By Gene EpsteinROM BARRON'S 3/31/14)
The long-term outlook for global oil prices is lower, perhaps much lower,
giving a strong boost to the U.S. economy while potentially crippling the
economy of Vladimir Putin's Russia. Vast new discoveries of oil and natural gas
in the U.S. and around the globe could drive the oil price to as low as $75 a
barrel over the next five years from a current $100.
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The demand side, too, will put pressure on the supremacy of petroleum. For
the first time in its 150-year history, the internal combustion engine can be
run efficiently on alternative fuels from a number of sources, including natural
gas. As these alternatives are increasingly introduced, global consumption of
oil will slow its growth and flatten out.
Citigroup's head of global commodity research, Edward Morse, believes the
combination of flattening consumption and rising production should mean that "
the $90-a-barrel floor on the world oil price over the past few years will
become a $90 ceiling." Within a new trading range with a $90 ceiling, Morse
sees an average of $75 as plausible.
That's a far cry from the old paradigm, promoted in the past 40 years,
which posited ever-greater demand for petroleum as developing economies grew,
and a slowdown on the supply side the looming prospect of "peak oil," whereby
global production maxes out and falls into decline. To the contrary,
unconventional sources of crude oil totaling more than a trillion barrels the
equivalent of more than 30 years of extra supply have been discovered in the
past five years. The majority is recoverable at $75 or less, and much is now
being tapped.
Within the next five years, growth in U.S. production of oil should make
this country a net exporter, ending a pattern that has persisted since World War
II. "While this country will still be importing plenty of medium and heavy
crudes, most of the imports will come from Canada and Mexico," says Morse. "So
the U.S. will no longer have to worry about disruptions in supply that might
disrupt economic activity. That's why we call it the era of North American
energy independence."
British economist Alfred Marshall famously likened supply and demand to
the blades of scissors, and the blades are also poised to cut oil prices in the
rest of the world. On the supply side, unconventional sources of oil are being
tapped in countries that include India, Bahrain, and Uganda. On the demand side,
a third of the auto fleet in Brazil can already run on fuel other than
petroleum.
The recent aggression by the oil-and-gas exporting nation of Russia
reminds us of the fragility of global energy supplies. At the same time, the
oil-and-gas abundance in this country has influenced concrete proposals for
dealing with Russia. Energy consultant Philip Verleger has publicly proposed as
a "meaningful response to Russian aggression" that the U.S. sell the nearly 700
million barrels in its Strategic Petroleum Reserve as a way to "drive oil prices
down and impose significant harm on Russia," since the SPR is "no longer needed
for national security." And an editorial in The Wall Street Journal recently
proposed that the Department of Energy "approve immediately the 25 applications
for liquefied natural gas . . . export terminals," since "every dollar of U.S.
gas is one less dollar flowing to Mr. Putin's economy."
Such proposals would have been unthinkable as recently as five years ago,
when the old paradigm was still dominant and domestic supplies of oil and gas
were a source of worry.
Over the next five years, the effects of the global oil-and-gas boom
should prove a grim object lesson for the Russian economy on the downside of the
" resource curse." Russia's economy "largely depends on energy exports,"
according to a study from the U.S. Energy Information Administration. That works
well when prices are high, but quite badly when prices fall.
Oil-and-gas revenues account for 70% of Russia's total exports and more
than half the income of its federal government. Russia exports more than seven
million barrels of oil a day, second only to Saudi Arabia. One key difference
between Russia and the No. 1 exporter is that more than 60% of Russian oil is
produced in Siberia, where costs are much higher. A fall in the world price to
$ 75 from $100 would therefore have a much greater impact on the net
revenues that Russia earns from oil than is earned by the Saudis.
The downside of the resource curse could also be felt in Russia's reliance
on sales of natural gas. About 75% of Russia's natural gas exports go to Western
Europe, providing 30% of its requirements, at prices that are two and three
times the price in the U.S. That enormous premium stems from the fact that there
is no world market for natural gas, given the prohibitive cost of shipping it in
its unaltered state. Hence, the argument for accelerated approval of liquefied-
natural-gas export terminals. With abundant natural gas now available in so much
of the world including Australia, South Africa, Brazil, and Argentina within the
next five years, something resembling a global market in liquefied natural gas
will likely develop. That would break the local monopoly of the Russians in
their market, enabling Europeans to buy from other sources, and weighing on the
premium Russian gas now commands.
Amy Jaffe, executive director for energy and sustainability at the
University of California, Davis, co-authored a recent study with Rice University
economics professor Mahmoud El-Gamal predicting that barring a "war that
destroys physical installations for the production and/or transport of oil," the
oil price will " fall precipitously over the medium term of three to five
years."
Jaffe believes the average price could fall below $75, based in part on
her view that oil-production costs are not fixed. "Research shows that costs
track oil prices and not the other way around," she observes. As oil prices move
lower, demand for drilling rigs and related equipment falls, lowering the cost
of drilling. And that's bad news for Putin.
"The Russian government's budget is expected to need an oil price of over
$100 to stay balanced between now and 2020," Jaffe says. "A $75 average
could make the ruble's recent tailspin look trivial by comparison."
Steve Briese, publisher and writer of the Bullish Review of Commodity
Insiders newsletter, is currently projecting an imminent plunge in the oil price
to the $ 70 region. His bearish outlook is based on the recent peak in the net
short position of businesses involved with oil. These businesses, also called "
commercials," use futures and options on West Texas Intermediate crude traded on
the New York Mercantile Exchange as part of their business strategy.
The futures and options market in WTI crude is actively used by refiners
that would naturally take long positions in these derivative contracts to hedge
against a price rise, and producers who would naturally take short positions in
order to hedge against a price decline. The fact that the net short position of
these commercials recently set a record indicates that refineries are lightening
up on their long positions. While this leaves them exposed to a price rise, it
also means they will benefit if the price declines.
Briese uses published data from the Commodity Futures Trading Commission
to track the bets of these bona fide hedgers with an eye to betting accordingly.
In his view, since they are in the oil business and therefore close to the
scene, they are the true insiders, whose consensus outlook is better than anyone
else's. Perhaps these insiders recognize that the new paradigm is here to stay.
The game changers on the supply side are the three new types of oil
production that have not been counted as part of the oil supply until recently:
deepwater oil, shale oil, and oil sands. Each of these sources of oil has been
estimated at more than 300 billion barrels, totaling more than one trillion
barrels in all. That's a huge addition to previously estimated reserves of some
1.5 trillion barrels. According to Citigroup energy analyst Eric Lee, a good
proportion of the extra trillion barrels could be recoverable at $75 a barrel
or less. In fact, he notes that a $75 cost estimate could even be on the high
side, as production costs for shale and even deepwater can continue to fall over
time.
Deepwater oil has been tallied at 317 billion barrels by the Norway-based
oil- and-gas source Rystad Energy. Of that total, Rystad estimates that 53
billion barrels are recoverable off the shores of North America.
What slowed development of deepwater drilling was the 2010 disaster in the
Gulf of Mexico involving BP (ticker: BP), which killed 11 people and spilled
millions of barrels of oil. But two weeks ago, the Environmental Protection
Agency lifted the ban on BP's right to bid on oil leases in the Gulf of Mexico.
A few days later, BP bid successfully on 24 leases in the Gulf in an auction
held in New Orleans. Elsewhere, activity had already picked up in regions that
include East Africa (63 billion barrels) and the Asia-Pacific region (32 billion
barrels).
Shale oil, recoverable mainly through hydraulic fracturing, or fracking,
has been estimated by the U.S. Energy Information Administration at 345 billion
barrels, of which 58 billion barrels are recoverable in the U.S. The EIA report
of June 2013 estimates that the 310-million-barrel increase in U.S. oil
production in 2012 over 2011 was "largely attributable to increased production
from shales and other tight sources."
Oil sands, according to the BP Statistical Review, are found in just two
countries: Canada, at 167.8 billion barrels, and Venezuela, at 220 billion. In
the oil-sands case, it is not clear whether production would continue with $75
oil. But as Citigroup's Morse points out, "While current investors might be
discouraged by $75, other companies would be open to investing, including
state- owned companies in the Far East, since the cash flow would be robust for
40 years or so." Investors with a 40-year outlook might not be deterred by a
$75 average price if they are bullish on a long-term basis.
Meanwhile, at current prices, the BP Statistical Review reveals 25.9
billion barrels of Canadian oil sands as "under active development."
On the demand side, petroleum's monopoly of the transportation market is
being challenged by abundant natural gas recoverable from shale. According to
estimates by Advanced Resources International, an energy consulting firm that
compiles data in conjunction with the EIA, shale-gas resources in the U.S.
amount to a staggering 1,161 trillion cubic feet, compared with 285 trillion
cubic feet in Russia, and a world total of 7,795 trillion cubic feet. On a
British-thermal-units basis, 7,795 trillion cubic feet of natural gas is the
equivalent of 1.4 trillion barrels of crude oil.
As the chart on page 22 shows, domestic oil and natural-gas prices used to
track each other fairly closely. The reason for the correlation: Oil drilling
invariably produces natural gas as a byproduct. By 2009, however, the
correlation began to break down, with natural-gas prices moving to a steep
discount to oil prices, as gas production soared. A barrel of oil contains the
energy-equivalent of some 5.55 million BTUs. At the current natural-gas spot
price of $4.30 per million BTUs, a barrel at $75 buys nearly 17.5 million
BTUs- worth of natural gas more than three times as much.
This multiple is already being exploited. In a major study, Citigroup's
Morse, together with a team of other analysts, has calculated that there is huge
potential for savings if trucks, buses, ships, and ultimately passenger vehicles
are run with natural gas rather than petroleum fuels. The study also notes that
the conversion is well under way. Waste Management (WM) has made it known that
80% of the trucks it buys are fueled by cheaper natural gas. Cummins (CMI) and
joint-venture partner Westport Innovations sell an engine that runs on both
liquid natural gas and compressed natural gas. Westport Innovations specializes
in retrofitting engines with natural-gas components.
According to the Citigroup study, the low-hanging fruit lies in commercial
fleets setting up refueling stations along routes of 400 miles or less. In the
U.S., that includes heavily trafficked routes in the Northeast and in Southern
California. Intracity traffic that includes passenger buses and other short-haul
vehicles can also shift to natural gas.
Transportation accounts for nearly half of the oil the world consumes each
year, and trucks alone use nearly one of every nine barrels consumed. Also ripe
for natural-gas substitution is the consumption of oil for industrial uses
accounting for more than one in five barrels consumed and for electricity
generation, which still accounts for one in 18 barrels consumed worldwide.
Moreover, when mixed with petroleum, fuels that can be made from natural gas,
like ethanol and methanol, can help meet ever-more-stringent Corporate Average
Fuel Economy, or CAFE standards, being mandated over the next several years.
Taken together, these trends should be more than enough to cause global
consumption of oil to slow its growth over the next several years and then
flatten out. There is even the potential for global oil demand to begin
declining. Yossie Hollander, co-founder of the Fuel Freedom Foundation, a
nonprofit dedicated to breaking the world's oil addiction, argues that passenger
vehicles can run economically on methanol and ethanol made from various sources,
including natural gas.
"Methanol can be made today competitively with existing technology, from
energy resources with which the United States is well endowed natural gas, coal,
biomass, garbage, or any other organic material," Gal Luft, an advisor to the
Fuel Freedom Foundation, argues in Petropoly, co-authored by Anne Korin. "In the
future, perhaps even recycled carbon dioxide could be commercially converted
into methanol, providing an elegant solution to the otherwise seemingly
economically irresolvable issue of fossil-fuels-derived greenhouse-gas
emissions."
The oil and gas boom is not welcome to environmentalists, although it
should be. The replacement of coal with natural gas for electricity generation
has reduced carbon-dioxide emissions, and emissions of sulfur dioxide and
nitrogen oxides fall as natural gas replaces petroleum. Also, lower energy
prices confer disproportionate benefits on people of modest means, who spend a
larger share of their income on energy than do richer folk.
But the dangers of deepwater drilling and of fracking, and the use of
fossil fuels for decades to come, are already provoking pushback from the
greens. In the end, however, as Trevor Houser of the Peterson Institute remarks,
"Provided that industry accepts reasonable levels of regulatory oversight, the
oil-and-gas boom is unlikely to be stopped by environmentalists."
"The history of mankind," observes Morse, "at least since the invention of
the wheel, is a history of cheaper and cheaper energy. Modern civilization would
be impossible without cheap energy. I believe we are entering another period of
cheaper energy that should last 50 years or more."
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