A Short Talk about the Oil Market

A Short Talk about the Oil Market

Remarks to a Women’s Investment Club

Ambassador Chas W. Freeman, Jr. (USFS, Ret.)
Washington, DC, 25 February 2015

Remember “peak oil?” It’s been proven to be the nonsense some of us thought it was at the time. How much oil there is depends on how much you’re willing to pay for it. There is always some price level at which it is profitable to extract and refine it.

We’re seeing that illustrated now in reverse.

Not long ago, oil was $100 or more per barrel and interest rates were very, very low. This had all sorts of economic consequences:

– it became very profitable to produce oil and a great deal of it was found and produced. The major oil companies ramped up capital expenditures and launched big new projects all over the world.

– tar sands – which yield oil at about $85 plus transportation – became a potentially competitive energy source. Hence the Keystone XL pipeline project.

– exploration and production (E&P) in challenging (and therefore expensive) environments like the presalt off Brazil, other very deep waters, and the Arctic became financially feasible.

– oil producers, like Russia and Saudi Arabia, made bundles of money. Venezuela could afford to run its oil company and economy into the socialist ground.

– hydraulic fracking and horizontal drilling to extract oil and gas from shale – techniques pioneered by the US Department of Energy through public-private partnerships – became very profitable, sometimes obscenely so.

Small companies here in North America borrowed $200 billion in bonds and bank loans to go into the fracking business. Their debt grew much faster than their revenues.

Renewable energy sources, like wind and solar, as well as hydro and nuclear energy, became cheap enough to justify investing in them for environmental reasons. Hybrid and electric cars became attractive to wealthy consumers. We became progressively more efficient at using energy of all kinds.

All this has now changed.

Since 2008, North American crude output has risen from 7.5 million barrels per day to over 11 million.

Over that seven year period, Brazil, Iraq, and Russia added another 3 million barrels per day to global supply. Meanwhile, the world economy remained mostly in recession, curtailing demand growth. High oil prices encouraged efficiencies, further reducing demand.

In 2014, supply of 93 million barrels per day exceeded demand by about 1 million barrels.

Supply grew by 1.9% while demand grew by 1%. Inventories began to build up.
This oversupply caused prices to fall to about $45 per barrel. This is having complex effects:

– development of tar sands as well as investment in deep sea and Arctic oil are not economic at current prices and are being postponed. The oil majors have cut their investment plans by about 15%. That means that some of the oil that was expected to be produced in the 2020s will not be. A lot of current projections of future supply and demand will prove incorrect.

– Brazilian production from the presalt layer breaks even at about $45 plus about $7 in transportation costs. It has become iffy.

– the first bankruptcies of overleveraged frackers have already occurred. Some are still profitable but many are staying in production just to service and retire debt.

– fracking depletes fields in a couple of years instead of the 20 – 30 typical of “conventional” reservoirs. In a year or two oil supplies from fracking are going to be a lot less than anticipated.

– the oil majors will snap up many of the smaller companies that have been doing the fracking.

– with prices low, demand for oil is likely to pick up but the increased strength of the dollar relative to other currencies means that foreign countries that import oil will not experience price cuts like those here.

– oil producing countries face austerity. Some, like Venezuela, face bankruptcy. Others, like Iran and Russia, face the double whammy of low oil prices and sanctions.

– some kinds of renewable energy are no longer economic. (On-land wind and some forms of solar power are probably exceptions.) There will be a shakeout in the green energy sector. Demand for energy-saving vehicles will lessen.

– contango – that is, buying for purposes of arbitrage – has set in. Buying oil at current prices for resale at higher prices later makes sense. A lot of oil is therefore going into storage.

– employment in businesses with high energy consumption like airlines or petrochemicals will increase. But a lot of jobs will also disappear, at least for a while. (1.7 million North Americans are now employed in fracking or related industries, like steel, pipe, rigs, and construction.)

– the effects will be felt differently by different regions. Oil producers will suffer. Oil consumers will benefit.

What next?

All things being equal, around September, supplies will begin to contract fairly sharply and the gap between supply and demand will narrow.

Prices will rise but not to levels high enough to save most of the frackers. Say $60 – $65 a barrel. Just guessing.

A year or two later, supply shortfalls will send the price of oil way up again. Think $140 / bbl. That will bring the shale producers – by this time many of them owned by the majors – back. And a year or so later, that will push prices down.

In the longer term, the availability on fairly short order of oil from fracking promises to help stabilize prices. Fracking is likely to supplement and may displace Saudi Arabia from its current role as the world’s swing producer. Eventually – sometime in the 2020s – this should stabilize what will otherwise be a volatile oil market. I’d guess the equilibrium price will be about $75 but your guess is as good as mine.

Of course, all things may not be equal. If pressed too hard, Iran or Russia or both could decide on a breakout strategy, taking out other nations’ oil production with cyber or military sabotage. That would send prices through the roof.

Barring that sort of thing, however, the prospects are pretty sure to be as I’ve outlined them.