Month: May 2018

So now we know?  Well, maybe not.  Front page headline on this weekend’s Wall Street Journal: “Saudis Push for Oil at $80 A Barrel”.   For several decades Saudi announcements to which one paid attention were in Vienna; others not so much. This article is a bit strange; not what one expects from the Journal.  It is datelined Dubai and does not report an announcement.  It says that “Saudi Arabia is maneuvering to push oil prices up to at least $80 a barrel this year shifting away from its longtime role as a stabilizing force in global energy markets.”  This rather long article offers no source for this statement or how current Saudi actions are a shift of roles.

The Saudis historically have not been too subtle on their choices of oil prices or their reasons.  They want a price high enough to maintain a healthy investment level for the industry but not so high as to kill demand for products.  They do not want it so low the rest of the industry goes out of business and their own income is lower than they need to maintain their own economy, culture, and governmental programs – they know that will lead to shortages and sudden spikes to economically de-stabilizing levels.

We have witnessed both extremes in the last dozen years.  As shortages developed in the first decade of this century, prices levitated to more than $100 per barrel which attracted massive investment and an oversupply at the same time as a financial crisis caused a drop in demand and drew governmental attention to other forms of energy.  With that high price, supply increased significantly and demand decreased followed by a sudden price drop of more than 60%.  That caused investment cuts for new fields and widespread bankruptcies of companies in the business of developing oil and gas fields.  Thus the stage was set for another shortage and sudden price increase and another disruptive cycle.

The Saudis are in the business for the long term; oil price is a major determinant for their government budget and thus their military capability, civil tranquility, and foreign policy success.  Volatile prices are disruptive to their long-term planning and stability.  They much prefer a stable price to keep the industry healthy and their revenues steady without killing product demand.

For several decades the Saudis seemed to favor an oil price around $75 /barrel.  During the price drop in late 2014, when the price approached $75 the Saudis announced they would not cut production to maintain that traditional level.  But they later realized that was a mistake so they re-initiated long-standing policies of production constraint with other members of OPEC to bring prices back up to that level.  This policy should not surprise us or be considered a major policy shift.  If they have now induced some non-OPEC members, particularly Russia, to join them in production constraints that is also not a major policy shift; only a more widespread application of the same strategy they have followed in the past.  Likewise, if the preferred price is now $80, that is not so much different from their historical $75.

This is a price range which seems to fit with industry practices as well.  Exploration and production company bankruptcies have decreased significantly, the industry is actively developing new production, and capital budgets are increasing.  Many new projects which were postponed are now being considered for resumption.  The industry is healthy and demand is still increasing so this price level is not killing the industry on one hand or demand on the other.  To stabilize the situation, the Saudis are negotiating with other participants to extend the production constraint commitments from a few months to several years.

The question becomes: If the Saudis have a stable price objective, can they achieve it and maintain it – with a little help from their friends?  Can they fine-tune supply and demand in a nearly balanced market with prices determined by bidding on open exchanges?

During the 1970s, Saudi Arabia became the swing producer.  In a period of supply surplus, they decreased production to maintain price until they decided not to lose their market share further and refused to lower production any more to maintain prices for other producers.  The large supply surplus then became evident and caused a significant price drop in 1986.  Following that price drop, prices were stabilized by the Saudis imposing production quotas on themselves and their OPEC partners.  Prices fluctuated around $18 /bbl for the next 20 years as the large production capacity surplus was worked off.  Price stability could be maintained much more easily during a protracted period of surplus than currently with supply and demand in near balance and fluctuating quickly from surplus to shortage with small variations of supply or demand or both.

The current trend of increasing prices was achieved by OPEC members curtailing production and inducing other producers to join them.  In addition, production is declining in some OPEC members, particularly Venezuela and Angola, Libya varies, and Nigeria is a wild card.  Of particular importance, the Saudis have reached out to Russia, another of the top three producers but a non-OPEC member, to join them in the current production constraints – and they have.  Thus, the Saudis are curtailing production in much the same manner as they did after the 1986 price crash only this time they are joined by other than just OPEC members.  The curtailment has been effective in reducing storage volumes which is considered an indication that the market is no longer operating with a production surplus.

The Wall Street Journal notes that “By aiming to force prices even higher (from $74 to $80), Prince Mohammed is stepping away from a compact that has defined the kingdom’s foreign relations for decades – offering stability in oil prices in exchange for security assistance from the US and other big energy consumers.”  The article also notes that “The strategy isn’t without risks, as higher prices could test the Saudi monarchy’s warm relations with the Trump administration”.  These are strong statements but seem to have no basis in the current Saudi policies or in anything reported in the article.  It is not clear how Saudi current actions are a change of strategy, a new strategy is not defined, nor why it is risky.

The Saudis are offering stability of oil prices at or near traditional Saudi preferences and the US and the Saudis are still aligned against Iran, the US is still selling arms to the Saudis and advising their military.  As noted, the production-curtailment strategy is the same as followed before to maintain prices at a reasonable mid-range level; the only difference is that the Saudis have more partners than before and are trying to put production constraints on a longer-term basis. No big changes; one hopes policy makers do not read the article.

 

23 April 2018

Oil prices reported from trading on open exchanges in a worldwide fungible market vary over a range of approximately 10% largely based on exchange traders’ perceptions of the importance of “builds” and “draws” of oil storage.  Storage data are micro-analyzed with respect to amount and timing.  Storage in Cushing, Oklahoma, the basis of trading contracts on the NYMEX has an outsized influence but is only about one-half of one percent of the world’s storage and is determined as a small difference of two large numbers, each of which is inaccurate and corrected a few months later.  Nevertheless, these bad data are combined with conjecture, fantasies, and rumors regarding value of the dollar, bombings in the Middle East, driving habits of millennials, electric car sales, ice sheet melting, Kim’s missile tests, Chinese teapot refining volumes, Palestinian riots, Saudis letting women drive, Comey’s memos on phony dossiers, and Russian birth rates to fine-tune oil trade pricing decisions.

The oil industry itself is more influenced by long-term trends, however.  Periodically, political and economic trends converge with technological developments to cause fundamental transitions in the industry, its business relationships, oil markets, and oil prices.  Such profound convergences and transitions happened at the turn of the 20th century, in the early 1930s, in the 1970s associated with the Arab Oil Embargo and other perceived political disruptions, and late in the first decade of the current century.

Around 2005 to 2006, world oil demand reached the world oil industry=s production capacity for the first time in history putting upward pressure on oil prices.  At about the same time, technological improvements in hydraulic fracturing and horizontal drilling, which were used successfully to develop the Barnett Shale gas field in Texas, were adapted to develop Bakken oil resources in North Dakota.

Following the financial crisis of 2008-9, the Federal Reserve injected liquidity into the US banking system (a program known as Quantitative Easing, QE, a term worthy of SNL) and maintained low interest rates.  The US Congress passed a bill, known as Dodd-Frank, to cripple banks and restrict their activities.  Under these conditions, an acceptable investment was oil drilling.  Access to low-cost capital, increasing oil prices, and effective development technologies for low-permeability oil reservoirs combined to stimulate independent US oil companies to develop resources which had been previously uneconomical.  An oil boom followed.  US production increased by about 4 2 million barrels per day; a disruptive event which surprised many parts of the industry and quite a few governments – including our own.

In August 2014, the Federal Reserve ended QE and triggered an oil price drop from the $100-$110 range.  In late November, as oil prices reached the mid-70s, Saudi Arabia, perceiving a threat to its market share by increasing US production, announced it would not cut back its production rate to maintain oil prices.  Evidently the Saudis believed they could survive a period of low prices better than American Ashale drillers@ and thus maintain their market share and stop further American production increases for the cost of a short-term revenue decrease.

In the event, oil prices continued to drop well into 2015.  US production increased until mid-2015 because of hedges and the wonders of Chapter 11; it did not start to decrease until mid-2015, one year after the initial price drop.  With US production increases, world production capacity exceeded world demand.  By late 2015, this excess capacity was generally estimated at about 1.5% – which the press immediately labeled a “Glut”.  After about two years of reduced revenues, the Saudis decided US drillers would not quit so they organized a production cut by OPEC members and drafted Russia and other non-OPEC members to join them.  This group, known as OPEC+, agreed to cut oil production by slightly more than the “Glut”; 1.8 million bbls/day, to support prices.  Compliance with the oil cut was surprisingly high; oil prices increased by about 65% to the $65 to $70/bbl range for a 1.8% production cut.  Even dictators and despots can understand the benefits of that – especially with the Russians involved.

Several trends are converging again – partly in response to these events, general economic trends, volatility and unpredictability of oil prices, and perpetual turmoil in the Middle East.

1. Capital budgets were reduced significantly after the oil price drop in 2014-15 for all non-Atight@ oil or gas development.  Worldwide, many large projects were postponed; after re-activation, these projects typically will need 4 to 6 years to reach full production.  Non-US oil production capacity is declining, not increasing, and OPEC+ has constrained production about 1.8 million bbls/day.  US oil production is increasing nearly one million bbls/day each year.  World demand is increasing about 1.5 million bbls/day each year.

Various storage reports now show storage volumes approaching the five-year average storage volume which was the original objective of the OPEC+ group production constraints.  The press is now touting The End of The Glut.  Of course, the five-year average storage now includes about 3 ½ years of increased storage since the beginning of The Glut – but never mind.

With these trends, demand will reach world production capacity in late 2020 – 2021.  As oil shortages develop with marginal pricing in open markets prices will increase rapidly over the next 2-4 years.

2. With a worldwide fungible oil market, supply and demand in near balance, and prices determined by open bidding for marginal barrels, small variations from oversupply to shortage cause extreme price volatility.  Volatility of the price of oil, the largest commodity in international trade and a vital component of a modern economy, is undesirable to investors, oil companies, governments, industrial and commercial users, and consumers; everybody but traders.

New marketing and price determination relationships and procedures will evolve to establish long-term price stability.  Several large international industry traders are already in discussions to establish such relationships.  Saudi Arabia and Russia are discussing long-term (ten- to twenty-year) cooperation to adjust production rates to market demand for price stability.  (This was a practice followed in the US, led by the Railroad Commission of Texas, for forty years from the early 1930s to the early 1970s).  As these relationships mature for ever-increasing amounts of production, volatility will increase for non-participants.  It behooves one to establish such relationships soon.

3. The Middle East shows no signs of becoming stable and peaceful.  The US is becoming frustrated and weary trying to help it become so with nothing to show for its efforts and costs.  Hallucinations about a Middle East populated by Jeffersonian democrats finally have faded.  The US needs to re-direct its foreign policy, diplomatic,  intelligence, and military efforts to other parts of the world and other concerns.  The US currently is in a strong position to work with neighboring countries and take oil out of the equation of its Middle East considerations.

 

The oil industry is entering a period of structural transition with the convergence of these trends.  It is an opportune time to initiate or expand investment in the industry and establish positions and relationships to take advantage of the coming changes.  One can also hope that Mr. Trump’s recent tweeted perception about oil prices “artificially too high” and oil “all over the place” is soon corrected and does not become the basis of policy.  It is a time for the US Government to analyze conditions accurately and to make policy on a clear understanding of current trends; it has a record of bad policy-making from lack of understanding.

 

16 March 2018

Last week was CERAWeek 2018 in Houston.  This is widely considered one of the most informative and critical meetings of the year of ministers, executives, financiers, bankers and other participants in the international oil and gas industry.  Representatives of the IEA and the US EIA reiterated their expectations of increasing US production for several more years with several years of production plateau followed by a slow decline. These predictions provide a basis for Trump Administration plans to establish US Energy Dominance announced by President Trump in June 2017 and repeated in the National Security Strategy in December 2017.

Several commentators made more conservative predictions with lower peak production rates and shorter flat production plateaus.  Of interest was that these commentators were all CEOs of companies actively developing tight oil reservoirs.

Nevertheless, it is expected US production will increase in 2018 and 2019 and OPEC plus Russia will curtail their production to maintain, possibly increase, oil prices.  By 2020 it is expected world demand will have increased enough to eliminate production surpluses, which are only about 1.5%, and put upward pressure on oil prices by 2020.  Capital investments were cut dramatically throughout the industry in 2015 and have been at a low level since then; many large projects worldwide were postponed.  The industry will probably not be able to re-activate large projects and increase production quickly enough to meet increasing production shortages.  With the current pricing system, bidding on open markets for marginal barrels, as an oil shortage develops prices will increase suddenly and significantly.  If the US is to establish a revised, stable, supply and price system it has a short, two-year window to do so.

CERA Week, as it often does, caused a lot of comment about peak oil demand, peak oil production, and when, and at what level, each will take place.  A lot of this requires differentiating between “conventional” and “unconventional” oil and how “unconventional” oil is so much more expensive than “conventional” oil.  Upon questioning “unconventional” seems to be anything produced with a new technology – so I assume that also includes most of the twentieth-century oil produced by wells drilled with rotary drilling.  Also, I note that as of this writing, “unconventional” oil is priced based on WTI at $61/bbl or about 4.6% of an ounce of gold.  In 1970, “conventional” oil was priced at about 7.4% of an ounce of gold.   So much for the idea that “unconventional” oil is so expensive – or that today’s oil price is so high, for that matter.

Also last week, President Trump kicked over the prevailing international trade system by establishing tariffs on US imports of steel and aluminum.  He also made it clear this was a first step; the US would revise its international trade relationships. These actions caused quite a storm of criticism and objections in Congress, by various commentators, in the domestic and foreign press, and by foreign governments as breaking the international free trade system, crippling globalism, damaging the liberal international global order, and starting a trade war.

A little investigation reveals that so-called international free trade is not very free, however.  Despite claims by the press and globalists, many of our trade partners have had barriers to trade from the US for years and we have done nothing about it.  Globalization benefits are largely at the expense of the United States.  The liberal international order is not so equally applied to all parties and is crumbling due to attacks by Russia and China with little pushback from so-called supporters.

What is even more obvious is that a trade war is already underway with little opposition from our side; we are the sucker here.  Other countries have trade barriers to imports from the US which have not been reciprocated by the US.  Examples are: 25% taxes on imports of US automobiles to China and 2.5% taxes on imports of Chinese cars to the US; 10% tax and 19% VAT imposed on US cars imported to Germany and 2.5% tax on German cars imported to the US.  Nevertheless, in a show of blatant hypocrisy, Angela Merkel and Xi Jinping were two of the loudest complainers about the steel and aluminum tariffs as being against the free trade system – which they have been violating for years at our expense.

China is obviously trying to establish an alternative system of trade, finance, and infrastructure which it will dominate.  Despite rhetoric from Xi Jinping at Davos and elsewhere about China being a benign and friendly partner, China’s actions, as a Communist socialist dictatorship, show it will dominate, coerce, humiliate, and oppress participants in its system.  Its trade barriers are impregnable and its technology theft is extensive. It restricts investment and ownership of assets by foreign companies in China but enjoys open investment environments elsewhere. But China is not a friend; a fact the world is slow to realize.  Over the last 25 years or so globalization advocates seemed to think that if the world reached out to China it would become a friendly, benign, open society and join the existing global order.  People claimed the world was flat, that the world had accepted democracy and history had ended, and we would all go off together into the sunset singing Coca-Cola commercials.  Those ideas were naïve to start with; China is run by the Communist Party, a particularly repressive form of socialism and it is more and more apparent that Xi Jinping has consolidated power and intends to rule China as a dictator. He just re-established a commissariat to further tighten his grip and suppress the population.  China’s reality is becoming evident; even The Economist, not the quickest responder, is wondering how they got it so wrong about China.

Mr. Trump exempted Canada and Mexico, our two closest neighbors and trading partners and participants in NAFTA, from the tariffs.  He also reached out to Australia to discuss an exemption.  He made it clear that he is not against trade but that it must be reciprocal and “fair for both sides”; one-way or asymmetric barriers are not acceptable.  Mr. Trump made it clear he is willing to negotiate trade relations and exemptions with anyone and everyone and will favor friends and allies. What is to complain about here?  This attitude toward trade policy should not be a surprise; it was expressed in the National Security Strategy in December and in his Davos speech in January.

It is obvious the main target of revised trade policies is China but other asymmetric relationships will also receive attention.  China and Russia were clearly identified in the National Defense Strategy report (available only in an unclassified summary) published in February as rivals or competitors. Our extensive long-term trade with China and sponsoring them into the WTO was ill-advised; it has mostly served to make China rich and transfer our technology to China to be used against us.  A bad idea.

The tariff action and the ensuing negotiations demonstrate waning Wall Street influence on Administration policies.  No doubt investment bankers were probably influential on the tax reform considerations with their deep understanding of the US economy.  But investment bankers have not been long-term strategic thinkers since about 30 years ago.  Up until then, investment banking firms were partnerships and the firms managers were partners with their clients in investments.  They took a long-term viewpoint and were careful about the welfare of the US as the environment in which they did business.  About 30 years ago the firms went public and their leaders became corporate managers.  They are paid high salaries and collect exorbitant bonuses annually for short-term profits.  They do not share in losses, however, and therefore tend to take on riskier investments with potential for high profits.  Investment bankers have become short-term quick-profit thinkers without long-term strategic viewpoints; trade policy is a long-term strategic issue.

It will be interesting to see how the trade deals play out.  Instead of going to each of our trading partners to try to negotiate fair and equal trade conditions with each of them one-by-one, Mr. Trump has put all of them in the position they have to come to him to solicit exemptions and make concessions to get them.

Taking actions to balance trade relationships could also lead to establishing an oil supply and price system with a few friends and neighbors which could take us out of the business of maintaining oil supply systems for other parts of the world.  New technologies are already being developed which could bring many more billions of barrels of oil to commercial production within our own borders and with a few neighbors. We should take this opportunity, when our domestic industry is in a strong position, to establish a reliable oil supply and stable price system for ourselves.