OREANDA-NEWS. The IEA's recently appointed chief economist Laszlo Varro spoke to Argus in Paris. He discussed the impact of low prices on demand and on different categories of investment. In these highlights of the interview he says the IEA was impressed by the resilience of US tight oil production but that it "cannot overcome the law of gravity".

How is the lower oil price environment impacting supply and demand?

In 2014 and the first half of 2015 there was a very rapid acceleration of production, which ran ahead of oil demand. In a situation like this, price decline triggering an investment cut that will rebalance the market is a natural phenomenon. The majority of the rebalancing will have to take place on the supply side.

Low oil prices did trigger a measurable demand [growth]. However, it is also fair to say that the price impact on demand is significantly weaker than it used to be. The only really large oil market where prices directly fed to end-users was the US. We had some demand pick up, but most of the rebalancing will have to come from the supply.

And investment?

Companies are cutting investment, and they are cutting investment in three broad categories. One is the US light tight oil (LTO), where you have a very short impact. You have very high decline rates. You stop investment, and production goes down almost immediately. But investment did not stop, and we have been impressed by the resilience of the US industry, both from the technological and financial points of view. They have technological resilience because they have been reducing drilling and fracking costs to a remarkable extent. This was not a pleasant process, but it was very effective. And they also have financial resilience. In the first quarter of 2016, with $30-40/bl oil, with all the credit ratings agencies putting the US shale industry on watch, and after the Paris climate summit, the media being full of fossil fuel divestment [articles] and so on, the US shale independents raised more than $10bn of fresh capital. If an industry can raise $10bn in a quarter such as the first quarter of 2016, I think it tells you a lot about its ability to access capital.

They are playing their cards very well, but they cannot overcome the law of gravity. The US shale industry, in aggregate, was running with a negative free cash flow even at the time of $100/bl oil. They are squeezing very hard, but essentially their ability to drill and frack is constrained by the ability to pay for investments. They are retrenching to the hotspots where activity is still happening, but there is no doubt that the short term outlook is a significant decline for oil. And, of course, in the US there is a very powerful interaction between shale gas and light tight oil, so that will impact gas as well.

Then you have a second category of investment cuts, which are long time, difficult megaprojects. Probably, to say delay is more appropriate than investment cut, because in most cases the companies that are involved — this is the field of super-majors essentially — are not stating that they are never going to do the projects, but they are saying ‘This is on hold'. They want to see market developments, they want to see cost developments as well. In many cases, as the oil will not run away, the projects can be restarted three years from now.

And then there is a third category: companies are cutting investment in normal field management and field development operations. It does not generate big headlines, unlike when a company X is delaying a $10bn Canadian project. Companies cutting investment to the bone on the secondary field development and enhanced recovery of existing assets shows up on the depletion rate of existing production. In this category, very often there is a geological window of opportunity — this is the time when you can do your enhanced recovery project. You miss this window of opportunity because of the investment cuts, and the oil stays underground forever, and the ultimate recovery rate will be affected.

For US LTO, our medium term projection is a rollercoaster of investment. It is really an up and down and up again cycle in the US shale industry. We believe that investment will pick up as early as 2018, for US LTO output to come back and by 2020 reach higher production level than the 2015 peak. Of course, that will require the oil market rebalancing as well.

Megaprojects are much more dependent on the long-term evolution of the energy policy environment. Restarting LTO drilling in 2018 depends very little on what you believe about climate policy. But returning in the Canadian Arctic in 2020, we have to think in billions [of dollars] in the first decade and then produce a lot of expensive oil from 2030 to 2050. There are some companies that will have to think really hard about how climate policy affects the projects.

There are quite important components of oil demand which will generate a sizeable oil industry even with a strong climate policy. But if and when an upturn comes, the industry will have to consider very carefully where technology and policy are going.

Is the current level of investment enough to meet growing oil demand in the coming years?

There is absolutely no doubt that the current level of investment will not meet the demand growth. Production falls — especially in the US — are more rapid than the adjustment of demand. If I take our current demand projections, they range from 1.2mn b/d a year growth in the current macroeconomic, technology and policy environment to around 300,000 b/d a year in the 450ppm scenario with extremely strong climate policy efforts. With those very strong climate policy efforts, demand growth by 2020 will total only about 1.5mn b/d and not 5mn-6mn b/d. But with the current investment cuts, if we never invested more than we are investing today, we will actually see a significant physical decline in production.

If there is a wave of bankruptcies in the US shale industry, how will it affect investment and output there?

US bankruptcy legislation creates very strong incentive to continue to operate the assets. We have seen airlines in the US going bankrupt but happily flying. There are several large US coal companies that are insolvent but continue to dig out coal during the bankruptcy procedure. If there is a low marginal cost asset that generates positive cash flow, the incentive is to continue to operate it and to try to minimise the loss for creditors and investors.

There are certain US shale companies that I would not necessarily advise you to buy their shares as your pension savings, because they will have very significant difficulties. But if those companies are sitting on good quality assets, somebody will continue to operate those assets.

The sad fact is that not all shale plays are created equal. The US has some absolutely exceptional ones such as Marcellus for gas or Permian for LTO. But the US has some plays that are average or below average. There will be shale plays where activity will stop. You will see a retrenchment.

Upstream costs have come down since 2014. Can we be sure they will not go up again once oil prices head up?

No, we cannot be sure. In the 2006-2014 period you could go to any major oil conference and chances are that there was a speaker who explained that the oil industry was facing a skill shortage, facing aging workforce, and explain that what a stupid strategic mistake it was to fire all those good professionals back in 2000 when oil prices were low. What we observe now, with oil prices being lower, is professionals being fired in their thousands. You can very safely predict that at the 2020 World Petroleum Congress there will be a keynote speech explaining that the industry is facing aging workforce, a skill shortage, and analyse the implications of these layoffs in 2015-16.