A Lesson in Oil Pricing

• The recent oil-price collapse confirms what we should have learned in 2007-8 about the influence of the last increments of supply and demand on price.
• This also means that future oil prices should be largely independent of the size of the oil market, even in a decarbonizing world.

In 2008, near the peak of a historic oil-price spike, the US Energy Information Administration (EIA) published a study projecting that opening the Arctic National Wildlife Refuge (ANWR) for drilling would reduce oil prices by no more than $1.44 per barrel, compared to their forecast without ANWR. Adding up to 1.5 million barrels per day to US production by 2028 would thus save motorists less than 4¢ per gallon. That result appeared during a Presidential election campaign that featured the slogan, "Drill, baby, drill!" and received significant attention.  I hope the authors of that study have been watching the current oil price collapse, because it provides some useful lessons in how oil prices are determined.

Oil traders and most economists understand that oil prices are ultimately set by the last few million barrels per day of supply and demand in the market, and resulting changes in inventory. The oil price spike of 2007-8 provided firm evidence for this phenomenon, as rapidly growing demand and production problems eroded global spare production capacity to a level of around 2 million barrels per day (MBD) compared to more than 5 MBD in late 2002, prior to the Venezuelan oil strike and the start of the Iraq War. This may have been obscured by the rise of the widely publicized Peak Oil meme, which provided a more viscerally appealing explanation for high oil prices until it ran out of steam recently.

A chart from one of the International Energy Agency's recent Oil Market Reports provides a neat illustration of the main factors leading to the recent price collapse. (See below.) Here, the emergence of a sustained surplus of 1-1.5 MBD starting in early 2014--less than 2% of the global oil market of around 93 MBD--was instrumental in depressing oil prices by more than half. Another factor was that, contrary to a key assumption of the 2008 EIA study, OPEC elected not to "neutralize any potential price impact of (additional US) oil production by reducing its oil exports." While shale technology has expanded US oil output by a multiple of what the EIA expected ANWR might add, the benefit for consumers isn't just pennies per gallon, but more than a dollar, at least for now.

Since the price of oil is set at the margin, it is also essentially independent of the total size of the oil market. That has important implications for how we envision the future of the oil market, especially in a world that is increasingly concerned about greenhouse gas emissions and transitioning to cleaner sources of energy. Even if future oil production were to be increasingly constrained by energy efficiency improvements and environmental policies, it doesn't necessarily follow that future oil prices must be low. That would only be the case if producers mistakenly invested in more production capacity than the market actually ended up needing.

As things stand today, there is a significant risk that the industry will not invest enough in future capacity, and that prices will again rise sharply before electric vehicles and other alternatives could scale up sufficiently to fill the gap, particularly if low oil prices also deter their growth. That's because without large investments in new oil output, current production will eventually decline from today's levels. Field-level decline rates range from just a few percent to 65% per year, depending on whether we're looking at the conventional oil reservoirs that make up over 90% of global supply, or at US shale production, which accounts for less than 5% of world oil.

Perhaps the bottom-line lesson is that we should never become complacent about the potential price volatility of what is still, at this point, an indispensable commodity. The shale revolution and OPEC's current behavior don't guarantee that oil prices must remain depressed, any more than previous concerns about Peak Oil meant they would remain high indefinitely.





 

Turning to Energy for Jobs

Yesterday's Energy Jobs Summit at the US Capitol, hosted by The Hill and API, focused on the potential of the energy sector to add large numbers of new jobs to help alleviate the national jobs crisis that President Obama will discuss in tonight's speech. The figures presented by API and others were impressive, with the oil and gas sector alone capable of creating over a million jobs if provided increased access to US resources. Panelists also discussed "green jobs", including those from energy efficiency projects. Yet I was struck by the inherent tension between today's job-creation imperative and our long-term need for an energy sector that is as productive and cost-effective as possible, in order to support economic growth and reemployment in the roughly 92% of the economy beyond energy. That makes highly productive private-sector energy jobs requiring little or no public investment especially valuable.

In a new study released at the summit, Wood Mackenzie estimates that the US oil and gas industry could increase its employment by 1.4 million by 2030, with a million of those jobs attainable by 2018--more than half in the next two years--under new policies that would lift the current bans on offshore drilling outside the established areas of the Gulf of Mexico and on shale drilling in New York, speed up permit issuance in the Gulf, open up new onshore acreage for leasing, and approve the Keystone XL pipeline. In the process, domestic production of oil and gas liquids could eventually nearly double, while natural gas output would grow by over 60%. Even better, from a deficit-and-debt reduction perspective, this effort would require no new government expenditures and stands to contribute a cumulative $800 billion in additional federal and state royalties and tax receipts.

The potential jobs impact is extraordinary, when you think about it. Oil and gas is an incredibly capital-intensive industry with very high worker productivity--one reason that salaries in the industry tend to be much higher than average. An industry like that is hardly the first place one might think to look when seeking massive job growth. The fact that such growth is even possible is both a validation of the tremendous untapped resource potential we still possess, and an indictment of decades of bipartisan energy policy mismanagement that has preferentially outsourced US energy production, rather than exploiting our own resources.

What about the contribution of "green jobs"? The growth of cleantech--renewable energy and energy efficiency--can certainly contribute to US job growth, yet we should understand clearly that such jobs won't spring forth spontaneously from the private sector without substantial continued government incentives and subsidies. Nor are those a guarantee of success. The US wind industry installed just 2,151 MW of new capacity in the first half of 2011. While that was considerably better than last year's pace of 1,250 MW, it's still 47% below installations in the first half of 2009, despite last December's against-the-odds extension of the Treasury renewable energy grants, which paid out $2.2 billion to wind projects this year. And the recent solar bankruptcies and the aggressive offshoring by solar manufacturers fighting to stay competitive with Asian suppliers also demonstrate that green jobs, other than those in installation and construction, are just as vulnerable to global competition as in any other US manufacturing industry.

Conventional energy jobs aren't immune from competition, either. I was startled to read yesterday that regional refiner Sunoco plans to exit the refining business after more than 100 years. Its two Philadelphia-area refineries will either be sold or shut down by mid-2012, with 1,500 jobs at stake. Prospects for a quick sale of these facilities look poor, because these plants are among the most exposed to global oil prices that have been running more than $20 per barrel higher than for crudes produced in Canada and the US mid-continent. Idling these plants would take a big bite out of east coast gasoline supplies and inevitably lead to both higher product imports and higher gasoline prices in the northeast and mid-Atlantic regions. As someone pointed out at yesterday's session, it's a sad commentary that Sunoco can make more money selling sodas and snacks at its retail facilities than it can refining crude oil.

That dynamic makes the production-related jobs in the Wood Mac study even more attractive: Despite being tied to a depleting resource, US oil & gas exploration and production enjoys a greater sustainable competitive advantage in the global marketplace than either refining or cleantech manufacturing, at least when it has sufficient access to domestic resources.

However, these opportunities also pose a test of our seriousness on the jobs issue. Opening up the Virginia and California coastlines, for starters, along with the coastal plain of the Arctic National Wildlife Refuge to exploration raises a host of NIMBY and environmental concerns. I don't want to trivialize them, but I would suggest that the time when we could afford such sensibilities may have passed, heralded by our continued descent in the rankings of national global competitiveness and the rapid growth of our indebtedness. Creating a number of "green jobs" comparable to Wood Mac's estimate of 1.4 million from oil and gas would require the expenditure of tens to hundreds of billions of dollars the federal government doesn't have, and that the current Congress seems unlikely to be willing to appropriate. It would also risk embedding expensive energy at the core of the US economy, hobbling our non-energy economy, where most Americans are employed.

Yesterday's energy jobs summit was held in the new Capitol Visitor Center, which I hadn't seen before. It's a gorgeous facility and a suitable addition to the paramount edifice of our democracy. However, I was also struck by the contrast it provided with the meeting's subject matter. Recall that the Visitor's Center ended up costing over $600 million, well over twice its original plan. I hope that when the President presents his jobs program tonight, it will be grounded in the crucial distinction between that kind of government-funded, "shovel-ready" project that might put some of our fellow citizens back to work for a few years and an energy-and-jobs resurgence funded entirely by companies and their investors.

The Contango Warning

President-Elect Obama is expected to name his energy and environmental team shortly. Whoever is nominated as the next Secretary of Energy will be swamped with an array of competing priorities, including modernizing the nation's electrical grid, managing the nuclear weapons infrastructure, and above all guiding the shift to a greener energy diet that will reduce our greenhouse gas emissions, and perhaps also our dependence on imported energy. With regard to the latter outcome, however, the incoming Secretary should pay careful heed to the signal that the oil market is sending about the importance of boosting declining US petroleum production. While the media focuses on a front-month futures contract price for West Texas Intermediate crude oil in the low $40s per barrel, traders have been paying north of $60 per barrel for delivery in 2010 and $80 for oil in 2016. That suggests that the relief we are seeing at the pump today is only temporary, while the global economy is gripped by a recession and credit crunch. Our oil worries will return soon enough, once the economy recovers.

Aside from the remarkably rapid drop in the price of crude oil for prompt delivery, the current market conditions are unusual because of the steep rise, or "contango", of the prices in successive futures contract months. At yesterday's settlement on the New York Mercantile Exchange, oil for delivery in February carried a $2.59/bbl premium over January, and March was another $2.20/bbl higher. Oil for delivery in December 2009 was a whopping $13.81/bbl higher than the January '09 futures. The fact that sufficient oil is not being bought today and put into storage for future delivery to close the arbitrage opportunity this situation creates is a clear indication of just how tight commercial credit has become, recently. As it is, US oil inventories have climbed by 26 million barrels since the end of September, rising from close to the bottom of their seasonally-adjusted range to near the top.

Although the oil market isn't any more prescient about future oil prices than the stock market is about future corporate earnings, it still reflects the current consensus on the future--and not just of those with an opinion, like me, but of those willing to bet serious money on it. In that light, the extreme contango of the current market reflects many factors, chief among them the extraordinary weakness of current demand that has caused prompt prices to collapse, combined with the seemingly-inevitable collision between limited global supplies and the long-term demand from the large developing economies of Asia. Even if US oil demand never returns to its high-water mark of 20.8 million barrels per day in 2005--a level 6% above our monthly average for 2008, to date--the potential demand from China and India is more than sufficient to drive prices back to OPEC's desired floor price of $75 or more. Throw in a bit of political risk from our old friends Iran, Venezuela and Russia, and it's the current price that looks like the outlier, not today's long-dated futures prices between $60-$80/bbl.

That certainly supports the case for the next Secretary of Energy to push hard for the fuel-saving technology and alternative fuels that can reduce our dependence on expensive sources of foreign oil, but it might be less clear why maintaining domestic oil production and increasing it to the maximum extent possible matters just as much. We can't escape the mathematical certainty that imports must cover the difference between demand and domestic production. Those domestic supplies, which still represent 13 times as much gross energy content as our current 10 billion gallons per year of ethanol production, and contribute more than 30 times as much net energy to our economy, remain essential. Even a modest further drop in US oil production could negate the energy security gains from efficiency and additional biofuels.

There's also a lot of money at stake for the country, not just for oil companies. A new study from ICF International, commissioned by the American Petroleum Institute, confirmed the findings of the 2007 National Petroleum Council study in which I participated, to the effect that allowing drilling on the off-limits portions of the Outer Continental Shelf, onshore federal lands, and the Arctic National Wildlife Refuge could increase US oil production by 2 million barrels per day in 2030, above the expected baseline. That would displace tens of billions of dollars per year of imported oil--even at today's low prices--while cumulatively generating hundreds of billions in state and federal royalties and corporate income tax revenue that would be very helpful in covering the enormous debts being run up combating the financial crisis and recession.

As I noted frequently during the summer's debate over offshore drilling, there's no question of drilling our way to energy independence. We urgently need to expand and diversify our energy supplies and become much more efficient in how we use energy, but that doesn't mean we can turn our backs on oil, just yet. The new Energy Secretary will have to work hard to ensure that the oil replaced by the aggressive adoption of renewable energy and efficiency technology doesn't end up being our own.

NIMBY vs. TANSTAAFL

It is encouraging that our reaction to the current energy crisis has reached the stage at which we are beginning to see concrete plans for addressing it systematically, rather than via the grab-bag approach employed in last year's energy bill. The same applies to the related, but not quite parallel problem of climate change. But whether voters ultimately gravitate towards the Pickens Plan or to Mr. Gore's more dramatic goal of eliminating fossil fuels, such approaches are likely to run afoul of the same factors that have hampered the ability of the US conventional energy sector to keep pace with demand. Real progress in this area will require us to confront the collision between our desire for abundant energy and our distaste for the means of providing it.

The current debate over offshore drilling exemplifies many of the same obstacles that renewable energy sources will face, as we attempt to scale them up to a level that can compete with oil, gas and coal. Too many advocates of alternative energy cite our inability to drill our way out of this energy crisis--kicking a dead dog, if there ever was one--without realizing that the sensibility that opposes oil exploration off our coasts or in Alaska is not so different from the one raising lawsuits against the transmission of concentrated solar power from the desert to coastal markets.

Whether we are talking about oil wells, refineries, wind farms, or uranium mines, most Americans would prefer them to be far enough away from us that we can't see, hear or smell them. Until recently, it has been just barely possible to satisfy both our demand for energy and our state of denial about its origins, because the energy sources we have relied on are so concentrated. One mid-sized offshore oil platform contributes as much net energy production as the entire US ethanol program did in 2006. But as we shift toward renewable energy, it will become increasingly difficult to shield our sources of energy from our view. Generating the electricity necessary to displace natural gas from the power sector into transportation, as Mr. Pickens suggests, would require between 90,000 and 200,000 wind turbines, using current technology. In order the make that a reality, the viewscapes of millions more Americans must include either wind turbines or the new transmission lines necessary to bring their output to market.

Breaking this tension between NIMBY and TANSTAAFL--the popular acronym about free lunches that restates the Laws of Thermodynamics--will require a willingness to set clear national priorities and make the compromises necessary to turn them into practical reality. Does our desire to become energy independent, or at least reduce our reliance on unstable oil suppliers and the financial drain that accompanies it, exceed our preference for keeping big, ugly infrastructure out of sight and out of mind? Does our concern about the potential consequences of climate change trump the ability of small, vocal minorities to block essentially any project that doesn't fit their vision? Or has this energy crisis finally become painful enough to force us to grapple pragmatically with the consequences of solving it?

Striking a Bargain

For several years I have been intrigued by the possibility of a "grand compromise" on energy and the environment, so I was pleased to see this idea resurface in Steven Pearlstein's column in today's Washington Post. Starting with the proposition that Democrats and Republicans each hold only half the recipe for a serious response to our vulnerability to high oil prices and the risks of climate change, he frames our political choice as one "between compromise or stalemate." The evidence for this has been in the headlines throughout the past month. The recent failure of the Lieberman-Warner-Boxer cap & trade bill and the current debate on opening up more areas for oil and gas drilling demonstrate the inseparability of our energy and environmental challenges. It is time to recognize this as an opportunity, rather than an obstacle.

Wednesday's posting looked at how expanded drilling fits into our larger energy and environmental challenges and concluded that it can make positive contributions on both fronts, though it is hardly the entire solution. The feedback I received suggests that many people would be receptive to more drilling, if it weren't seen as a means for enabling a return to cheap oil and wasteful behavior. Expanding supply without addressing demand merely postpones tough choices, while ambitious planning for "energy independence" that constrains demand and boosts alternatives but leaves US oil production on a glide path to oblivion is doomed to failure. And as Mr. Pearlstein notes, a package combining "well-regulated drilling" with reductions in greenhouse gas emissions could benefit everyone.

The formula for a winning compromise isn't obvious. It could involve expanded drilling with royalties dedicated to funding alternative energy R&D, or it could go as far as linking economy-wide emissions cap & trade with carefully-monitored access to the Arctic National Wildlife Refuge and all federal waters beyond the 3-mile state limits. The best place to define it would be in a bi-partisan conference of the House and Senate. An election year might not seem well-suited for pursuing such sweeping legislation, but as I learned in my years of trading oil commodities, you can't always wait for the timing to be ideal. When conditions provide the right combination of motivated parties and market drivers, that's the time to strike. This could be just such a moment for sweeping energy/environmental legislation.

Mutually Inclusive Solutions

The combination of the current presidential campaign and the high price of energy is prompting a long-overdue national debate on the relative contributions of the various energy options available to us. A new grassroots campaign, "Drill Here, Drill Now, Pay Less" is putting our self-imposed constraints on oil drilling at the center of that discussion, where it deserves to be, based on the scale of oil's contribution to the economy and the difficulty of replacing it any time soon. However, for this debate to be productive, we need to shed some of the hyperbole on both sides, and approach this as something other than a mutually exclusive proposition. The harsh reality of this energy crisis is that solving it will require more conventional energy, much more alternative energy, and a much greater emphasis on conservation, of which efficiency is only one component. Above all, we must learn an uncharacteristic degree of patience. It took us a decade to get into this fix; it could take at least that long to put this crisis behind us, and its ultimate resolution is unlikely to resemble the status quo ante.

Start with the rampant misunderstandings about the way oil production works. How often have we heard that the US consumes a quarter of world oil but has less than 3% of global reserves? That's true, but it is equally true--and much more relevant--that the US produces 10% of the world's oil output (including natural gas liquids) and has produced a cumulative 200 billion barrels from "proved reserves" that never exceeded 40 billion barrels. Nor do assertions that the remaining US oil resources would only amount to a few years of consumption correspond to the way oil is actually extracted. Oil fields produce over an interval determined by geology and technology, not wishful thinking. New fields brought on line this year will operate for anywhere from 10-40 years, and our current output is the aggregation of hundreds of thousands of wells in thousands of oil fields, with half of total production and 2/3rds of our reserves coming from the top 100 fields, a fifth of which were discovered since 1990.

In order to make sensible plans, we must also factor in the relative contribution of new increments of supply from the various possible sources. For example, after accounting for the oil, natural gas and electricity that go into its production, an extra billion gallons per year of corn ethanol yields the net energy equivalent of only 14,000 barrels per day of oil--the amount we get from a single, highly-productive deepwater oil well. A 3.5 MW wind turbine delivers, on average, as much electricity as could be generated by 230,000 cubic feet per day of natural gas. It takes 300 such turbines to produce as much energy as the least productive of the top 100 US gas fields. Replacing the energy content of current US net imports of petroleum and natural gas would require the equivalent of an extra 837 billion gallons per year of ethanol and 55,000 large wind turbines. Cut these figures in half to account for the potential contribution of conservation and energy efficiency, and they are still overwhelming, without a substantial contribution from additional conventional energy supplies.

On the other side, proponents of expanded drilling access need to be clear about the uncertainties and time lags involved. No one can predict the exact quantity of economic oil reserves--even at the current $130/bbl--into which the current estimate of up to 85 billion barrels of untapped US oil would translate. Members of Congress are already complaining that companies aren't drilling all the prospects that have been opened up to them in the eastern Gulf of Mexico, no doubt reflecting the availability of drilling rigs and personnel, and the relative rankings of all of the undrilled inventories of the lease holders. Nor does an exploration program yield immediate production. If a new field is adjacent to existing infrastructure, it might be brought onstream in three or four years. But that's not relevant to the portions of the offshore that are currently off limits. If new pipelines are required, that raises the bar for what will be economic, and it could extend the time from discovery to first production by years. With regard to the areas currently under drilling bans, we are thus debating our energy mix in the middle of the next decade, not today, and it's not obvious how the futures market would react to a green light for expanded drilling. Near-term price relief at the pump could be essentially zero, unless a perceived wave of new US supplies in 2012-2016 was sufficient to dry up the speculation that has compounded the very real tightness in the current global supply/demand balance.

As for the repeated assertions that more drilling won't amount to a hill of beans, we should apply some critical thinking and common sense to forecasts suggesting that even large increments of future production, as from the Alaskan National Wildlife Refuge, would hardly cause a ripple in world oil markets. I wonder how many of the economists responsible for these estimates have ever traded a barrel of oil. With enough supplies from all new sources, including oil, gas, and biofuels, we could shift the market dynamic that has tilted so strong in OPEC's favor and bring oil prices down, even if only to create policy headroom for a cap & trade system or carbon tax to address climate change.

Nor are the environmental trade-offs in this discussion as simple as many advocates would have the public believe. The latest science casts doubts on the greenhouse gas benefits of biofuels versus conventional fuels, and conventional oil emits less CO2 from well to tailpipe than the large-scale default options of extracting hydrocarbons from oil sands, oil shale, or coal. Producing more oil in the US, where industry practices are more strictly regulated than in developing countries, would not create an environmental catastrophe--perhaps quite the opposite.

I'm encouraged that this subject is finally getting the attention it merits and requires, even if the quality of the debate still leaves something to be desired. If we accept that there are no simple and obvious solutions to the fix we're in, then we should be willing to engage in a rational debate without resorting to unflattering characterizations of opposing viewpoints--or of the people holding them. At the same time, nothing should be off the table simply because it offends someone's sensibilities or beliefs. The potential contribution of expanded US oil drilling should not be dismissed out of hand or without carefully considering the combination of alternatives that would be required to make up for its continued exclusion, or without a serious assessment of whether replacing all oil use is even our highest priority, when power generation accounts for 20% more of our greenhouse gas emissions than transportation. Energy security can no longer be divorced from climate policy, and it's going to take real creativity and cooperation founded on mutual respect to tackle both of these problems simultaneously, as we must.

Candidates & Energy: Romney

My push to review all the major candidates before next week's Super Tuesday moves on to former Massachusetts Governor Mitt Romney, the winner of the Michigan Republican Primary and the Nevada and Wyoming Caucuses. The latest poll in Florida shows him in a statistical dead heat with John McCain, going into tomorrow's primary in that state. While he seems to share the general concern of all the candidates about energy insecurity, his views on climate change separate him from Senator McCain, and from all of the Democratic candidates. And while he clearly views energy policy as a major national priority, advocating action on a broad range of options, he speaks about the details more tentatively than most of his competitors.

The format of the energy page of Governor Romney's campaign website reflects his experience in management consulting and strategy. It leads with a video of the Governor outlining his ideas on energy. The site includes a concise statement of the energy security challenge, along with a graph of the growing gap between US oil consumption and domestic production. It lays out a vision of policy leadership, supported by four succinct, high-level strategies, with a bit of detail under each. "Increase Focus On Energy Security" looks like a filler, so it really boils down to three key ideas: more R&D, more nuclear power, and more domestic energy production. Mr. Romney would open up the Arctic National Wildlife Refuge and more of the offshore for drilling, and he's the first candidate I've seen to identify natural gas as a key concern and opportunity. It lacks the masses of detail available on the Obama or Clinton websites, but it's all pretty straightforward, with no radical departures from the status quo.

Discerning Governor Romney's position on climate change took a little more digging. Although he affirms that climate change is occurring, he stops short of apportioning responsibility between nature and humanity. More worrying, he frequently conflates climate change and energy security in a way that goes beyond any of the other candidates I've studied. He appears to believe that any progress on energy security will inevitably help the environment, including turning coal into liquid fuels. Although he mentions the potential of sequestering the CO2 emissions from coal liquefaction plants, it's not clear that he regards that as an absolute precondition for their deployment. Moreover, the idea of a price floor for liquefied coal, mentioned in the video on the campaign site, ignores our experience with the 1980s Synthetic Fuels Corporation; there are better ways to encourage technology than writing blank checks on the Treasury. Ultimately, his climate strategy appears to rely entirely on technology and incentives, without either a carbon cap or carbon tax.

While I applaud the Governor's candor on how long it would take the US to become energy independent, many of his comments on energy reflect a tentativeness and casualness about details that don't match his reputation for exhaustive analysis. Perhaps that should be reassuring. Anyone who hasn't been immersed in the details of energy for a long time ought to be cautious about appearing overly certain concerning matters that even the experts debate. At the same time, though, he has a habit of attributing ideas to others in a way that suggests they could easily be jettisoned later. He could also stand to make a clearer distinction between energy security and climate change and correct some of the misunderstandings that he has conveyed, such as the notion that we must look to France for the technology to build new nuclear power plants or reprocess nuclear waste.

As things stand now, the 2008 presidential election will hinge on the economy--with energy widely viewed as a main contributing factor--and on the perception of change. If Governor Romney became the standard-bearer of his party, he would have to convince voters that his energy plan is at least as detailed and coherent as those of the current Democratic front-runners, while also differentiating it from the policies that have led to the current situation. For many Americans, the time for "no regrets" strategies on energy and the environment has passed.