Deja Vu All Over Again

The views, opinions and market outlook in this op-ed are those of the author and do not necessarily reflect the perspectives of RBN Energy.

 

If you are reading this, Rusty has forgiven my first attempt at a thought piece for RBN.  What I want to do in this blog is to explore the world we find ourselves in today with the rather abrupt collapse of crude oil prices over the past few months and the less abrupt - but no less severe - world of New York City Gate prices for natural gas which averaged a paltry $2.40/MMbtu during August through October 2014, dipping below $2.00/MCF for a number of days, even a few days during December.

The title suggests that over my 50 plus years of working in the energy industry, what we are seeing is not without precedent.  But just like these cycles in the past, many of those in the industry and those who observe, regulate, and invest in the industry seem to forget one of the most basic laws of physics which applies somewhat equally to economics—for every action there is an equal and opposite reaction.

Let’s start with the oil markets. As we all know, crude oil trades as an international commodity. The 1973 OPEC embargo, which led to the formation of the U.S. Department of Energy, came into existence when the countries which comprised OPEC discovered that they could "control" the price of oil by regulating supply.  That regulation came mostly in the form of Saudi Arabia being able to flex its production up and down to accommodate the cartel’s objectives of aggregate production levels.   Now that world is history.  What has happened over the past half-decade or so is that North America has emerged as an incremental supplier at scale.  The abundant shale plays in the lower 48 states, plus the oil sands production from Western Canada have, by all accounts, driven the current global surplus to between 600 and 1,500 Mb/d, depending on who you want to believe.

The potential impact of increasing supplies has been building for years, but it was masked by growing demand, mostly in the Asia/Pacific region.  Thus during the buildup to the crude price crash, forward price curves suggested the good times would continue to roll.  But eventually the reality became evident.  Over time you simply cannot produce more of a commodity than there is demand for that commodity without driving the price down.  The more extreme the oversupply, the more dramatic and abrupt the price drop. 

So why haven't the Saudis' stepped up to bring those supplies back into balance?  The root cause is probably grounded as much in religious and political differences as it is in the fundamental economics.  While the leadership in Saudi Arabia has changed in recent days due to the death of its leader, the orderly nature of the change within the royal family suggests the decision to maintain, and perhaps even build market share.

The forces at work today which affect the rebalancing of world supply are much more nuanced than in the past.  Certainly we have already seen the leading edge of companies announcing layoffs, budget reductions, and the laying down of drilling rigs.  Those responses have probably been made more quickly than in the past but are not yet at the extremes that were reached in earlier price collapses.  One mitigating factor is that U.S. dollars continue to be the principal currency internationally for the purchase and sale of oil.  With the winding down of QE by the Fed, we have begun to see the dollar regain strength against other currencies that had increased in value in relation to it.  With the Euro zone announcing a form of QE of its own, and Japan and other Asian countries including China consciously weakening their currencies against the dollar, we temper the need for OPEC and other countries to raise prices as they will sell in dollars and their buying power in the other world currencies is increasing. 

[Should the Fed decide to increase the Fed Funds rate, it will only exacerbate the problem although there might be a small but silver lining as well.  Many banks have been able to play the arbitrage of borrowing from the Fed and buying Treasury securities which produces a very low risk return and adds strength to their balance sheets.  Dodd Frank has reduced bank’s appetite for risk, and without that arbitrage, they might be more inclined to provide capital to the independent producer community—a group who has found capital harder to find but who is responsible for much of our drilling success. ]

This puts North America squarely on the hot seat of standing as the primary market player to resolve the oversupply imbalance.  But, the answer for Canada and the lower 48 are somewhat different.  While there is conventional oil and gas production in Western Canada, the big driver has been heavy crude from the oil sands factory.  Unlike conventional oil and gas, about half of the oil sands crude is mined, and so its decline curve is simply governed by the tonnage mined.  As long as Canadian producers keep digging, supply from this source can and likely will remain consistent.  This greatly increases pressure on the lower-48 producers.  The good and bad news is that the typical type curve for a shale well shows steep decline in the first two years.  The good news is that as drilling slows dramatically, the production response is not far behind.  The bad news is that the majority of shale drilling is uneconomic at today's prices and much of the leased acreage in these plays is held by production.  So a producer's crystal ball, therefore has to predict when prices will rebound to economic levels, and that prediction—influenced by hedging, credit facilities, and the inherent industry paranoia that the other guy might know more than I do and could quickly step in and latch on to any lease I let lapse, will affect those decisions.  Those are all factors that will attenuate the rebalancing of supply and demand.

Let us now turn our attention to the natural gas market in North America.  The commodity is essentially landlocked on this continent and as a result has moved somewhat more gracefully into its oversupply situation; however, it has clearly reached the same flash point as crude oil.  Again, shale decline curves are both good news and bad news for this industry. Because the Canadian oil sands factory is not at play in this circumstance, the decline curves will have a greater impact in the short term if producers elect slow drilling.  In other words, the rebalancing is much more in their control; but once again, those aforementioned factors surrounding the crude oil markets will affect the pace of this rebalancing. 

But there is another factor at work as well and it is a very important one.  When we were "running out of energy" in the Carter years, a number of controls were placed on the end use of fuel with preference given to the residential consumer in the case of natural gas.  Even after the elimination of the myriad of price controls that had natural gas selling at the wellhead for prices that ranged from cents on the dollar to double-digit dollars and the realization that we are no longer "running out" but rather have an abundant supply, certainty of that supply is a critical factor in the only real growth area for new demand, which is electric power generation.  The most critical factor for power producers is not the price, it is having the physical supply where and when it’s needed.

There is another reason to believe that natural gas might reach balance more quickly than crude oil and that is the potential export through LNG facilities like Cheniere and Cove Point, offering the opportunity for dramatic step changes in demand.  And politically it seems that there is some possibility of the typically divergent views of the two parties and the NGO's (non-governmental organizations) engaged in the climate change debate to find common ground here. Clearly the NGO's and policy makers who are most concerned about climate change see natural gas as a transition fuel to a move away from hydrocarbons altogether over the long term.  They are also aware that many countries are building coal-fired generation due to its abundance, cost, and reliability as a fuel source and the existing large-scale proven technology to burn it.  They could very well conclude the export of our natural gas could attenuate the rush to coal in the developing world and (depending on their political perspective) that increased prices in the U.S. would be a good thing.  One believing it would support the producers and the other believing it would suppress demand and accelerate the transition to green energy in a more cost effective way.

Just a few more elements to throw into this stew.  Shale gas is currently providing the diluent used to blend with the bitumen produced by the Canadian oil sands to facilitate its transportation.  If the producers overshoot their rebalancing as they have been prone to do in the past, then the lack of diluent might attenuate the ability of the oil sands miners to produce at the same or higher levels.

There is also the complexity of the economic benefits of lower energy prices.  The talking heads off Wall Street appear to be concerned that the extra $500-$700 "windfall" experienced by retail consumers hasn't already found its way into the results of K Mart, and the like.  They ignore the obvious, that this money comes in ratably over the course of the years in $40-$60 increments and much may be devoted to savings as the lessons of the recession of '08-09 are still reasonably fresh on people’s minds.  For government, it is a mixed bag because much of the energy produced in this country is produced on Federal or State lands and the royalty fees and leasing payments are likely to take a big hit. 

When all of this is blended into an energy gumbo what conclusions can be drawn?  While the complexity of the financial overlays to the fundamental energy market today will affect the rates of change, it should not alter the direction or the ultimate result.  For 50 plus years I have heard various elected and government officials talk about “obvious collusion and price fixing and gouging" by the industry when supply is tight and prices are high.  I also know that could not be further from the truth.  Instead, the industry's real challenge has been that, like lemmings, everyone tends to run in the same direction at the same time.  And everyone's competitive nature wants to get them to the finish line first, whether it is who can buy the most acreage the quickest or who can have the most dramatic layoffs and budget reductions first.  They do this time and again only to eventually have to reverse course and start running hard in the other direction.

If you have stayed with this blog with the expectation of a firm prediction at the end you will be disappointed.  What I would like to say is that for those young people who are graduating with energy related degrees this spring, if this industry is where your passion is, do what you have to do to get a job in it.  If you are one of the older employees whose companies has a good retirement plan with a lump sum option, and they offer a 5 and 5 incentive to retire - take it.  Low discount rates maximize your lump sum, you can work on your fishing and/or golfing technique for a while, and within the five years they add to your retirement your skill set will be in high demand again and you can probably reenter in a better position than you left.  And for those high school seniors who have been considering a degree related to the industry don't let the near term discourage you.  Within the 4-5 years it will take to complete that degree you will be back at the top of the food chain in terms of the number and level of job offers you enjoy.