Progress in the Energy Dominance Sweepstakes since my last commentary:
Rosneft, Russia’s international oil company, bought Essar, a large Indian refining company, strengthened its relationship with the Libyan faction operating its largest oil field and a major oil export port, and continues to negotiate with PDVSA, the Venezuelan national oil company, to take over several fields. These are all moves to expand Russia’s influence in the worldwide oil industry; Rosneft acts as an instrument of Russian government strategy and policy.
The US prevented Rosneft from taking control of CITGO, a Venezuelan government-owned company in the US, blocked CITGO from sending its dividends to Venezuela, and prohibited American companies and financial institutions from participating in PDVSA financing; these are all defensive actions.
American companies, as private enterprise organizations, are limited as to transactions in which they can engage with foreign governments without US Government support – a support which has rarely, if ever, been forthcoming. On the contrary, US State Department actions are generally deliberately neutral or taken in opposition to US companies in relations with foreign governments.
A review of second-quarter financial results for American companies active developing unconventional or “shale” oil reservoirs brings into question whether this sector of the industry can continue to grow and increase US production as contemplated in the announced policy of establishing worldwide Energy Dominance by the US. It is becoming apparent that although some of these companies may be able to produce profitably at current oil prices, the capital provided by debt and equity investment for drilling and fracturing programs to develop the fields will likely never be repaid.
This realization is becoming widespread among financial institutions; as investors realize they will not recover their investment, it can be expected they will stop investing, drilling and fracturing unconventional reservoirs will stop, and US production will decline. Development of unconventional reservoirs as a basis of significant further US production growth seems unrealistic.
In addition, the Energy Information Administration continued its practice of revising its weekly production figures downward and corrected its May figures by nearly 200,000 bopd and June figures by 220,000 bopd and June showed a decline from May.
So the US is not producing as much as previously thought, its production is declining, and field development for production increases is not profitable – not an optimistic outlook for establishing Energy Dominance by exporting oil worldwide.
Following the price drop in 2014 and 2015 more than 200 oil companies entered bankruptcy and the number of active US drilling rigs dropped from nearly 1600 to a little more than 300 in a year and half. Numerous international long-term capital projects were cancelled. Without continued drilling US production rate declined at an annual exponential rate of about 9 ½ %.
When the oil price seemed to stabilize in mid-2016, the number of active drilling rigs started to increase, dominated by activity in the Permian Basin of West Texas and SE New Mexico. Companies revised their cost structure and concentrated their engineering and operational management attention on operating cost reduction. Most companies entered a program of debt and equity re-structuring. In many cases, former equity holders became severely diluted and debt holders became new equity holders as part of debt re-structuring. Managements announced they could operate profitably with oil prices at various levels between $40 and $50 per barrel.
As noted above, at current oil prices evidence that these assertions are accurate is rare. Financial results show recovery of capital for development costs is not a reasonable expectation. Companies are again increasing debt for capital to pay for development programs. Free cash flow is not a common characteristic of the financial results of this activity.
Commodity Oil Pricing System
On 30 March 1983 a contract for 1000-barrels of West Texas Intermediate Oil stored in a tank in Cushing, Oklahoma, started trading openly on the New York Mercantile Exchange. This was the critical event in response to the pricing and marketing chaos of the preceding decade accompanying the so-called “Energy Crises” and loss of control of oil markets and prices by the international major oil companies; it established an orderly and transparent market and quickly caused significant oil price decreases. This was followed by oil contract trading on the International Commodities Exchange in London and elsewhere, and later by a natural gas contract on the NYMEX.
The start of oil trading on the NYMEX was one of the most significant events in the history of the oil business. It established an open pricing and trading system with a worldwide market of a fungible commodity and was one of the events that ushered in an international trend to general trade globalization.
Within a short time, the price of “WTI” became the quoted oil price in the US and determined the price of oil throughout the world although the Brent price quoted in London gradually came to dominate international transactions. Oil pricing acquired the financial and pricing characteristics of all commodities:
- All commodities whether an airplane seat-mile, a personal computer, a gallon of milk, a pound of copper, or a barrel of oil, require large up-front capital expenditures; few of those traded on open markets return the investment of the up-front capital investors. Commodity production is generally over-invested in times of shortage and high prices which leads to over-supply and low prices; only low-cost producers then survive. Up-front capital investors lose.
- Open market commodity bidding leads to marginal pricing; the last trade determines the price of all units of the commodity world-wide. Such markets are volatile depending on perceptions of small surpluses or shortages by market traders. The price to buy the last oil barrel at any time is the price of any barrel and all barrels; the last trade of the day of WTI on the NYMEX is that quoted in the Wall Street Journal the next morning.
These two characteristics are interconnected. Marginal pricing causes high commodity prices as long as a shortage, no matter how small, is perceived. These high prices attract capital investment. The capital investment increases commodity supply but when a surplus supply situation is reached, even by a small margin, commodity prices drop significantly. (Recent low prices in the oil industry are associated with a surplus supply of approximately 1.5%). Companies which remain in business are those with low operating costs. Competition for survival among suppliers is based on operating cost. The investors providing capital for the development of the sources of supply typically do not recover their investment.
Once capital investors realize they will not recover their investment, they will discontinue their investment in these programs, the number of active drilling rigs will decrease again, and US production will again start to decline; probably at an annual exponential rate of about 9 ½%. Fantasies about US Energy Independence or Dominance will then be replaced by concerns about supply shortages and disruptions.
At that point, foreign suppliers will regain control of oil prices and markets; prices will increase significantly. The US will then again become a victim of an oil market and volatile price system it created, but is now manipulated by adversaries. A pricing system subject to rumors as to the actions of OPEC quota cheaters, the actions of Nigerian thugs, and the daily course of Libyan civil wars will not attract investors to capital projects with 4 to 6 years lead time.
For the sake of the long-term health of its own economy, the US must withdraw from that system while we are still in a strong position and establish an independent stable system of oil supply and prices for itself and a select few reliable suppliers and trading partners.
The United States largely created and developed the oil business worldwide and now finds itself the world’s largest petroleum user and one of its largest producers with a marketing and pricing system subject to the whims of adversarial foreigners. Prices are highly volatile, set by market traders based on bad data, rumors, fantasies, and conjecture. The domestic industry is an unrecognized but potentially major geopolitical asset largely financed and regulated in New York and Washington by people isolated from, and with limited knowledge of, the industry. We now have the largest internationally-traded commodity intertwined with a precarious international financial and banking system operating mainly to finance American debt. This entire system is metastable and subject to forces outside US government or oil-industry control which have the potential to impact catastrophically our economy and political systems. This situation is a result of actions taken during the Nixon Administration and the so-called “Energy Crises” of the 1970’s and their aftermath. We again seem to be in the position of making policy based on wrong perceptions. The United States is now a victim of a market and supply system of its own creation in the hands of adversaries – it is imperative we regain control.
Globalization has not served the American people well and they realize it. Globalization has mainly benefited China and made it rich. The US is confronted with 4 or 5 adversarial situations in the world and seems to directly or indirectly finance our adversaries in all of them. This is a policy which at best can be considered shortsighted and at worst just plain stupid.
Opposing globalization, considered to be free trade with anybody and everybody, seems to be interpreted as advocating isolationism. Not so; trade policies do not need to be 100% one or the other. Trading partners can be chosen as reliable financial, political, and business counterparties who are not adversarial and not expected to become so. Establishing trading blocs can be beneficial to all concerned – a form of limited globalization.