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The Road Back from Oilmegeddon

Thanks to the North American Energy Revolution and the resulting fall in oil, gasoline and natural gas prices, the share of total consumer expenditures going to pay for “energy goods and services” fell to 3.92 percent in December.

That’s a lower share than in all but six months of official Bureau of Economic Analysis data going back to 1959. And it’s likely that the energy share of consumer expenditures in January and February 2016 will fall to all-time record lows as the price of oil continues to plunge.

Just about every economic commentator says this is a bad thing, foreshadowing a disastrous wave of bankruptcies, stock market crashes, deflation, and political turmoil.

However, that’s not surprising because they are typically paid to see the world from the point of view of producers, rather than consumers, who are enjoying a big cut in the cost of living.

Admittedly, the ongoing oil price collapse is having a severely negative impact on the wealth of those who own oil reserves. Several pundits have referred to this disruption as “Oilmegeddon.” The numbers are enormous and the threat to certain companies and nation-states may be existential. The short-term reality is that we are witnessing global wealth destruction of epic proportions.

Consider this: In mid-2014, crude oil prices averaged just over $100 a barrel, depending on which grade you wanted to buy. At the end of February 2016, prices hovered near $30. That’s roughly a 70 percent decline.

Based on the reduction in the value of oil reserves, this means we’ve wiped over $100 trillion in paper assets off global balance sheets in just 18 months.

Stop for a minute and let that sink in.

The total value of all the world’s oil reserves is over $100 trillion less than it was just a year and a half ago. No wonder stock and bond markets are down as sovereign wealth funds liquidate securities to cover shortfalls created by this evaporation of net worth.

But all is not negative. Since mid-2014, the collapse in the oil price has already transferred over $2 trillion from petroleum producers to petroleum consumers, worldwide. And rather than simply changing the numbers on the balance sheet, this has impacted the P&L and cash flow statements. This impact will be truly enormous and pervasive.

Why?

Petroleum is the largest and most indispensable commodity on which society depends; it’s the vital energy-amplifier of our everyday actions. The value of the petroleum produced every year exceeds the value of natural gas, coal, iron ore, wheat, copper, and cotton combined.

Without oil, every industry would collapse (agriculture would be the first to go). Cutting the price of petroleum enables you to travel, eat, and clothe yourself more cheaply, which leaves you more money to spend on something else, which gives somebody else a job supplying that need, and so on.

It’s important to recognize that the low petroleum price is in part a symptom of a weak global economy, but not a significant cause of that economic weakness. The OPEC-triggered price war will probably cause some producers and explorers to go out of business. As we’ll explain, that supplier hardship ensures a medium-term partial rebound in oil prices.

But, the biggest implication is that lower energy prices will boost living standards, not just in the OECD countries, but globally. As we explained in Ride the Wave, this boost is not temporary because it’s a byproduct of a technological paradigm shift, which removes control from the hands of OPEC and Russian oligarchs and returns it to the United States.1

The shale revolution is the dominant basis of this paradigm-shift. A combination of horizontal drilling and much improved hydraulic fracturing, first developed for shale gas, then adapted for oil, has unleashed a petroleum river from North Dakota and Texas.

It has taken the United States right back to the top of the oil-producing league, reversing a 30-year, 50 percent decline, in just 3 years. This is one of the most momentous innovations of the modern world.

The Price of Oil, by Roberto Aguilera and Marian Radetzki, predicts that this shale revolution has a long way to go.2 Although the current low oil price is bankrupting many producers and explorers, and many rigs are now standing idle with jobs being lost, there has only been a very modest fall in production.

That is because the technology for extracting oil is improving rapidly and the cost is falling fast, so some U.S. producers can break even at just $30 a barrel and a few at just $20. Every year, it takes fewer rigs to generate more oil - and as with so many disruptive technologies, this benefits the consumer more than the inventors.

Because of this new “technology-based” paradigm, the shale industry has now put a lid on future petroleum prices. As Aguilera and Radetzki argue, not only is the U.S. shale industry still in its infancy, but there is another revolution on the way. When the price is right, conventional oil fields can now be redrilled with the new techniques developed for shale, producing another surge of supply from fields once thought depleted.

They also explain that other countries - beginning with Australia, Argentina, China and Mexico - are ripe to join the technology revolution begun in American shale.

As a result, Aguilera and Radetzki calculate that, barring political crises, the oil price could well stay low till 2035 - about $40 to $60 a barrel in today’s prices. This is in sharp contrast to recent projections from the International Energy Agency and the U.S. Energy Information Administration, which forecast an oil price in 2035 of $128 and $130, respectively.

Why is the price of oil so volatile? Aguilera and Radetzki make the case that depletion has never been much of a factor in driving oil prices, despite the obvious drying up of certain fields - such as what the North Sea is now experiencing. Nor did OPEC’s interventions intended “to fix” prices make much difference over the long run. What caused the price of oil to rise much faster and more erratically than other commodities was a shift in the geopolitical control of the resources.

There was a wave of nationalization in the oil industry beginning in the 1960s. Today, nationalized companies hold some 90 percent of conventional oil reserves.

In terms of owned reserves, ExxonMobil and BP are small compared with the companies controlled by the governments of Saudi Arabia, Venezuela, Iran, Iraq, Kuwait, the United Arab Emirates, Nigeria, and Russia.

Post-colonial nationalization affected many resource-based industries, but whereas many mineral and metal companies were privatized in the 1990s as their grotesque inefficiencies became visible, the same has not happened to state oil companies.

The consequence is that most oil is produced by companies that are milked by politicians, and consequently starved of incentives for innovation and productivity. This created the perfect opening for disruption by new entrepreneurial entrants operating on private lands with private capital.

Given this trend, we offer the following forecasts for your consideration:

First, relatively small shifts in supply and demand for petroleum will continue to have an enormous impact on its price.

This is illustrated by price behavior over the past three years. According to the U.S. Energy Information Administration, crude supply and demand during 2013 was essentially balanced, with demand exceeding supply by 0.1 percent on average. During 2014 and 2015, the balance shifted, resulting in two years of overproduction. A very small oversupply in crude oil during the years 2014 and 2015 led to a phenomenal decrease in the commodity’s price. In 2014, an average oversupply of 0.9 percent resulted in a plunge in crude prices by 46 percent, while in 2015, an average oversupply of 2.1 percent resulted in crude prices further plunging by 32 percent to reach an overall decline of 63 percent during the two-year period.

Second, petroleum prices will be significantly higher by year-end 2016.

There are still many predictions for oil to fall to $20 or even $10 per barrel; while anything is possible, investors have to decide what is most probable. The Trends editors don’t see $10 oil being in the cards, and even if we experience oil in the $20 per barrel range, this won’t be sustainable. The International Energy Agency reports that the demand for global oil is running at about 96 million barrels of oil per day. There is no way the industry can provide that much oil at even $30 per barrel on a sustained basis. That is why major oil stocks like Chevron and Exxon are already trending higher.

Third, growing demand, encouraged by low prices, will play a major role in driving prices.

In the past 15 years, oil demand has increased 20 million barrels per day in developing countries, while demand for oil in OECD economies was reduced slightly. The world consumed 94.5 million barrels per day in 2015. As a result, the International Energy Agency projects that oil markets will still have a surplus of 1.5 million barrels a day in the first half of 2016. But notably, a 1.2 million barrel per day increase in demand in 2016 will help close this gap,

Fourth, the recent preliminary OPEC agreement to cap production coupled with natural declines outside OPEC will combine with rising demand to ensure that supply falls below projected demand in 2016.

On February 16, Russia, Saudi Arabia, Venezuela, Oman, Kuwait, and Iraq agreed to freeze their output levels; Iran is the only major OPEC member exempted.3 According to the Energy Information Administration, U.S. production will drop by 620,000 barrels a day (about 7 percent) from the first quarter to the fourth. That may pave the way for a rebound as lower prices have stimulated global demand. For that reason, oil is the “trade of the year,” according Citigroup, which is among many banks including UBS Group and Societe Generale that predict a gain in the second half of 2016.

Fifth, even after prices quit falling, geopolitical stresses created by extremely low oil revenues over the past 18+ months may still trigger unrest, leading to supply disruptions.

Venezuela, Nigeria, Libya, and Algeria could all collapse into chaos, potentially interrupting oil exports. This would quickly transform the market from surplus to shortage. This makes surprises on the upside far more likely than on the downside.

Sixth, when oil prices reverse, a huge crowd of investors with short positions in oil and oil-related stocks will be rushing to cover those positions and that could lead to a massive “short squeeze.”

Many events could suddenly send oil much higher from recent low levels, whether it is a production cut by OPEC, continued production cuts from oil companies, geopolitical events cited earlier, or even a change in investor sentiment.

Seventh, while prices are likely to return to near $60 per barrel in the next few years, we’re unlikely to see petroleum over $70 per barrel before 2035.

The technology of the North American Energy Revolution has permanently transformed the economics of the industry. Whenever oil rises above $50 a barrel, dramatic new quantities of oil from newly exploited shale deposits and the rehabilitation of old conventional wells will flood the market. Unlike the state-owned oil companies of OPEC, these American shale entrepreneurs will continue to push the productivity envelope, passing on much of the economic utility to consumers.

Eighth, rather than leading to disaster, the collapse of energy prices is just another milestone of the Fifth Techno-Economic Revolution, which will contribute to an unprecedented leap in global affluence.

As forecast in Ride the Wave, the North American Energy Revolution will help create as many as 21 million new jobs in the United States by 2035. Only about 2 million of these jobs will be in the energy industry; the rest will be created indirectly. This will drive up per capita incomes, while restoring the workforce participation rate.

References

http://www.business-standard.com/article/international/saudi-arabia-russia-to-freeze-oil-output-116021601355_1.html