An Analysis of Exxon's 2015 Energy Outlook

A couple of years back, I attended a presentation by Tom Eizember, Exxon's head of strategic planning.   During the presentation, Eizember asked how many in the audience believed in peak oil, and I raised my hand.  I believe I was the only one.  Exxon does not subscribe to peak oil

And yet.  Exxon has issued its new Outlook (which is well worth a look).  One of the interesting features of this report is its view of conventional oil production, comprising traditional onshore and offshore / deepwater production.  In Exxon's view, conventional production peaked around 2005 and is not projected to revisit this level until, at best, around 2040.  This is not particularly controversial, but it is interesting to see Exxon acknowledge it.  And it's important for our understanding of the long term outlook for the oil supply and oil prices, which I consider in greater detail below.

Exxon Production Outlook 2015.png

Exxon Global Oil Supply Outlook 2015

Source: Exxon 2015 Energy Outlook, Conventional / Unconventional dividing line by Prienga

So, let's take Exxon's supply outlook, segment by segment:

Conventional Crude and Condensate Supply

Exxon sees a gradual decline in onshore conventional production.  This is actually a fairly pessimistic view of the segment, although not unwarranted.  Notwithstanding, the future may prove be both better and worse than Exxon is thinking. 

A decade ago, forecasts from the IEA and EIA typically saw OPEC conventional production increasing by 10-15 mbpd to the present.  Instead, OPEC production flatlined, and for all that, is only marginally higher than it was in 2007.  As a result, the analyst community has tended to come to the view that OPEC is unable or unwilling to raise production by any significant amount.  This belief may prove unfounded, and in fact, earlier predictions for OPEC may prove closer to the truth in the long run.

From 2003 until 2011, OPEC could count on price increases to meet their fiscal needs.  Increasing oil prices tripled OPEC receipts, reprising the golden age of petrodollars in the Middle East last seen in the late 1970s. 

Index of OPEC Liquids Supply, Oil Revenues (at Brent prices), and Brent Oil Price, 2004 = 100

Source: EIA

However, prices cannot rise by double digits forever.  Indeed, a supply-constrained approach suggested that the oil price had reached the global carrying capacity in 2011, and price gains thereafter would be relatively modest.  And this proved to be the case.  More recently, surging shale production and the return of Libya to oil markets have collapsed prices back to marginal cost, and the supply overhang has in fact pushed them even lower.  Be that as it may, OPEC countries acquired some some expensive spending habits in the interim, habits which can no longer be served through price increases alone.  Therefore, if OPEC wants more oil revenues, it will have to do so the old fashioned way: by increasing production.  While OPEC had been able to find  "money for nothin' and checks for free" (with apologies to Dire Straits), from here on out, OPEC will be forced to increase production or reduce public spending.  Therefore, OPEC's motivation will change, and we should expect increased production over time.  This increase in production will constitute a key source, perhaps the key source, of Exxon's incremental crude and condensate production.

Paradoxically, the same pressures--the absence of meaningful oil price increases (beyond the carrying capacity level)--will have exactly the opposite effect on non-OPEC conventional production.

Exxon Oil Supply Outlook 2015

Source: Exxon, rotated annotations added by Prienga

From the early 2000s until 2011, just like OPEC, non-OPEC producers could count on increasing oil prices to support investment activities.  Production challenges could be addressed with 'more metal': larger production platforms, deeper wells, and more sophisticated drillships, for example.  Capex more than tripled during this period.  And yet, all this yielded little by way of production gains.  

By 2011, oil prices were at carrying capacity, and by 2013, operators began to trim their capex budgets, as E&P costs continued outpace oil price gains.  This mismatch between revenues and costs is set to persist, and therefore the industry will not able to rely on price increases to support increasing investment.  Rather, production gains will have to come from technology improvements.  Brains, rather than money, will have to carry the load--even if oil prices recover.

For conventional production, this is a big challenge, and maybe a very big challenge.  It is far from clear that technology can advance as fast costs have been rising.  Thus, any increase in conventional production will depend on the difference between OPEC production gains and non-OPEC conventional losses to the extent not sustained by technology improvements.  At $85 / barrel, conventional losses will be outpacing OPEC gains, at least for a few years.

Deepwater

Within conventional production, Exxon sees deepwater as carrying much of the load.  Growing deepwater supply is to offset  conventional declines elsewhere.  This seems far from certain, however.  Offshore exploration results in the last two years have proved disturbingly weak.  Of course, Brazil will add a few million barrels / day to 2025, but one has to wonder whether deepwater production is sustainable at high levels beyond 2030.  Perhaps Angola will see Brazil-like finds and production gains.  Notwithstanding, Exxon's deepwater forecast looks too optimistic, particularly after 2030.  Deepwater may well peak before that time.  Also, the deepwater outlook suggests a high oil price environment.  If oil were $80 / barrel (and Brent's currently an astounding $65), deepwater would be lucky to hold current production levels to 2020.

Notwithstanding, if we consider the conventional outlook as a whole, Exxon has taken the view that the conventional system, as it existed in 2005, has done what it can. 

Unconventionals

From here on out, Exxon sees all net supply growth coming from unconventional production.  Shale oil, Canadian oil sands and natural gas liquids (associated in significant part with shale gas production) are viewed as meeting the needs of global demand growth.  This reflects realities on the ground since 2005.  For the last decade, these sources have provided more than 90% of global supply growth.  Exxon sees more of the same.

Oil Sands

There is nothing particularly controversial about Exxon's outlook for oil sands, other than to note that, again, it suggests a high price environment.  New oil sands projects are among the most expensive to develop, and continued growth in the segment suggests that Exxon is envisioning a Brent price, on average, north of $100 / barrel--in essence, consistent with the earlier company guidance of $109 / barrel for 2017.

Tight (Shale) Oil

The most interesting aspect of Exxon's outlook, in my opinion, revolves around its projection for shale oil production.  There are perhaps two different paths of development for shales.  The first of these would mirror the experience of shale gas and perhaps warrants labeling at the 'Citi School'.  According to Citi, the marginal cost of shale oil ranges between $50-70 / barrel.  By this line of thinking, shale would continue to expand at an increasing pace until price is brought to the marginal cost of shale. 

On a corporate level, it might look like the story of EOG, the most successful US shale oil producer.  As the graph below shows, EOG's production increases at an increasing pace, with cash flow turning from negative to positive as investments come to fruition.

EOG Oil Production and Free Cash Flow

Source: Bloomberg, forecasts pre-date recent oil price declines

If we project EOG's experience onto the macro oil picture, we would expect unconventional production to increase at an increasing pace, thereby lowering price and squeezing out more traditional, high cost producers.  The graph below, for example, shows the impact of natural gas from the Marcellus shale (and other similar shales) on conventional Gulf of Mexico gas production.  Before the shale era, the Gulf of Mexico was a primary source of US natural gas.  With the 'shale gale', Gulf production has fallen by half, displaced in large part by Marcellus natural gas production, which has come from nowhere to production levels twice that of the US Gulf of Mexico. 

Natural Gas Production, US Gulf of Mexico and the Marcellus Play, bcf / day

,Source: EIA STEO and DPR

That's the gas story.  If applied to oil, then shale oil production would increase at an increasing pace, lowering the oil price, and squeezing out high cost sources of oil, for example, onshore conventional as well as a good portion of offshore / deepwater production, and virtually the entirety of more exotic sources of oil like the Arctic, new oil sands, and HPHT (20 kpsi) applications.

So what does the data say? 

US Shale Crude, Condensate, and NGL Supply Growth, kbpd / year

Source: EIA

The data suggest that shale oil and NGL growth has indeed reached the levels at which they can, ceteris paribus, push down global oil prices.   The global economy has demonstrated an ability to absorb an annual increase of as much as 1.2 mbpd at around $110 / barrel, on a Brent basis.

US shale liquids production blew through this level in mid-year 2014, with annual growth exceeding 1.6 mbpd in some months.  This, coupled with a supply surge from Libya, was more than adequate to tank oil prices. 

Where to from here?  Well, if we roll the film forward, we can see the EIA forecasts a screaming deceleration of US oil production growth into 2015.  If $100 /  barrel is a good price, $65 / barrel Brent is a train wreck, especially bearing in mind that US supply growth is pretty much all of global supply growth.

US Annual Liquids Production Growth, Actual & Forecast, mbpd, by Type of Liquids

Source: EIA December STEO, calculated Month on Same Month Previous Year

But that is just one year.  Shales have demonstrated that they can increase at 1.6 mbpd at $100 / barrel, Brent.  After next year's downturn, could shale again see recent growth rates?  Is fast shale growth an anomaly, or indicative of the sustainable characteristics of shale production?  It's too early to tell, but the EIA was forecasting a material downturn in shale production growth for 2015 even before oil prices collapsed in early autumn.  The torrid pace of recent shale growth may prove unsustainable over a multi-year timeframe.

On the other hand, shales have outperformed expectations to date, and perhaps can do so over the longer term.  To do so, however, will require higher prices.  At $85 Brent, every country in the world (perhaps barring Japan) can add oil consumption.  The carrying capacity for the US is around $100 / barrel, and for Europe, about $90 / barrel.  And China's consumption growth should be largely unfettered at that price.  This supports the view that oil demand at $85 could average around 1.6 mbpd, about as much as recent shale oil production growth. 

However, at this price, assuming OPEC does not move to increase production, conventional non-OPEC production will be falling, perhaps by 500 kbpd / year.  Thus, to hold prices at $85 / barrel Brent, shales will have to add roughly 2 million barrels per day each year.  This capability is far from demonstrated today.    Shales have never achieved growth reaching 1.7 mbpd for any month, much less for an entire year, and have never done so at a sustained price below $100 / barrel Brent.  As a consequence, it is premature to call $85 Brent a sustainable number.

On the other hand, shales have demonstrated an ability to push prices off the $100 / barrel threshold, and for now, merit respect in being able to do so in the future as well. 

Therefore, based on recent shale performance, a longer term price of $85-100 / barrel on a Brent basis would seem justified.  This in turn suggests Exxon is being too optimistic about oil sands, deepwater, and conventional ex-OPEC supply.  With lower oil prices, demand growth is likely to be somewhat higher than the company is projecting, with shales taking share from more traditional sources.  The majors may find the sledding more difficult than Exxon implies.

For the next year, however, expect carnage on the supply side if oil prices remain at current levels for another hundred days.  By late 2015, expect a price spike as too many operators will have headed for the exits too fast.  Other than shales, as Exxon points out, the conventional supply continues to struggle.  Finding conventional oil remains 'no cheaper, no easier', and that has not changed in the last year.  If the deceleration in shale production is as severe as the EIA predicts, the global economy will be seriously short on the supply side by this time next year.