After a significant reduction in investments over the past two years, oil companies can no longer overcome the production declines from legacy wells.

The oil business is nothing more than a rat race. Oil companies continually have to drill new wells to offset the decline from legacy wells. If they drill too much it causes the price of crude to crash and can often result in their own demise. If they don't drill enough, the world condemns them as greedy because of the pain they're feeling at the pump. It's an endless cycle that has played out before and is playing out again before our very eyes with oil companies now hitting their breaking point, no longer having the cash resources to drill enough wells to maintain production. As such, it has the potential to start another cycle were producers won't be able to keep up with demand, likely causing a painful spike in prices before the decade is out.

Can't keep up
According to a report by Rystad Energy, 2016 will be the first time in years that oil companies will add less oil from new fields than they're expected to lose to the natural decline of legacy fields. According to its estimate, about 3 million barrels of new oil production will come online this year thanks to projects from a variety of oil companies, including for example, Anadarko Petroleum's (NYSE:APC) Heidelberg field in the Gulf of Mexico, which is adding 80,000 barrels per day to global oil production after coming online this January.

Those 3 million barrels of incremental production, however, won't fully cover the 3.3 million barrels of production that will be lost as production from legacy fields declines or is depleted. That's because companies like Whiting Petroleum (NYSE:WLL) for example, just don't have the cash to keep drilling. In Whiting Petroleum's case it only has enough cash to enable it to continue fracking wells through the first half of this year after weak crude prices forced it to slash its spending by 80% over last year's level. Because of that under investment, the company's average daily production is expected to decline 18.5% from last year's average, which is roughly 30,000 barrels of oil equivalent per day. It's not alone, joining dozens of oil companies in the North America that can no longer afford to invest what it would take to offset declines from legacy wells.

Only going to get worse
While this year's global supply shortfall is projected to be relatively minor at 300,000 barrels per day, and easily covered up by the glut of oil already on the market, it's literally all downhill from there. According to Rystad by 2017 declines will outstrip new supply by 1.2 million barrels with an even wider shortfall projected in 2018 before significantly worsening by 2020 given current projections. That's all coming as oil demand is expected to march higher by about 1 million barrels a day per year because of global economic growth. It's an alarming scenario that offshore driller Transocean (NYSE:RIG) pointed out in the following slide:

SOURCE: TRANSOCEAN INVESTOR PRESENTATION.

On that slide Transocean takes an amalgamation of estimates from Rystad and others, which is then run through three different oil price sensitives. The result is a potential significant shortfall in oil supplies should oil prices remain under $50 a barrel for the next three years.

One reason for this potential huge shortfall in supply is the high cost and long lead-time it takes for offshore projects to be developed. Using Heidelberg as an example, that field was initially discovered in 2009, but the project wasn't sanctioned until May of 2013 and didn't deliver first oil until this past January. That three-year construction period suggests that major offshore oil projects sanctioned today might not start producing until 2019. However, given where oil prices are right now analysts only expect nine of the 232 pending projects to be given the green light this year because most of these projects aren't economic. That lack of projects moving forward is causing Transocean to caution that it's business might not see a pickup in the dayrates of offshore drilling rigs until the 2019 to 2020 timeframe because it will take the industry that long to get back up to speed.

That could leave a big production gap to fill in the medium term, which actually bodes really well for shale producers like Whiting Petroleum because shale is much shorter cycle, often delivering production in months as opposed to years. Having said that, given the significant balance sheet deterioration during the downturn, oil prices would need to be significantly higher in order to entice shale producers to ramp up activity. That just might happen because higher oil prices would be the result of a significant shortfall in supply.

Investor takeaway
At the current sub-$40 oil price, oil companies have finally hit their breaking point. They no longer have the cash flow or access to capital that they need in order to bring enough new supplies online so that they can overcome declines from legacy wells. It's a situation that's only expected to get worse over the next few years unless oil prices vastly improve, which would enable shorter cycle shale wells to fill in the gap until the industry can bring larger offshore developments online. It's an outlook that suggest that there could be just as much volatility to the upside over the next few years as the sector has seen to the downside in recent years.

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