There is one thing we all need to learn from history: things that have never happened before do occur.
In the northern hemisphere it is summer now, but if you are watching us from the moon, then you may not be able to be reading this article now, but instead you may see a pretty busy picture down here. There is a buzz of activity in parts of the fast developing world. The cranes crank, the rigs rig, the pumps pump and the Federal Reserve Board ruminates. From the charming poppy fields of Afghanistan with their 2000% margin, to the empty floors of the profitless Bear Stearns building in Manhattan, the shifts in the relative wealth are of tectonic proportions.
We live in a world that over the last seven years has become much more energy intensive, more metal intensive and more food intensive. A cyclical recession, even in a large developed economy, may, at most, slow down this process of intensification, but will not reverse it. Tragically for a belt-tightening shopper from the developed world, the aggregate consumption patterns in OECD countries are not particularly relevant for what is happening to the prices of raw materials. And only the most myopic of analysts and investors still cannot reconcile the rising commodity prices with US recession…
Because of the fast pass-through into consumers’ pockets, the last leap in oil prices has grabbed most attention. The ubiquitous banner at the bottom of US TV screens is proclaiming daily the so called “America’s oil crisis”. But on a global basis, the wealth does not just evaporate from US households into the overheated, summertime atmosphere. It pops up elsewhere – in commodity producing nations and among those who supply them with machinery and technology. If the oil market was worth $2 trillion in 2007, it is now worth $3.5 trillion. In this way, one and half trillion dollars have changed hands, a sum roughly equivalent to 8% of consumer demand in the developed economies. Back in the 1970s, the Arab oil wealth was spent on Patek Philippe watches, buried around Lake Geneva or, worse, squandered. Today these petrodollars are put to better use. They are mostly reinvested in infrastructure development that is destined to serve the industrialization benefiting from stranded energy sources. At the same time, these petro-economies generate a multiplier effect much larger than the Western executives’ favorite mirage: “the Chinese consumer demand”. Postjudice will return to this last myth, but let us focus for the moment on what has happened to the oil market.
STILL IN LOVE WITH YOUR CAR?
Oil demand is today largely about driving, floating and flying. With few exceptions located mainly in oil producing countries, oil has lost its market share in global power generation. And although it represents only 5% of global fuel use for power generation, it towers over other forms of the overall energy supply. It has reached nearly 40% of market share in developed economies, but it is the increasingly mobile population of the populous and fast growing emerging markets that affects the prices most.
Global oil demand has been stagnant in the last 3-4 years. The number of cars in Japan actually dropped in 2007. Indeed, net consumption losses in the developed economies had to be offset by growth in developing markets. And offset they did. While in the first quarter of 2008, the developed world’s demand fell by 1 million barrels of oil per day, the emerging market demand grew by 1.5bn barrels. In these conditions, it is not surprising that the oil prices responded accordingly. The price signal should have invited producers to capture some of the fattening margin, but they failed to come to the party. This development has set the stage for a panic in the market now bracing for flat future supply of ‘black gold’. With the global oil supply largely stable at between 84 and 86 million barrels per day, the oil price reciprocated with a 400% increase over the last four years.
But surely, “there is plenty of fossil fuels around, so this is just another bubble, isn’t it”. In a collective show of cognitive dissonance, the politicians, casual observers and drivers fail to understand that the occasional excitement about a “great new oil find” – be it off the Brazilian, Angolan or Nigerian coast, is often just a geological find, in other terms - a resource. And they fail to comprehend that a geological resource is not an economic reserve. And an economic reserve does not equal productive capacity. Nor does capacity instantly translate into refined product at the pump.
It is true that the Persian Gulf region, which provides 44% of all internationally traded production, still has between 500bn to 700bn barrels of oil of reserves. But OPEC’s production last February was 32mbpd, despite the presumed capacity of 35mbpd. This gap seems to be entrenched for several years now. For all the cheap politicized wailing against the Arab sheiks, the fact is that the number of Saudi oil rigs has actually grown from 20 four years ago to 55 now. Still, the production has been declining.
Optimistically, both vowel-rich information collectors - International Energy Agency and Energy Information Administration - show the OPEC supply projections rising from 32mpbd to 56mbpd between now and 2030 (equivalent to four Saudi Arabias). Unfortunately, industry insiders laugh this off.
So, with the geology that is so forgiving and the prices so inviting, why is there not more capacity? There are several reasons for this, the most important of which are reserve maturity, refining capacity and cost inflation.
STILL IN LOVE WITH YOUR CAR? BRACE FOR A SLOW RIDE
Reserve maturity. Most large oil discoveries were made in the 1950s, 1960s and 1970s, turning pieces of Arabian desert into paradisiac oases. Today, approximately 40% of the world’s oil production comes from over 500 giant oilfields. The majority of these fields are in advanced stages of maturity with average reserve depletion of 53%. Of the 38 supergiant fields in the Middle East, 30% are depleted. Still, some four fifths of regional production comes from exactly these fields. Unaware of this, the world drove its voracious vehicles into the 21st century, overreliant on just a couple of oil fields: Ghawar in Saudi Arabia, Burghan in Kuwait, Canterell in Mexico, Samotlor in Russia and Daqing in China. Each of these is in various stages of decline.
Luckily, in Saudi Arabia, by far the most richly endowed nation, production is not determined by the geology of the reservoir, but by the quality of long term management of the reservoir. Conversely, keen to grab the marginal petrodollar, Russia has already picked up 10mbpd in low-hanging fruit and will see its production ebb from now, moving to smaller deposits. A recovery will take time because Russian state’s overtaxing of private operators may have delayed for many years the pipeline of new projects. Elsewhere, there are simply no virgin basins, except, possibly, in deep waters off the coasts of Mexico and Brazil. But that is 2000ft deep underground, below 10000ft of water. Kind of far from your nearest gas station...
More sanguine observers, addicted to the religion of mean reversion, point to new capacity coming from some 91 projects currently in development. Indeed, new non-OPEC capacity will eventually expand by 10.7mb/d, mostly in Kazakhstan, Brazil and Canada. In addition, Nigeria and Angola do offer a big upside, but their reservoirs are not massive, naturally continuing structures. Helpfully, by 2030 we should also obtain from 10 to 14mb/d from unconventional liquid fuels.
What does it all mean? The existing reservoirs are losing production by about 2% a year, which means that the new capacity is barely in balance with the demand growth. For the market to stay in equilibrium, all this new capacity is simply insufficient. Meanwhile, large scale supply solutions are of eminently political nature. Who would sell today technology to Iran, or durably secure exploration and development in western Iraq? Unfortunately, if politics does get in the way, then it is by potentially constraining the supply – as the destabilizing pronouncements by Venezuelan and Libyan leaderships have proved. Long term stability in the Niger delta would take even optimists by surprise.
Refining. But another development is durably changing the trade patterns. Much of the oil produced by traditional exporters will no longer leave the region in the form of energy source. Rather, it will now be consumed locally; ethane, methane, liquefied propane and butane will all be beneficiated near source. The Persian Gulf countries will send us not crude oil, but plastics. In this way, some 4.5mbpd of newly pumped crude will end up in local refineries. The building spree that these plans have caused affects other markets, such as steel. In Saudi Arabia alone some 50 giant petrochemical plants are projected. All together, the country has slated $500bn worth of capital projects – sunken into refineries, petrochemicals, smelters, roads, ports and rail. This is a far cry from shopping for Patek Philippe.
Because of the plateau that the global oil production has reached at 83mbpd or 85mbpd, you could end up with negative global demand and durably high prices because those who can afford it will pay for it. But this is not the end of this world-transforming story. If the near term price driver is the insecurity of supply, laced with some market speculation, then the long term floor under the price is supported by the cost of producing an incremental barrel of oil. And here the picture is not encouraging because the cost inflation is out of control.
Cost inflation. It would be tempting to look at the operating costs of, say, Exxon Mobile, compare them to the spot price of oil and infer how steep the price fall should be to still provide an incentive for pumping the smelly thing from the ground. Alas, in the current conditions of tight supply, the operating costs no longer tell the full story. Instead, we have to understand the costs of replacing the existing capacity. This “replacement” often has to take us to new areas in difficult climates and uncertain political settings, where we have to pump a product of lower quality and from deeper underground. In short, it will cost a lot more to build the infrastructure around the greenfields project than to simply manage the existing reservoirs. The huge increase in the costs of steel and other components will make this a nearly prohibitive exercise.
If you invest in a new drill hole, you usually look at the project’s internal rate of return (IRR). The current inflationary scare would probably require at least 18% return. In order to reach this level of return, the investor will need the long term price of oil to stay at about $100 per barrel. This sounds like a relief from the current (June 2008), prices but we should not yet rush to buy a gas guzzler because these are merely assumptions for a greenfields project, years away in terms of reaching its nameplate capacity. The wake-up call comes from those large-scale industrial projects which are already underway. To many an investor’s chagrin, these projects have seen an increase capital expenditure in the order of 100% over the last 3 years. Only over the last 18 months, the returns of the main oil projects have fallen by 46% on average… Barring a major recession in the developing world, it is hard to see quite how these headwinds could subside anytime soon.
STILL IN LOVE WITH YOUR CAR? THEN FIND A SCAPEGOAT
It has become fashionable to look for a scapegoat. Major oil and gas companies pump up their frequent flyer miles by sending their CEOs on regular pilgrimages to Capitol Hill. In US and in certain European countries, there is always a threat of additional taxes, but so far the CEOs’ confessions have ended in a common prayer, or something equally benign. In fact, the western majors are giants with the feet of clay. Their oil reserve position is usually shrinking and their access to new oil fields is severely constrained by the widespread “resource nationalism”.
Next in the picking order are the so-called ‘speculators’. They are apparently solely responsible for the run up in the oil prices. Unfortunately, there is little evidence to support this claim. Investment in commodity indexes has certainly more appeal now than in the past, but many of the commodities incorporated into these indices have actually fallen in value over the last year. Besides, the aggregate index positions correspond to about 740m barrels of oil, barely 0.31% of global crude oil consumption. Meanwhile, many of the commodities that are not traded internationally have seen their prices run up even more through various iterations of contracts between suppliers and their customers. This is not to say that energy traders are incapable of taking major directional bets at various junctures of the value chain, offsetting them in the futures market. Some sudden shifts in the market certainly point to such activity. But for the physical dealers to impact the market by selling futures to indexers, massive hoarding would have to take place. Instead, there is no evidence of inventory build up in the developed countries. In short, while the financial players do have impact, their activity mostly helps the market find its level before we are hit by the massive demand tsunami pushed by several years of difficult supply constraints.
The third whipping boy is the foreign government. It is always ‘them’ with their market-distorting fuel subsidies, which artificially delay demand destruction. It is easier to be sympathetic to this allegation. In China, wasteful urbanization and lack of commuter train network means that more wealth will translate into more cars and more gasoline or diesel demand. When several years ago I mentioned to Chinese officials that it would be helpful to plan for urban de-congestion by introducing Japan-style light train network, I only heard a rather unconstructive response: “we hate the Japanese”. Today, Chinese oil subsidies keep local prices 55% below international level, shielding the consumer and flattening refiners’ margins. But the subsidies represent less than 1% of China’s GDP and the government can take some time before responding to international pressure. Your average Mr Wang does not yet drive a car and thus energy and fuel correspond only to 0.5% in consumer price inflation. Overall, the relation between the gasoline prices and consumer price inflation is not straightforward in emerging markets. In Latin America, Brazil may have the highest prices at the pump (2.3x Mexican level), but the annual inflation differential between the two countries is hardly meaningful.
STILL IN LOVE WITH YOUR CAR? THINK INFLATION
The 1970s taught us to associate oil price upswings with inflation. And yet, in the developed economies, the signs of widespread inflation are few and far between. The US economy is hobbled by its unsold house inventory and tightened credit markets, neither of which fuels inflationary expectations. And the American worker spends most of her time trembling for her job, so it is unlikely that she will ask for a raise to offset the fuel costs. Indeed, the miles driven by US cars have collapsed this year – a healthy adjustment to the economic conditions, unseen since the 1970s.
Two weeks ago I visited a oil exporting country and expected to experience first hand a booming mood full of arrogant nouveaux riches and their cocky mistresses. I had last been there six months before and sensed tangible effervescence as the oil prices approached the magic barrier of $100/b. Now, at nearly $140/b, I found instead astonishing gloom. Businesses delayed spending and capital projects. Contracts were on hold. Everyone expected the oil prices to fall from the current levels. The aggregate result of these expectations was a slowdown of economic activity, something that is not particularly conducive to inflation. Only the oil producing region is still enjoying fast growth, but is slowly hitting capacity constraints as there are only an X number of drill rigs that can be manned by a Y number of engineers per square mile.
These casual observations could indicate that, at the current level, the oil prices affect the personal and business well-being by generating anticipatory behavior which will eventually slow down the rate of price increases. Whether or not it actually depresses the prices of crude oil will depend on the aggregate effect in the economies that are enthusiastically embarking on the development of their own transportation network. The sooner the oil prices clip their dreams of catching up with America’s resource wastefulness the better.
In the longer term, the only solution lies on the demand side. One does not have to travel to Tokyo’s Auto Show and get excited about the future of lithium batteries. But an increase in fuel efficiency from 20 miles per gallon to 30 miles per gallon would alone increase available crude supply by 15%. This is where the solution has to come from, and sooner rather than later. Or so believe the Saudis I met…
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