC has the capability of expanding production to an extent. But the underlying reality is far from what most people think. OPEC supply has not changed much in the last seventeen years. US shales, by contrast, are still considered the newcomer, a nice addition to the oil supply, but are thought of as just the icing on the OPEC cake. Nothing could be farther from the truth. The global oil system has been fully dependent for growth on US shales since 2005.

Looking Forward

What can we expect from the world oil supply in the coming years?

This hinges, first and foremost, on trends in US shale oil production. Shale oil comes essentially from just five plays, the Permian, Bakken, Eagle Ford, Niobrara and Anadarko (using EIA nomenclature). The Permian, in west Texas, is by far the most important.

The EIA has muted expectations for US oil production growth in 2023, with supply in October 2023 forecast to be only 0.1 mbpd higher than this past November. That will not come even close to the 1.9 mbpd of demand growth the European IEA expects this year.

Figure 3.
Source: Various editions of the EIA monthly STEO

On a longer horizon, the situation is potentially even more problematic. Not all shale plays are the same. The key shale plays other than the Permian -- that is, the secondary plays comprising the Bakken, the Eagle Ford, Niobrara and Anadarko -- are producing 0.9 mbpd less than their peak production in October 2019. They are more than three years past peak production. Indeed, the secondary plays are collectively producing less than they did eight years ago. Although their production is recovering modestly, they are unlikely to ever regain earlier highs.

As a result, the Permian basin has been left to meet global demand by itself, and it has successfully done so since 2015. The question is how long the Permian can continue to do this. As the graph above shows, Permian production growth has been solid, adding about 40,000 bpd every month, potentially 0.5 mbpd for 2023 as a whole. Nevertheless, the drilling rig count in the Permian (below) is largely unchanged since June. If rig counts remain stuck at their current level, production may also be expected to plateau within 12-18 months, that is, the Permian could reach its maximum output this year. In fact, some analysts have begun to question whether peak US production has already arrived or is perhaps just a few months ahead of us. Historically unusual production declines in November and December are consistent with this view.

Figure 5.
Source: Baker Hughes, Bloomberg

A peak would come as no surprise. A plateau for US shale oil production has been forecast for the 2023-2025 time frame since at least 2017. The EIA's forecasts from 2017, 2019 and 2022 can be seen below, and all of them expect US production to plateau by mid-decade. Nor are EIA forecasts outliers. Mainstream forecasters like Goldman Sachs have expected a mid-2020s peak since at least 2017. Those who follow the data have known for years that US production could crest in the mid-2020s. It has been expected for a long time.

Figure 6.
Source: EIA Annual Energy Outlook (AOE), 2017, 2019 and 2022 editions

If US production can no longer meet incremental demand growth, what other countries could step up?

Brazil and Canada are the key countries outside the OPEC+ cartel. Other major producers like China or Norway do not add much extra oil. In recent times, Brazil and Canada have been able to add 0.3 mbpd / year, just enough to offset declines elsewhere. In a very good year, they might add net 0.4 mbpd. Therefore, if the US is out of the picture, the remaining non-OPEC+ countries — principally Canada and Brazil — can be relied on to meet no more than one-third of incremental oil demand in a better year.

For the balance of needed barrels, the world must look to Russia and OPEC.

Russia is, of course, under sanctions, but production there is only 5% below expected levels. As a result, Russia's spare capacity is minimal, even if it were able to freely export. Further, Russian oil production under Putin has tended to show steady growth of about 0.2 mbpd / year, and we might expect similar growth in the future, all other things equal. The war, however, has adversely affected the outlook. Sanctions have delayed a number of Russia's more sophisticated projects, and Russia’s wartime fiscal needs are likely to cannibalize at least part of the capital expenditure programs of companies like Gazprom and Rosneft. Consequently, stagnation or even decline in Russia output would come as no surprise. For planning purposes, a meager Russian addition of 0.1 mbpd / year might appear plausible for the balance of the decade. This is far from sufficient to meet world demand growth.

That leaves OPEC.

OPEC produced 2 mbpd above current levels before covid, but cut production to counter weak demand associated with the pandemic. As a result, OPEC has excess capacity of 3 mbpd, of which approximately 1.5 mbpd could be brought back on line over a period of 6-18 months. This is enough to meet the IEA's anticipated demand growth of 1.9 mbpd for 2023 without any notable price shock.

For Russia and OPEC, however, the question is intent. All business cartels -- including OPEC -- exist to maximize selling prices by limiting production. As a result, OPEC -- and now the OPEC+ cartel including Russia -- have an incentive to add production with a lag, that is, to allow growing demand to drive up oil prices, commit some capacity to slow the price rise, allow demand to grow again, and let oil prices rise again, and commit some additional capacity. The result is a gradual spiraling up of prices, with supply never quite catching up to demand.

By implication, those expecting OPEC to save the day and materially increase production over the next several years are likely to be disappointed. OPEC's average additions are likely to be similar to those of the last ten or twenty years: +0.2 mbpd / year on average, with significant lumpiness. OPEC's modest additions -- even supplemented by Brazil, Canada, and Russia -- are unlikely to keep pace with demand growth.

Instead, OPEC will be looking to recreate the conditions of 2011-2014, when oil prices averaged $110 / barrel. Adjusted for inflation, that is $140 / barrel today, just the number Pierre Andurand highlighted.

This should not be taken to imply that oil prices will rise to $140 / barrel in the near term. Supply continues to run ahead of demand, OPEC still has a comfortable spare capacity cushion, and the outlook for the global economy remains choppy.

Nevertheless, the conditions are present for a material tightening of the market in the medium to long term. After 2023, oil price trends favor Russia, and perhaps substantially so. For Ukraine, this could pose a serious threat, as the current European and US sanctions on Russian oil are unsuitable to deal with such an eventuality.