Thoughts on Energy after the Price Collapse
(Guest Commentary by Ryan Kellogg – February 26, 2009)
Dear Subscribers and Readers,
I hope all of you are having a good week so far. While Main Street is still dealing with a great dose of uncertainty, the financial fog that has been clouding Wall Street since early 2007 is certainly starting to lift. As I mentioned in our MarketThoughts Special Alert (please email us if you did not receive it – and note that we are now 125% long in our DJIA Timing System) on Tuesday, many credible and leading financial figures have publicly discredited the notion of nationalizing parts of our banking system – including William Isaac, head of the FDIC when Continental Illinois was nationalized, PIMCO's Bill Gross, and obviously, Ben Bernanke and Tim Geithner. Moreover, I highly believe that the US Treasury's “stress tests” on the 19 largest banks in the US banking system will provide us the transparency (by the end of April) that we've always needed – and that by the end of those tests, it'd be painfully obvious to the bears that both nationalization and larger write-down fears were wildly overblown.
On Tuesday morning, I attended the ALOUD business breakfast forum, where the keynote speaker was none other than PIMCO's CEO and CO-CIO, Mohamed El-Erian. In his speech, he stated that where past financial crises have been a crisis “within the system,” the current crisis resembles a crisis “of the system” itself. The financial institutions that were the investment banks in the last few years will not come back in a long time. The US-Chinese relationship – where US consumers bought goods with (more or less) vendor financing from China – has been broken. US consumers have piled on leverage since the end of World War II, and we are now re-embarking on a savings culture – for the first time since the Great Depression. Because of deleveraging within housing, consumers' balance sheets, and the US banking system, both the government and the Federal Reserve have been forced to step up to make up for this by government spending and increasing the size of the Federal Reserve's balance sheet.
El-Erian further contends that this current crisis will have long-term implications, especially for our children. He asserts that banks will most likely follow the “utility system” of old – and that financial innovation will be dead for a longtime. He believes potential GDP growth will be constrained for years to come – with the US potential growth rate coming down from around 3% to closer to 2%. Of course, many of our subscribers know this part of history and understand most of the crisis' implications already. What got lost among all the pessimism in the room was his assertion that – because of the crisis – US policymakers, with support from Main Street, have finally begun to tackle some long-time and structural problems in our country, such as: 1) our unsustainable reliance on foreign energy sources, 2) rising healthcare costs, and 3) our lack of innovation of commercialization in the sciences over the last decade. As the eminent historian, Arnold Toynbee wrote decades ago, whether the US economy can move on to the next boom or the next stage of her progress would depend on our ability to meet our major challenges. Almost always, it is the “creative minorities” that tend to derive solutions to these challenges – while others in positions of power then follow. Obviously, our challenge is not just our reliance on foreign oil – but all the accompanying problems that come with it, such as social and race inequality and the empowering of hostile (and close-to-totalitarian) States such as Iran. Moreover, cheaper energy sources will further reduce the re-proliferation of poverty around the globe – factors which all tend to be destabilizing to long-term economic/productivity growth and global social harmony. The widespread adoption of cheap solar technologies, for example, will bring decentralization to the power grid and allow every household to be a capitalist. Should cheap energy ultimately become limitless – this will not only propel US technological/productivity growth to the “stratosphere” (think of the tens of millions of dollars that are needed annually to run and cool the fastest supercomputer in the world today) but will also go a long way to eradicating poverty in the United States and ultimately to most capitalistic countries around the world. This is the goal we should all be aiming and hoping for.
Speaking of the energy industry, I believe this is now the right time to take a re-look at the state of the global oil industry and the implications of the current financial crisis on the industry. Since I am no expert myself, I have tapped a close friend and colleague, Ryan Kellogg, in the UCLA Anderson MBA program to write a guest commentary for us. I want to thank Ryan for graciously for his time and wisdom. But first of all, I believe a little bit of introduction is in order: Ryan Kellogg worked in the petroleum industry from 2002-2008 at locations in the Netherlands, Nigeria, and Brunei in a variety of engineering and business roles. He is currently pursuing an MBA at UCLA Anderson School of Management and hopes to return to the industry following graduation. Following is Ryan's commentary.
Disclaimer: This commentary is solely meant for education purposes and is not intended as investment advice. Please note that the opinions expressed in this commentary are those of the individual author and do not necessarily represent the opinion of MarketThoughts LLC or its management.
Of all the markets roiled by the financial maelstrom of the past 6 months, perhaps none has been more dramatically impacted than energy. In just a few months, the price of crude and natural gas has dropped ~70% since July 2008 thanks to the dramatic collapse in global demand. With a recent consensus among US economists that 2009 will be recovery-free, oil and gas prices will remain flat, or decline somewhere below the $30/bbl level, during the remainder of the year. But what happens after a return to normalcy, whether in 2010 or 2011? How much of the 2002-2008 rise in crude oil prices represent a fundamental shift in global supply and demand and what portion was ‘irrational exuberance' of the commodity bubble? To help answer this question it's useful to take a step back and see the causes behind the rollercoaster ride of the past few years.
Oil and the Rise of China
As the chart below shows, prices for a barrel of West Texas Intermediate rose from ~$25/bbl in 2002 to its peak of ~$140/bbl in mid-2008. During this period of price appreciation, two clear trends can be seen: 2002-2006 (Demand Shock) and 2007-2009 period (Boom and Bust).
On the latter period, much has been written on the causes of the exponential rise in energy prices and subsequent collapse. Instead, let's draw our attention to the span from 2002-06 and the fundamental shift that occurred in oil and gas demand driven by the rapidly expanding economies of the developing world. The chart below shows the energy demand for the developed world along with China and India.
Back in 2002 the International Energy Agency (IEA) had forecast energy growth for China at a rate four times less than the actual rate that was realized. China's surprising double digit growth during much of this period was the key driver in increasing the Middle Kingdom's share of global energy demand to 15% by 2006; a portion nearly double that predicted by the IEA. This huge gap between expectation and reality was critical to the steady price increases in crude oil seen during this period as supply struggled to meet demand at 1990s price levels. It is this fundamental increase in systemic demand, primarily from Chinese growth, that drove the rise in energy prices from 2002-06. It is this same growing demand that will enable a quick recovery to 2006 pricing levels ($60-$80/bbl) following a return to global economic expansion.
A relatively rapid price correction seems especially likely given the anemic investment in future supply that will be the legacy of this lower price environment. Case in point, consider the daily global crude oil production from 2001-2008. As the chart below shows, despite tremendous incentives to expand capacity, the global production rate remains relatively flat, especially during the 2005-08 period where prices increased most dramatically.
The production increase from 70 to 75 MM bopd between 2003-2005 largely represents increases in spare capacity in OPEC countries and to a previously underdeveloped Russia. Countries like Saudi Arabia have tremendous onshore fields with thousands of ‘simple' wells (vertical wells of no more than a few thousand feet) whose marginal cost both in terms of money and time to delivery are the lowest in the industry. Up to a point adding capacity to a field can be as simple as adding wells and, when necessary, providing pressure support via water or gas injection to the reservoir. However given the age of some of these fields, many producing since the early 1950s (e.g. the ~100 billion barrel mega field, Ghawar, in Saudi Arabia), the recovery rates are approaching levels where conventional, and even secondary recovery techniques, can no longer yield increases in capacity. What's left are approaches far more costly and technically challenging. It seems likely that by 2005, most national oil companies (NOCs) had exhausted the ‘easy' methods of ramping up production and were faced with longer term capital investments needed for further expansions in capacity. How likely is it that these projects will continue at a $40/bbl price level? If the dramatic decline in drilling budgets for 2009, the postponement of new refineries in Saudi Arabia, Kuwait, and India, and the delay of a number of offshore drilling projects in West Africa are any indication—it seems likely that global supply will be roughly equal to the production levels seen in 2008 for the foreseeable future. This of course assumes that the declines in current producing fields are roughly offset by the maturation of projects in the later stages of development.
A Brave New World
For the average investor looking at battered firms in the oil and gas patch, forecasting the price of crude oil is a bit of a crapshoot—as a few analysts found out during 2008. That being said, there are a number of developments worth paying attention to that will shape the supply/demand equation going forward:
1) Capital investment patterns both at NOCs and IOCs
It's worth noting upfront this can be a difficult metric to follow. NOCs over the past few decades have becomes increasingly assertive in the amount of control they exert over mineral resources. Continuing a pattern that began with Arab nationalism following the end of European colonialism in the Middle East, the Western integrated oil companies (IOCs) have largely lost their dominant role in shaping supply. This balance of power can be illustrated by the chart below which shows the estimated reserves of the world's top NOCs and IOCs.
The colored bars above represent wholly or majority nationally operated oil companies around the world. Future growth will largely depend on NOCs which are notorious for their inefficiencies and lack of transparency. The decline of the Venezuelan oil industry following its complete nationalization under Chavez is a good example. With most NOCs managing the decline of aging fields, the peak oil long projected by analysts will likely be realized, barring a dramatic change in investment patterns, by a number of nations, including Saudi Arabia, Russia, Venezuela, Mexico, the EU (primarily the UK/Norway) and Iran, collectively making up 40% of current daily production. The notable exceptions, are those nations with either current undercapacity relative to existing probable reserves (e.g. Iraq) or countries with new offshore prospects (e.g. Brazil). With adequate investment, an additional 5-7 MM bopd can be realized from these two countries within 10 years, which would at least partially offset declines from other areas including the North Sea and the Gulf of Mexico.
For the IOCs, long faced with declining access to the world's largest and most accessible reserves, the next year will be spent re-phasing development projects that are highly uneconomic at current levels (e.g. the ‘oil sands' of Alberta; economic only at $70+/bbl), while looking to bring down costs through renegotiations with suppliers. Re-phasing still attractive projects in order to realize lower cost structures seems to be a possibility that most IOC management teams are looking into for this year. In the Q4 conference calls all the oil majors (XOM, CVX, RDS, BP, TOT, COP) planned on maintaining CAPEX spending roughly equal to 2008 levels. Assuming that depressed price levels are not sustained far beyond 2010, many of these firms (in particular XOM and CVX) should be well positioned to capitalize on any improvement in market conditions thanks to their relatively strong balance sheets. Since the IOCs play a dominant role in North America and Europe, investment patterns in this lower price environment could have long ranging impacts on future oil supplies to local refineries and natural gas markets.
2) Decline of oil field service costs
Impacting CAPEX investments going forward is the relative stickiness of oil service costs. During the price run-up the cost of oil services rose dramatically as the demand for drilling rigs and specialized surveying and well testing equipment surged worldwide. These costs, along with raw materials like steel, have been slow to decline compared to the drop in crude prices. This has helped drive delays in projects, especially among IOCs, hoping to rebid at lower rates. Based on stock performance of oil service companies compared to a selection of the IOCs, it seems like there are market expectations for much lower earnings from the Schlumbergers and Halliburtons of the world. The faster these costs come down, the more willing production companies, will be to commit resources for planned projects.
3) Changes in governmental regulations related to carbon emission
With the election of the new administration in the US, there now seems to be alignment between western nations and Japan concerning climate change. Whether this new agreement will result in any fundamental shifts in energy policy is doubtful given the state of the global economy and the costs associated with these reforms. However there are several issues worth paying attention to:
How aggressively will the US pursue carbon emission reductions?
The Obama administration campaigned promising direct action on climate change and has adopted a cap and trade system, similar to the one employed in the EU, as its preferred solution to industrial CO2 emissions. Considering the current economic environment, this seems unlikely to be pursued in the near term. Many IOCs are already operating under stricter conditions in Western Europe, and in fact see potential opportunities through carbon capture and storage. However given the price collapse of CO2 credits in the EU in recent months, the long term viability of this option as a business, or even as a way to reduce emissions, is still unproven.
Perhaps more realistically, will the recent federal decision to allow California to set its own emissions guidelines be a precursor to a new direction for the US? After similar collapses in the oil price, the American consumer has always reliably returned to large, inefficient vehicles. However with stricter fuel efficiency standards planned by Congress and state budgets looking for a boost in revenue, it doesn't seem likely that gasoline prices will reach the sub-$1/gallon levels last seen in the late 1990s.
Will renewables, with adequate government support, emerge as a viable alternative?
Renewables, perhaps even more than traditional energy firms, have been hammered by the collapse in the price of crude. Between the lack of obvious economic incentive and the credit freeze, many startups are struggling to build the economies of scale needed to remain viable. The funds allocated in the 2009 American Recovery and Reinvestment Act and the planned $15 billion a year for renewable energy expected in the Federal Budget, will help keep many of these initiatives afloat, but without a significant intervention resulting in a higher floor on fossil fuel prices, there will be little impact on US demand for oil due to these sources.
In contrast to the rollercoaster ride of 2008, crude oil prices this year will most likely stay in the $30-$50/bbl bandwidth; this upper estimate driven by additional OPEC cuts and weather related (e.g. hurricanes) or political (e.g. Russia-Ukraine; Nigeria) disruptions, but not due to increases in global demand. As both NOCs and IOCs cope with this new world, the commitment to the development of additional capacity both at the wellhead and refinery will slacken as costs for these projects remain sticky compared to the rapid slide in the oil price. NOCs remain the key to future supply, but many are nursing aging fields that require significant investment to maintain 2008 production rates. The notable exceptions are Iraq and Brazil, which have sizable undeveloped reserves that could add 5-7 MM bopd of additional supply within the next 5-10 years. Based on a short-term outlook there seems little support for prices to remain at current levels following the return of normal economic conditions. Meanwhile IOCs are forced to deal with declining fields in their home markets as peak production has arrived for the North Sea and, in most likelihood, for the Gulf of Mexico. With the Canadian oil sands now uneconomic at $40/bbl, the focus for these firms will be on maximizing recovery from current assets and turning to more distant shores primarily in West Africa and Central Asia for future growth where governmental terms are still attractive. In the end, long term organic reserves replacement will be even more difficult for these firms than it was the past few years. Still several IOCs, most notably XOM and CVX, have strong enough balance sheets to weather these storms and to capitalize on the price upswing that is sure to happen following an economic recovery.