There’s Not Enough Oil

“Nobody goes there anymore. It’s too crowded.” – Yogi Berra

We have a small confession to make. Discovery Channel’s Gold Rush is one of our favorite television shows. For those that don’t know, a television is a thing that looks remarkably like a computer monitor, but instead of simply watching whatever you feel like whenever the urge hits you, you must wait for specific times to see the shows you like. Crazy, we know.

Currently in its 12th season, Gold Rush profiles various gold mining operations as they set about chasing the dream of extracting life-changing riches from the ground.  While the crews being chronicled and the locations of their mines have changed over the years, the series is grounded in the Klondike region of the Canadian Yukon. Mainstays like Parker Schnabel and Yukon mining legend Tony Beets have enjoyed significant business success, while Todd Hoffman and his father Jack – leaders of the first crew ever profiled by the show – ultimately had to give up their mining dreams after burning through too much money.

photo credit: Discovery Channel

Gold mining, even on television, is a business – and a brutally tough one at that. Heavy equipment represents capital investments, spare parts are working capital, fuel and labor are variable costs, and gold is the only source of revenue. The miners on the show are constantly balancing the various cash pressures involved in operating a successful gold mine, while holding out hope of hitting the proverbial mother lode.

One operational decision that fascinates us is how mine owners balance the need to remove overburden to expose gold-rich paydirt with the actual processing of that paydirt through their sluice plants (i.e., the facilities that wash the paydirt and capture the gold). Removing overburden (otherwise known as stripping or “opening up a cut”) is a necessary precondition to obtaining paydirt, but it is cash intense and generates no revenue. Poorly capitalized operators tend to tightly balance stripping with sluicing, and sometimes must shut down sluicing for lack of paydirt.  Better capitalized operators can afford to open cuts well ahead of processing, optimizing the on-time performance of their revenue-generating sluice plants. If cash is plentiful, they might proactively strip cuts for processing in future campaigns, keeping a healthy inventory of low-cost sources of revenue for rainy days – or gold price spikes – in the future.

We were reminded of this strip/sluice tension when we came across a fantastic article written by one of our favorite Substack authors. Rory Johnson is the writer of Commodity Context and his most recent piece, US Shale Patch’s Lackluster Recovery is a Problem for the Post-COVID Oil Market, is a fascinating and sobering read (subscribe to Johnson’s Substack here and follow his Twitter account here).

As Johnson explains, US shale operators function in an analogous manner to the miners on Gold Rush, balancing the drilling of new oil wells with completing them for production. Just like overburden can be stripped for future processing, so too can oil wells be drilled but left uncompleted. Such wells are colloquially known as DUCs. Here’s a relevant quote from Johnson’s piece:

“Drilled but uncompleted wells are a function of the fact that the US shale production process has two major steps: (1) a well is drilled with a drilling rig and then (2) it is “completed” by a different team (i.e., the actual fracking part) after which it begins to produce marketable crude. When drilling runs ahead of completions as it largely did through 2017-19, the industry accumulates a sizable mountain of this potential production. These DUCs were yet one more bearish factor weighing on pre-COVID market prospects: even when US drilling declined, producers could lean into their DUC inventory to keep production humming along despite weaker rig activity.”

The shale boom enabled the US to reestablish itself as the top global producer of oil and gas. Prior to the Covid-19 lockdowns, the US was producing approximately 13 million barrels of oil per day (mbpd) – more than double what it had been generating just a decade earlier. To put that number into context, the world consumed an average of just under 100 mbpd in 2019 (i.e., pre-Covid). For 2020, that number dropped to 91 mbpd, but some estimates peg current global demand to have fully recovered to the 100 mbpd mark in Q4 2021. Interestingly, US oil and gas production is still lagging its early 2020 peak:

While many assume the gap in current production from the pre-Covid highs represents spare production capacity that can readily respond to incremental oil demand once the global economy fully reopens, the reality on the ground is different. As Johnson flags, producers are busily completing previously drilled wells at a rapid pace without backfilling the inventory of DUCs. In effect, US shale oil producers are sluicing previously stripped ground and not opening enough new cuts. This is clearly unsustainable.

What explains this behavior? We see a combination of factors. First, shale operators destroyed significant shareholder value through excess drilling and mismanagement during the boom. Many companies filed for bankruptcy protection shortly after the Covid-19 lockdowns were implemented and the price of oil collapsed. The recapitalized companies that emerged from reorganization are expressing a commitment to more a disciplined approach, and the numbers certainly reflect this. Second, the Biden administration has signaled its desire to move beyond fossil fuels, which – at a minimum – makes the investment environment for new exploration and drilling more uncertain than it was under Trump. Third, the move to defund the fossil fuel industry by environmental activists and Wall Street financiers alike is making access to capital more challenging. Finally, uncertain timing of the world’s emergence from both the pandemic and the ongoing supply chain crisis is likely adding to the cautionary stance.

Surely, the members of the Organization of the Petroleum Exporting Countries (OPEC) and their cooperative of non-members including Russia (collectively, OPEC+) have more than enough excess pumping capacity to make up for the anemic performance of the US shale patch? Perhaps not. For insight into that all-important question, we turn to Josh Young, CIO of Bison Interests – an investment fund focused on oil and gas public equities – who has been sounding the alarm on the potential true nature of the spare capacity of OPEC+ for several months. You can read the firm’s published content here and follow Young’s Twitter account here. This is how Young describes the conundrum in his piece from September 18, 2021, appropriately titled The Myth of OPEC+ Spare Capacity:

“As energy prices across the globe rise, many observers and pundits continue to downplay the possibility of a global energy supply crisis, often citing OPEC+ spare capacity as the panacea. The perception that OPEC+ is flush with spare capacity is pervasive.  But due to a lack of reliable data and no formal reporting or verification requirements, many industry experts and analytics firms have adopted OPEC+’s self-reported numbers. No one knows exactly how much spare production capacity OPEC+ really has, and few seem interested, despite the potential implications.”

After performing a bottom-up analysis of several key OPEC+ producers with a more realistic lens, he closes with a sobering assessment:

“With likely 2 million barrels per day less spare capacity than claimed and widely believed, the oil market is much tighter than believed. As world oil demand recovers post Covid-19 and grows to new highs there may be a call on OPEC+ spare capacity, particularly as inventories deplete and as US shale is “on strike" with a new focus away from growth and towards capital return. We may be approaching a time of higher world oil demand than world oil supply capacity.”

Others are equally skeptical of the true nature of OPEC+ spare capacity. Take Alexander Stahel, an excellent Twitter account we follow closely, who has posted several provocative threads on the topic, including this one from June of 2021.

The final November production numbers for OPEC+ certainly seem to lend credibility to the camp of the skeptics. According to a summary published by Young, the cartel came up one half million barrels short of its own quota.

Not to worry, the propagation of electric vehicles (EVs) and renewable power is going to lead to much less demand for oil in the post-Covid economy, right? This is certainly the belief of many visible leaders of this current bull market. Cathie Wood of Ark Invest was speculating as late as this October that the world would never again see demand for oil reach the levels it did in 2019:

An exercise in simple arithmetic may be sobering to those counting on EV growth to dampen oil demand. The number of vehicles on the road powered by internal combustion engines (ICE) will continue to grow until EVs achieve a near-total share of new vehicles sold. This is because the size of the total ICE passenger vehicle fleet is dictated by flows in and out (i.e., the removal of ICE vehicles from the road). In the first half of 2021, the EVs represented just 2.4% of all new passenger vehicles sold in the US. Modern vehicles have incredible reliability and longevity. New vehicles sold today tend to remain on the road for decades. Here’s how the online magazine Charged Electric Vehicles describes the dilemma:

“The problem, ironically, is that automotive technology has become so good. As every long-time auto owner knows, gas-powered cars and trucks have become quite reliable, and this means that fleet turnover is slow. According to economic forecasting firm IHS Markit, the average light-duty vehicle operating in the US today is 12 years old, up from an average age of 9.6 years in 2002.”

Legendary energy investor Leigh Goehring and his business partner, Adam Rozencwajg, see demand for oil growing well past the 2019 highs. In a provocative but persuasive piece titled On the Verge of An Energy Crisis – which Goehring and Rozencwajg published all the way back in August of 2020, when the price of oil was far lower than it is today – they point out that as emerging economies scale their per-capita gross domestic product, demand for oil reaches an inflection point (Wood might call it an S-curve). The natural course for emerging economies is to transition from burning wood and coal to using much more oil and natural gas, and the global population on the verge of making that transition has never been higher. You can access all of Goehring and Rozencwajg’s work here and the specific piece from August of 2020 here (email required for downloading).

In a world where US oil production tapers off, spare OPEC+ pumping capacity fails to materialize, financing for new exploration and development continues to shrink, and demand for oil in the West continues to grow while exploding higher in the emerging economies, what happens to price?

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