Barrels? Texas holds-em!

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Allianz Global Investors’ Christopher Wheaton comments on on global oil demand and supply:

Pop quiz: which produces more oil, Texas or Iraq? It may surprise some to know that the answer is now Texas, which in the first half of 2014 surpassed Iraq as the world’s 8th largest oil producer, just behind Kuwait and the UAE , and rising an astonishing four places in the oil producers league table in 2013. For the oil market to experience that rate of change shows something unusual is going on – and that is shale oil.

That same shale oil is now why the oil price has dropped dramatically, with Brent crude oil falling from $114 per barrel in late June to just $85 per barrel in mid-October. The oil market has looked at the astonishing growth in oil supply this year- up 1.6 million barrels per day – the fastest growth since the late 1970’s- and weakening economic growth, and concluded that more supply minus less demand equals lower oil prices.

But is that the right conclusion, and is this low oil price now sustainable? I believe it isn’t, for a number of reasons. Let’s start with this supposedly unstoppable growth in oil supply. The natural decline in the world’s oil production is 6-7% per year, so the world needs to add another Russia or Saudi Arabia in output every two years just to stand still.

This decline is most severe in the US. For the US to grow its output by 1 million barrels per day from shale oil, it needs to add 2.5x this in new production, because in a typical shale oil well production declines on average far faster than the global average.

This rapid decline makes shale oil production very sensitive to the amount of cash oil companies can generate and reinvest into new production, so there will be a slowing of growth in oil supply in 2015 if oil prices stay at or below the current price.

The other half of the equation is demand- while the market is focused on year-on-year growth, it ignores that IEA estimates have 2014 and 2015 as consecutive all-time highs in world oil demand.

Demand growth from emerging markets outside of the famous BRICSs – particularly the Middle East – remains relentless, driven by rapid population growth and the rising number of the energy-intensive middle classes. Oil prices could remain here until 2015, but would be setting up the world for oil price spikes beyond 2017; there remains no easy oil, and no easy alternative to oil either.

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