Low Investment and Implications for Global Supply

Dean Foreman
Posted September 17, 2021

Global oil and natural gas investments have fallen to record lows so far in 2021, as we recently discussed here. Yet, demand for both has risen alongside the economic recovery. Consequently, supplies haven’t kept pace with demand, and the mismatch between the two propelled gasoline and natural gas prices this summer to their highest levels since 2014.

In fact, global natural gas prices set a record-high for summer months as demand outdistanced supply.  Oil prices eased in August following a 16% run-up over the previous three months for Brent crude oil, but were back above $70 per barrel in mid-September.

Although economic and pandemic-related uncertainties and expected OPEC+ output increases have also likely impacted prices, the lack of investment for oil and natural gas production is an ominous sign, given that major conventional global oil and natural gas projects can take years to start producing. We could be in for global oil market tightening in 2022 and further upward pressure on prices, with prices already at their highest level since 2014.

Let’s dig into some fundamental data that could help clarify the broader context, beginning with global drilling activity.

Consider global oil and natural gas drilling activity compared with Brent crude oil futures prices for delivery one year ahead on a three-month average basis. International Brent crude oil futures prices have broadly represented oil price expectations, and as can be seen in early 2016 and late 2018, a sustained change in futures prices has historically corresponded with changes in drilling activity in the following quarters. 

However, notice that a visible gap emerged in 2021 between low drilling and high prices. If we compare July 2021 with July 2019, crude oil futures prices have been 7.2% higher, but U.S. drilling remained down by 40.7% for natural gas and 51.3% for oil. International drilling was down by 30% for oil and 51.2% for natural gas. 

Anemic drilling activity tells us a couple of things. Since most international drilling is in conventional reservoirs, many long-lead projects may be unavailable to help meet near-term demand growth. Conversely, in the U.S. where unconventional shale drilling dominates, the historical responsiveness of drilling to price changes has weakened, presumably due to company financial and workforce limitations, supply chain and cost escalation issues, as well as questions fostered by the administration about the industry’s future. 

By contrast, the U.S. Energy Information Administration’s (EIA) projections assume that drilling will respond to higher prices, and EIA’s latest view is that the U.S. could add new production of 1.8 million barrels per day (mb/d) of crude oil plus 6.0 billion cubic feet per day (bcf/d) of marketed natural gas production between Q3 2021 and the end of 2022 – estimated volumes that have increased in the past couple of months.

That could be a tall order unless U.S. rig activity re-accelerates toward its 2019 levels.

For oil, which is a global commodity, the pace of drilling has been made less urgent due to the spare production capacity held by OPEC and its partners.  EIA and KAPSARC publish their forecast assumptions and share similar views that OPEC nations have between 5.6 mb/d and 5.9 mb/d of spare production capacity as of Q3 2021. KAPSARC additionally estimates that OPEC partners have an additional 1.6 mb/d, totaling upwards of 7.5 mb/d of spare production capacity.

If these estimates are accurate, one must subtract something more than 1.0 mb/d to account for the fact that some spare production capacity is medium and heavy crude oil that has virtually never been economic to produce and transport globally. 

Suppose OPEC+ has 6.5 mb/d of effective spare production capacity and now compare this with the need for new oil production in 2022. 

The need for new oil has two components: 1) new demand growth and 2) the replacement of natural declines in well production. EIA currently estimates global oil consumption will rise by 4.5 mb/d to 102.9 mb/d in December 2022 from 98.4 mb/d in August 2021. Separately, the International Energy Agency (IEA) has historically estimated that global oil production declines by 4% to 6% per year, with the lower bound requiring investments in workover programs to stem the decline. This means the natural decline of production in 2022 could range between 4.0 mb/d and 6.0 mb/d. 

Together this suggests that the world could need between 8.5 mb/d and 10.5 mb/d of new oil between now and the end of 2022. If the realized need for new oil next year turns out to be toward the lower end of this range, that might be met by a combination of re-deployed OPEC+ spare production capacity and non-OPEC production increases, as projected by EIA.

Importantly, the relationship between U.S. shale drilling and production is generally observable, but the extent of global natural well decline can only be inferred after the fact. If the natural oil production decline turns out to be closer to 6.0 mb/d in 2022 due to anemic investment – and the realized need for new oil consequently exceeds 10.0 mb/d – then it is possible that oil market fundamentals could tighten. 

Again, EIA and IEA’s projections do not anticipate a gap to emerge next year, but they also premise their outlooks on a relatively healthy drilling response consistent with historical investments that has not occurred so far.

Next, let’s look at U.S. natural gas in a global context, starting with record-high global gas prices for this time of the year.

As global natural gas demand has outstripped supply so far in 2021, landed natural gas prices reached new highs for summer months.  Specifically, natural gas prices rose in August to as high as $18.22 per million Btu in Asia Pacific and over $17 per million Btu in the United Kingdom and continental Europe.  By contrast, U.S. natural gas spot prices at Henry hub had been around $4 per mmBtu (and rose further to $5.18 per mmBtu as of September 13). 

These relative prices imply two important things for U.S. natural gas markets. First, U.S. natural gas exports – enabled by infrastructure including liquefied natural gas (LNG) export terminal completions and expanded natural gas pipeline capacity to Mexico – could grow by more than 10% between August 2021 and December 2022, per EIA.  Second and consequently, the U.S. natural gas industry appears to have an increasing divergence between producing regions and companies that participate in exports, versus those that largely cannot. This could be a boon for the Gulf Coast, but a continued lull for Pennsylvania and West Virginia, where as of Sept. 10 had 39.7% less drilling activity at the same point in 2019.

By comparison, the global natural gas production is expected by IEA to grow by about 3.6% y/y in 2021 and 1.4% y/y in 2022. And U.S. natural gas marketed production is anticipated to grow by 1.0% in 2021 and 3.1% y/y in 2022, per EIA. 

Notably, U.S. natural gas production this year has been achieved despite a rig count that has been historically low and continued to fall in August, according to Baker Hughes.  Production has been boosted by strong productivity and bringing drilled but uncompleted wells (DUCs) on stream. EIA estimates the number of DUCs fell by 35.3% in August 2021 compared with a year ago.

The rationales for weak drilling activity may vary, but common threads concern financial and workforce limitations; a need to reduce company debt taken on during the 2020 COVID-19 recession; uncertainty about when competing sources of natural gas associated with crude oil may return; and, policy uncertainties. 

In this sense, the Biden administration’s energy policies, which at a minimum stand to reduce the market for natural gas to compete in the domestic power sector, are a potential negative tipping point, rather an enabler of the U.S. energy revolution.