Tuesday, December 23, 2014

Is OPEC Washed Up?

  • OPEC's unwillingness or inability to reduce output to defend high oil prices raises doubts about the cartel's effectiveness and future.
  • Absent cuts by OPEC, it is not yet clear whether the burden of rebalancing oil markets will fall on shale production or larger, more traditional oil projects.
As oil prices continued their slide following OPEC's meeting on Thanksgiving Day, speculation has grown concerning whether the cartel might have run its course. Is OPEC now at the mercy of forces beyond its control? Will its apparent strategy, as widely supposed, mainly affect US shale oil producers, or could more conventional, but still relatively high-cost oil projects elsewhere bear the brunt--or OPEC itself?

A quick review of OPEC's history of reining in production to prop up oil prices reflects a mixed record. At least three distinct episodes come to mind:

  • Following the oil crises of the 1970s the cartel was unable to keep prices above $30 per barrel ($70 in today's money) in the face of surging output from the North Sea and North Slope, and a 10% decline in global oil demand from 1979-83. By summer 1986 oil had fallen to just over $10, despite Saudi Arabia's having cut production by up to 6.7 million bbl/day from 1981-85, along with the loss of another couple million bbl/day  of supply due to the Iran/Iraq War. Aside from a spike prior to the Gulf War, oil was rarely much above $20 for the next two decades.
  • OPEC's response to the Asian Economic Crisis of the late 1990s was more successful. When the growth of such "Asian Tigers" as Indonesia, Malaysia, Singapore, South Korea and Thailand stalled amid contagious currency crises, oil inventories swelled and prices collapsed from the mid-$20s to low teens and less. In March 1999 OPEC agreed to reduce output by around 2 million bbl/day, including voluntary cuts by Mexico, Norway and Russia. Although historical data raises doubts that the latter countries ever followed through on these commitments, this move stabilized prices and restored them to pre-crisis levels by year-end.
  • After oil prices went into free fall during the financial crisis of 2008, OPEC's members agreed in late 2008 to cut over 4 million bbl/day. They apparently achieved around 75% of that figure. Together with the measures taken by central banks and governments to restore confidence, that was enough to boost oil prices from the low $40s to mid-$70s by late 2009, still well short of the $145 peak in June 2008.
If today's situation were simply the result of slowing economic growth in Europe and Asia, a temporary cut similar to that of 1999 might have received wider support in Vienna. However, the analogy to the 1980s must have resonated strongly, especially with OPEC's longtime-but-not-this-time "swing producer", Saudi Arabia. The Kingdom bore most of the pain then, for little gain. It appears able to weather the current storm, at least financially.

The roughly 4 million bbl/day of "light tight oil" production (LTO) added from US shale deposits since 2008 has certainly depressed oil prices. It's hard to tell by exactly how much, because the growth of shale coincided with high geopolitical risk in oil markets and a volatile global economy. Superficially, it resembles the supply surge of the 1980s. LTO is also generally understood to be high-cost production. Estimates of full-cycle costs vary widely, from the $60s to $90s per barrel.

These factors support the narrative that OPEC, and the Saudis in particular, might be trying to "sweat" shale producers. It's even bolstered by forecasts from the US Energy Information Administration, predating the price drop, suggesting LTO production could plateau within a couple of years and decline not long thereafter.

I see two problems with this scenario. First, shale producers have various options for reducing costs, including some that a more receptive Congress might be inclined to facilitate next year. Then there's the recent history of shale gas pricing. I recall industry conferences in the late 2000s in which speaker after speaker presented curves indicating that the true cost of many US shale gas plays was likely over $6 per million BTUs, and certainly above $5. If that had been accurate, shale gas output should have started to shrink shortly after the spot price of natural gas fell below $4 in 2011. Instead, it has grown by around 13%. This suggests that estimates from outside the shale sector have generally exaggerated production costs that at least one analyst suggests might be as low as $25/bbl on a short-term basis.

If you take a long view, as Saudi Arabia and other Persian Gulf producers arguably must, it's questionable whether the bigger threat to OPEC comes from shale wells that cost a few million dollars each and decline rapidly, or from large-scale projects that can produce for 30 years. An example of the latter is Chevron's new Jack/St. Malo platform, which just began production in the deepwater Gulf of Mexico. (Disclosure: My portfolio includes Chevron stock.) This $7.5 billion facility is expected to recover at least 500 million barrels over its long lifetime. Sub-$70 oil surely means fewer such developments will proceed in the next few years, including offshore opportunities arising from Mexico's sweeping oil reforms. That will have implications for production stretching decades into the future.

The impact of low oil prices could be even more significant for conventional non-OPEC oil production  in more mature regions. Oil investments are expected to fall by 14% next  year in Norway, threatening that country's energy-focused economy. Prospects in the UK North Sea look no better, with a leading expert warning of long-term damage to the regional oil industry. An announced 2% cut in tax rates on extraction profits hardly seems adequate to offset a 38% price decline since June. As things stand now, voters in Scotland dodged a bullet when they  rejected independence, the economics of which depended in part on a sustained recovery in North Sea oil revenues.

Whether shale producers or large investment projects are squeezed more by OPEC's decision to stand pat, it could take months or perhaps years for lower production to appear. As Michael Levi of the Council on Foreign Relations noted, we shouldn't discount OPEC's willingness to act on the basis of its initial reaction to a crisis. However, history also suggests that even if OPEC ultimately acts decisively to defend its desired price level, the outcome may diverge significantly from what they intend. Energy consumers have more choices every day, and that could be the biggest constraint on OPEC's market power going forward.

A different version of this posting was previously published on the website of Pacific Energy Development Corporation.

Friday, December 05, 2014

The IEA's Stressful Outlook

  • The latest long-term forecast from the International Energy Agency suggests that the benefits of today's low oil prices might be temporary, with more volatility ahead.
  • The report focuses on a number of risks, including the adequacy of investment in both new oil capacity and low-emission energy, and the scale of nuclear plant retirements.
For an organization established by energy-importing countries in the aftermath of an oil crisis, the recent launch of the International Energy Agency's annual World Energy Outlook (WEO) took surprisingly little satisfaction in the current dip in oil prices, and none in the difficulties it is causing for OPEC.  Instead, the presentation  was peppered with terms  like "stress", "risk" and  "doubts",  and references to a "false sense of security" and a "stormy energy future." I see that as an indication of how much the global energy agenda has changed and broadened in the last decade or so.

For oil in particular, the IEA sees today's growth in North American production masking the consequences of the ongoing turmoil in the Middle East. In Iraq and other countries in the region, uncertainty is delaying investments that should be made now, if future supplies are to meet demand growth after US "tight oil" and other non-OPEC  expansion has plateaued. And that point could come sooner than expected if drillers reduce US shale investments by 10% next year, as IEA anticipates, or if the significant governance problems of Brazil's oil sector, which were only hinted at, are not resolved soon.

The launch covered several other areas, as well, none of which escaped suggested stresses of their own. Start with natural gas. IEA sees gas on its way eventually to become the "first fuel", consistent with the view of their "Golden Age of Gas" scenario of 2011. This would be driven in part by a large increase in LNG production from new sources such as East Africa, Russia and North America, along with growth from traditional LNG suppliers in North Africa and Australia. IEA expects increased competition from LNG with pipeline gas to improve energy security, especially in Europe, but not necessarily gas prices for end users. In fact, the high relative cost of LNG could impede the displacement of coal by gas in Asia. 

The presentation also highlighted the significant challenges IEA expects in the electricity sector in the period to 2040, a longer interval for which this year's WEO provides the first glimpse. A net expansion of global power generation by around 75% is more challenging than even that figure suggests, because it must incorporate the replacement of more than a third of today's generating capacity. As a result, only oil-fired generation will experience a net decline.  IEA forecasts up to half of new capacity through 2040 coming from renewables, on a scale posing significant risks for power system reliability, especially in Europe.

Nuclear power, a major source of baseload low-carbon electricity, is an area of special focus in this year's report, along with Africa. The expected growth of nuclear energy over the next several decades occurs mainly in the developing world, while 38% of today's nuclear capacity--nearly 200 reactors--will be retired by 2040. Many of those retirements will occur in Europe, and the Chief Economist of the IEA, Fatih Birol, expressed concern about the policies and budgets supporting such decommissioning on an unprecedented scale.

By 2040 the balance of nuclear power capacity would have shifted from around 80% in OECD countries and 20% in today's developing countries, to roughly 50/50. While the report also draws attention to the growing policy problem of nuclear waste disposal, it identifies nuclear as "one of a limited number of options available at scale to reduce CO2 emissions."

The largest source of stress in the report appears to be the disconnect between the narrowing window for reducing greenhouse gas emissions to a level that climate models indicate would limit global warming to 2°C, and the higher emissions inherent in the IEA's central "New Policies" scenario. Meeting the 2° target would require increasing average annual investments in low-carbon energy, including energy efficiency, by a factor of four compared to 2013. At last month's G20 summit in Australia we heard that "red warning lights are once again flashing on the dashboard of the global economy."  Could even the IEA's middle view of energy investments proceed if much of the world slid back into recession?

The presentation wasn't all gloomy, of course. Dr. Birol pointed out the competitive advantage that low energy costs confer on the US, and both he and IEA Executive Director Maria van der Hoevan highlighted the recent China/US emissions deal as a very positive development. (My own analysis concluded that it would still allow China's emissions to grow dramatically before peaking.) They also conceded that lower oil prices would provide oil-importing countries with some timely "breathing space."  And for the first time I heard that three out of four cars sold in the world are now covered by fuel economy regulations, suggesting increases in energy efficiency to come.

It also struck me that some of the negatives in the presentation might tend to cancel each other out. If the global oil industry, especially in the Middle East, fails to invest sufficiently in the next few years to ensure that supplies continue to grow in the 2020s, then the resulting higher oil prices could accelerate the transition to natural gas and renewables, while providing greater incentives for energy efficiency. That combination might reduce emissions sooner than IEA's main forecast indicates.

Last year the IEA's World Energy Outlook failed to anticipate the drop in oil prices; how many other forecasters likewise missed it? It featured some of the same big themes repeated this year, including the ongoing shift of the energy world's center of gravity toward Asia and the scale of the global emissions challenge. On a more basic level, however, a comparison of the two documents suggests that the agency is still trying to understand the transformation of global energy markets by the parallel shale and renewable energy revolutions. They aren't alone in that, either.

A different version of this posting was previously published on the website of Pacific Energy Development Corporation.