The 15-year cycle

Oil prices are influenced primarily by expectations of traders and investors buying and selling paper barrels. Over a sufficient period of time, prices arrived at on the paper market must take into account the physical balance of demand and supply, but at any moment in time the prices of physical barrels are more reflective of “sentiment” on the paper market than of physical availability.

It is quite remarkable how “sticky” the expectations of the paper market are. Certain narratives, or scenarios, come to be accepted as the consensus of the market although a little critical analysis would easily demonstrate that they are contradictory and untenable. This is partly due to the fact that on this market – as on most financial markets – money is made primarily by correctly anticipating the direction in which the market will move in the near future. This means that a specific narrative or scenario may well be irrational or unfounded, but as long as a majority of players believe in it, it remains the key to profitable trading.

We may ask why the market supported prices in the 100 to 120 dollars per barrel range for so long, creating conditions for the precipitous collapse of the last semester of 2014. The answer can only be that sentiment was influenced by several factually unfounded or logically contradictory expectations. Thus, to give a first example, there was the fear that political and military turmoil in the Middle East and North Africa would seriously affect the availability of oil and create scarcity conditions. In reality, there was little ground to support this expectation, because past experience has demonstrated that oil production and logistics are very resilient to conflict situations. The only serious loss in production was in Libya, and it was compensated by increases elsewhere in the world.

A further example concerns the impact of the increase in shale oil production in the United States. This was nothing short of phenomenal, adding upward of 3 million barrels per day to global production in three years, and growing exponentially. In fact, for several years the International Energy Agency has been updating a slide that clearly shows that the cost of production of practically all known and unknown oil resources is below 100 dollars per barrel.

IEA

The above is not properly a supply curve, because for most of these resources the investment required to bring the oil to market has not been sunk yet. That said, logic would tells us that if all these projects promise to be profitable, they will be undertaken at an accelerating pace – until the extent of supply will cause prices to decline and investment to slow down. US shale oil “revolution” is simply the one component of the total supply that has reacted more promptly to the attraction of extremely high prices – but a lot more is ready to follow. This means that prices above 100 dollars per barrel are unlikely to be tenable, because supply will eventually outstrip demand.

So, that is exactly what has happened. Ever since 2011 supply has exceeded demand, but prices remained high.

The last fallacy that the market believed in was that in any case if prices ever weakened OPEC (or specifically Saudi Arabia) would cut production in order to support them. The rationale for this was found in the so-called “fiscal break-even prices” – meaning the prices needed for specific countries to balance their budget. It was assumed that if prices were to fall below the fiscal break-even, OPEC countries would react by cutting production. This was a curious theory indeed, because it assumed that the more producers spent, the more prices would be pushed upwards – which is clear nonsense. It is spending that needs to adjust to the level of prices, not prices that will adjust to the level of spending.

So everybody was surprised when Saudi Arabia decided that cutting production would be futile in current market conditions, and prices above 100 dollars simply are indefensible. So surprised that most commentators and operators seem to believe that prices will soon bounce back, and are anxiously asking whether they bottomed out and how soon they will recover.

But what if prices will not recover soon? There are multiple reasons to expect exactly that: there is a lot of potential supply from various countries that is currently not available to the market for a variety of political or other reasons, but will come to the market in the coming months and years. Investment projects that are not yet completed but too far advanced to be called off will start producing even if they cannot fully recover the investment costs. Besides, there is plenty of oil that still is profitable even at prices hovering around 50 dollars per barrel.

In fact, when we look back to oil price history we can clearly see that the industry tends to have a 15-year price cycle: we had a high prices cycle between 1970 and 1985; a low prices cycle between 1986 and 2000; a high prices cycle between 2000 and 2015. This is clearly shown in the chart below, showing oil prices in dollars of 2013, and the average prices for the three 15-year periods. So I would not be surprised if we entered into a new low prices cycle to last until about 2030.

15-year

An extended period of lower prices would trigger very significant changes in the structure of the industry – and certainly also challenge the belief that we need to diversify away from oil because it is scarce and bound to be more and more expensive. We may not like oil because of emissions and climate change, but it will remain competitive, whether we like it or not.

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The 15-year cycle

Oil Price Blues

I had the opportunity in the past few days of participating in two high-level workshops where current oil prices and their likely developments were discussed.

Possibly the most important conclusion that I reached was that the information that we have available about oil fundamentals (supply, demand, logistics) is abysmally short of what would be desirable. We do non know how much oil is produced or is likely to be produced and made available on the market even in the short term. We are not sure exactly how much demand there is and how it is reacting to lower prices. We don’t know how much oil is accumulated in storage, and how much storage is available to accumulate more.

In the absence of sound information, the market reacts to information or events that may not be really significant or have an impact on fundamentals. Consequently, oil prices are likely to be very volatile in the short term.

To understand the situation it is convenient to ask ourselves first how prices react to fundamentals, and then how fundamentals react to prices.

Prices are determined by market expectations: if the market expects prices to rise, rise they will – and vice versa. Market expectations reflect fundamentals but are considerably sticky and react with a delay. Everybody knows that presently the market is oversupplied and prices have declined by 50% in six months, but somehow the dominant sentiment is that this is a temporary phenomenon. The dominant question is: have prices bottomed out? how quickly will they recover? There is a widespread implicit assumption that prices may not decline further and in fact will rebound soon. We have become accustomed to a world of 100+ $/b and we find that something is wrong or not normal in 50 $/b.

This has an impact on the second half of the question: how fundamentals react to prices. It appears that both producers and consumers do not yet consider that current prices are credible, a reality that is here to stay. Producers are waiting for a rebound in prices, and are not yet drastically reviewing their operations or abandoning projects that do not stand a chance to yield sufficient return at current prices. Consumers are said not to be ready to transform their increased spending power into increased demand and a boost to the economy. The latter supports the idea that lower oil prices are deflationary, and induce a decrease in aggregate demand rather than the opposite – an interpretation that I find difficult to accept.

But in fact there is little solid evidence to justify the expectation that prices will rebound soon. We may be in for an extended period of relatively low prices, such as we had between 1986 and 2000. Someone recalled that in 2000 one of the major international oil companies expected that prices in the following decade would average 15 $/b: instead they climbed to 145. We may be making the opposite mistake now.

An extended period of low prices would certainly affect investment in the most exotic and costly projects, but much of US shale oil production may well survive. Lower procurement costs and higher efficiency will guarantee that a lot of US shale oil will remain commercially viable. And in some of the major oil exporting countries production increments are profitable even at today’s prices – governments there will be keen to increase volume to offset at least partially the decline in revenue per barrel.

In the end, we may be in for a period of ten or more years of low oil prices. The implications would be far reaching in many directions: but should we be worried?

Oil Price Blues

Energy at center stage for Egypt’s economic development

The international conference « Future of Egypt » that was held in Sharm el Sheikh, meant to lay the basis for a new phase of development and growth in the Egyptian economy, has confirmed that investment in the energy sector is expected to be a backbone of recovery.

Once a significant exporter of oil and gas, Egypt has seen its energy position deteriorate progressively with little reaction on the part of authorities in the last few years of the Mubarak presidency and further in the four years that have passed since the eruption of the Arab Spring. Domestic consumption encouraged by subsidized prices has progressively eroded the exportable surplus, to the point that the country has become a net importer of LNG. Furthermore, the burden of energy subsidies has weighted very heavily on government finances, constituting close to 20% of total expenditure in 2013-14.

Companies investing in Egypt have been forced to give up on exports and sell gas to the government. The latter has been unable to keep up with payments due to the companies and accumulated debt that reached as high as $7 billion, leading several companies to threaten a total stop to further investment.

But in July 2014 the government significantly reduced subsidies: in the climate of emphasis on law and order, the cut was not met with significant protest, which was seen as a promising sign. The reduction in subsidies is only partial, and the burden is expected to remain heavy on the budget, still accounting for 16% of total expenditure: but a change of direction is good news nevertheless.

The government has also move dot reduce the outstanding debt to the companies, currently estimated at $3.1 billion, and pledged to pay all arrears by the middle of 2016. The companies have apparently been satisfied that investment conditions are again attractive. The most ambitious plans have been announced by BP, which intends to invest $12bn in the West Delta. Eni has pledged investment of $5bn, and BG of $4bn. These are very substantial sums, which run against the tide of cutting back on investment due to the collapse in oil prices – being therefore all the more remarkable.

In parallel, major investment is also expected to go into power generation. Siemens has signed deals and MOUs in excess of $10bn to improve the power grid and install 4.4GW of combined cycle gas power and 2GW of wind power generation capacity. At the same time, Masdar, Abu Dhabi’s clean energy initiative, and ACWA Power, a Saudi company prominent in solar and other clean energy investment, have pledged to consider investing in 2GW of combined cycle gas power, 1.5GW of solar power and 500MW of wind power generation capacity.

All of which are intentions, and firm commitments will follow if circumstances evolve positively and the Egyptian government remains consistent in its determination to pursue energy reform. The latter is not sufficient to guarantee a new period of expansion of the Egyptian economy, but is certainly a prerequisite.

One thing is for sure: after many years of advocating a triangulation of GCC investment money with European expertise to support economic reform and development in North Africa, the Sharm el Sheikh conference marks the first time that this strategy seems ready to be implemented at a credible level of engagement. In all previous occasions, lofty speeches were accompanied by minimal or very restrained investment promises. It may be too soon to declare that a page has been turned, but signs are encouraging.

Energy at center stage for Egypt’s economic development

Iraq: from low price to lower investment

Lower oil prices are pushing almost all companies to revise their investment programs downwards: budgets are reduced, projects are postponed, assets are being put on sale. This is of course normal, but there are some interesting and unexpected turns to this widespread trend.

Consider the situation in Iraq. The country has vast unexploited or underexploited resources and only a few years back envisaged a massive increase in production and exports. Until recently, the International Energy Agency considered that essentially all the increase in oil production expected from OPEC in the next 20 years would come from Iraq.

Iraq is not subjected to OPEC quotas, because of past wars and the need for reconstruction. In recent months, it has been systematically selling its oil at prices slightly lower than Saudi Arabia, to subtract market share from the Saudis. This has been a significant source of irritation in Riyadh. The Kingdom is unlikely ever to agree to a reduction in exports to shore up prices, unless Iraq is part of the deal and accepts OPEC’s quota discipline.

So it is surprising to read that the Baghdad government has now asked the international companies operating under its jurisdiction (i.e. in the Southern part of the country – the North being controlled by the Kurdish Regional Government) to reduce investment. One would normally expect the opposite: that the government puts pressure on the companies to maintain or even increase investment. How is this explained?

The reason is to be found in the kind of contract that the Baghdad government has imposed on the companies. Baghdad has refused to offer so-called Production Sharing Agreements (PSAs) and has imposed Service Contracts instead. In a PSA the international investor normally carries the entire burden of investment and is then entitles to a share of the oil produced to recover investment and operating cost (cost oil); and a smaller share for the rest  of production in excess of that (profit oil). In contrast, in a service contract the companies are entitled to a fixed fee per barrel produced, and the government must reimburse the investment costs.

The Kurdish Regional Government has signed PSAs with companies wishing to invest in the North, but Baghdad has taken a more nationalist line. Now, however, the central government is short of cash because of lower oil prices and the need to spend in defence and security to respond to the threat posed by the Islamic State (IS). According to an official of the Iraqi Ministry of Petroleum, interviewed by Gulf Times on March 13, “The oil ministry has irreversibly taken the decision to amend its service contracts with foreign firms, due to the cash crisis brought by oil prices drop. We have to acknowledge that current contracts were hastily drafted and short-sighted in failing to take into consideration the impact of a potential oil price crash.”

It is said that so far BP proposed a cut to $ 3.25bn from $ 3.50bn, Lukoil to $ 2.1bn from $ 2.3bn, while Exxon wants to maintain its investment level and Eni has not yet declared its intentions. Relative to cuts that the same companies are making to their investment budgets elsewhere in the world, these would be modest. Maybe the companies intend to « threaten » to maintain their expected level of investment to extract concessions in the revision of their respective contracts. Sometimes logic is turned on its head!

Iraq: from low price to lower investment

Why this blog

I am not an enthusiastic blogger, in fact in general I believe that we have even too much to read in our daily lives and am not presumptuous enough to think that I have interesting things to say on a regular basis. But occasionally, maybe yes.

Especially, I prize keeping in touch with the community of my former and present students, a community that has greatly expanded since the launch of the MOOC on Politics and Economics of International Energy. After considering various solutions, I thought that starting a blog might be the right answer to keeping in touch.

I will be reporting about discussions that I am participating in numerous international meetings – frequently tedious but at times also highly innovative and interesting. I will occasionally comment on recent developments that strike me as especially significant for anticipating future developments. I will post information about the educational projects I am involved with, and about my research and publications.

I do not promise or intend to post frequently or regularly, but if you are interested in keeping in touch, subscribing is the way to achieve this.

Giacomo Luciani

Why this blog