Low-cost, high-grade coal, oil and natural gas – the backbone of the Industrial Revolution – will be a distant memory by 2050. – Jeremy Grantham

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This is not a joke, but neither should you worry if you are long oil, as the price will most likely hit (at least) $100 long before it heads south, and that is due to a rising deficit between oil production and new oil discoveries (exhibit 1).

Absolute Return Oil Price

Exhibit 1: Oil discoveries vs. oil production (globally)

Source: The MacroStrategy Partnership LLP

I should also point out that, strictly speaking, I should have said fossil fuels, not oil, in the headline above, but there wasn’t enough room for all those extra characters! In other words, what I meant to say is that fossil fuel (oil, gas and coal) prices will most likely approach $0 over the very long term.

Just to complicate matters even further, strictly speaking, not even that is correct. What will happen to fossil fuel prices in the future is anybody’s guess, but what almost certainly will happen at some point is that demand for fossil fuels will approach zero.

Now to why that is. To begin with, a reminder. Energy is critical to everything we humans do. Without energy, we would soon run out of things to eat; we wouldn’t be able to use our iPads – a device that appears to be more important than food to many youngsters these days – and industry would die virtually overnight. Economically, nothing is more important than energy.

Phrased slightly differently, one could say that GDP simply cannot grow at a reasonable rate without access to energy at a reasonable cost. In that context, I note that, in the US, it requires 31 times more capital stock to extract a barrel of oil today than it did in 1977, just before ‘everything’ started to decline (exhibit 2).

Absolute Return Oil Price

Exhibit 2: US oil & gas capital stock index (real values) vs. industrial production of oil & gas (1977=100)

Source: The MacroStrategy Partnership LLP

What do I mean by that? Back in December last year, I first touched on the subject of declining ‘everything’. GDP growth is in decline – both in nominal and real terms – and has been in decline since the 1970s; productivity and workforce growth the same. Inflation is falling; consequently, interest rates are declining, and equity markets have also delivered more modest returns in recent years.

The problem in a nutshell

The problem in a nutshell is the geological depletion of existing fields and the growth of higher cost, geologically less attractive, fields. While drillers are more efficient today than they were, say 40 years ago, the increased share of more complex fields has dramatically increased infrastructure requirements.

Tying up so much capital in one industry has become a significant drain on productivity in other parts of the economy. That has again reduced the appetite – and the capital stock available – for energy exploration projects and, consequently, oil production has exceeded new oil discoveries for twenty consecutive years. The oil industry is quite simply doing a poor job in terms of replacing existing production. This will eventually have a major, and overwhelmingly negative, impact on GDP growth, all other things being equal.

Global oil production

Global primary energy production has grown from 487 million tons of oil equivalents (‘mtoe’) in 1900 to 12,798 mtoe in 2015 – an annualised growth rate of nearly 3%. Behind that number hides some significant variations, though.

The growth in energy production peaked in the 1950s and 1960s and has been slowing ever since (exhibit 3). A post World War II drive away from using coal as a direct source of motive power towards using it indirectly via electricity boosted productivity – and hence GDP growth – in the 1950s and 1960s. In the decades that followed, global energy production continued to increase as the economy expanded, but at a slowing pace.

Absolute Return Oil Price

Exhibit 3: Annual energy production (mtoe) growth by decade and the 6 years 2010-15 (%)

Source: The MacroStrategy Partnership LLP

As the global economy runs out of cheap oil, shale oil is widely considered the saviour but, in the bigger scheme of things, shale’s role is limited. Despite the sharp ramp-up in oil production from shale reserves, in the six years from 2010 to 2015, the annual increase in energy production was only 1.35% – the slowest pace since the 1900s.

If one were to exclude shale, the 1.35% annualised growth rate would only drop to 0.90%, so shale’s importance shouldn’t be exaggerated. I would certainly have expected shale to have made a more significant contribution to energy production growth in recent years.

Does shale production have a future?

US shale oil production peaked in March 2015. While nearly everybody has blamed the subsequent decline in growth rates on low oil prices, there is another way to think about it. As productivity growth has flattened, so has GDP growth. The combination of low (or no) GDP growth and high (and rising) energy production costs has resulted in energy prices that are still punitively high for the global economy.

Now, consider the fact that energy is a primary driver of GDP growth – both explicitly and implicitly. The US economy has clearly benefitted from having a handful of shale oil and gas fields that have proven very productive.

However, once you move away from those 5-6 sweet spots, productivity in the US shale industry drops immensely. Not a single shale field has been identified in the last couple of years, where productivity isn’t at least 30% – and in some cases up to 90% – below that of the top shale fields in the country.

I also note that production is no longer accelerating in several of the top US shale fields. In two of the very largest ones – Bakken and Eagle Ford – growth in production began to decelerate a couple of years before oil prices collapsed in 2014. With oil prices being well over $100 when that happened, you would have thought there are other reasons behind the decelerating growth rate – not falling oil prices.

When shale first emerged as a serious contender, production costs were (in most cases) in the $80s, but they have since dropped quite dramatically. The top US shale fields are now cash flow positive when oil prices are in the low $50s, and that obviously makes the industry a more serious contender at prevailing oil prices.

However, I also note that smaller US shale fields, as well as shale fields outside the US, need much higher oil prices to prevail. At present, even the most productive non-US fields need at least $65 to break even on a cash basis – and much higher prices to break even on a total cost basis. That will most likely change over time, but the appetite to invest in shale outside the US may be limited in the short term as a result of that.

The only conclusion I can reach is that shale production won’t grow as much as (nearly) everyone

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