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Why We Need Expensive Oil

Commodities / Crude Oil Jun 13, 2012 - 01:02 AM GMT

By: Andrew_McKillop


Best Financial Markets Analysis ArticleTo some it can seem a joke, but the new definition of "expensive oil" is about $75 a barrel. Even worse fol oil producers, $75 a barrel is rapidly becoming the base price for financially feasible oil production development strategies. Above all, the old paradigm of extreme high oil prices is long dead.

It was born from the oil panics of the 1973-81 period, called "oil shocks", and the paradigm says that cheap oil is the Holy Grail of economic growth and full employment, which today are folk memories in the OECD countries, while the linked claim of low inflation flowing from the low-priced barrel has no relation to what is left of the "real economy", and fantastically inflating debt-and-deficit lead balls and chains. These will need massive inflation (or default hidden by a quick changeover of national moneys) in a rapidly approaching period of future time, to be deleveraged.

Oil import costs for heavily import-dependent countries and regions (US, Europe, Japan) ranged from 2.2% to 2.7% of GDP in 2011 using IEA data: minuscule numbers compared with sovereign debt servicing and budget deficit financing, either at present or going forward !

Old time oil panic drivers have eroded or even disappeared. In 1973, at the time of the first oil shock the OECD group of countries dependend on oil for 52.6% of their energy, using IEA data. By 2011 this had fallen to 36%. By 2020 the figure may be 30% -  33%, although the IEA pushes the date much further forward, but under any scenario, any theory oil's energy role will be lower than today. Evidently, a high-price oil panic of today, if it comes, will be downsized and diluted relative to previous and well mythologized, less unreal, more credible panics.

Still today however we hear claims our political deciders took years to finally home in on the dire reality of our financial situation, and they will need even more years to face the dire reality of our global energy situation: read "energy scarcity". The fact is that now structurally weak, on again/off again Western economic growth over the last decade or 15 years has a sharply declining relation with energy demand, supply and prices, shown by fast declining energy intensity of economic output. Record Asian economic growth in the period 2004-2008, in particular, showed little in the way of negative impacts from oil and energy prices rising to a peak. Only in the period ending about 1985, was the then OECD-dominated global economy's growth fundamentally affected by oil prices.

The second fact is that that even if oil, of the "conventional" type will stay scarce, all other types and sources of energy are either relatively abundant or absolutely abundant: also, global energy demand growth is shrinking. In some mega regions and for unsurprising reasons, Europe for example, both energy and oil demand are on a steady downhill track, at about 2.5% a year in Europe for oil, since 2006. With much slower future demand growth, and more abundant energy sources, and more efficient energy technology, the potential for new 1970s-type oil panics are low or zero. The only rational hope for oil boomers and peddlers of oil crisis theory, today, is civil war or revolution in the Middle East, Iran bombing or unlikely inner circle Kremlin putschs with the Putin team thrown out of power.

The model for this is what is happening to the US energy sector because of the shale gas surge: near bankruptcy for the most exposed players like Chesapeake, and falling earnings for the biggest of all US energy coporations, Exxon Mobil, is the result. US gas prices are now suicidally low, but for a host of reasons including US energy players morphing into real estate gamblers, using drilling lease land as betting chips, the surge in US gas production will continue, now with the hope of large volume LNG exports at Asian or European prices (up to 6 times the US price of less than $3 per million BTU). To be sure, LNG export offer from a constantly mounting number of other new producers including Australia and potential new producers in a swath of countries, from Mozambique to Cyprus and Guyana, will surely trim these prices. The IEA's present forecast is for global gas prices to fall 30% by 2020.

In no way ironically, global energy corporations both in the OECD and Emerging economies now need high oil prices - defined as about $75 per barrel - to offset the huge costs of developing the huge finds of "stranded" gas that continue to be made, and to maintain their oil production, at constantly rising investment costs per barrel-day of replacement capacity. Spending elasticity on oil E&P (exploration and production) by global energy companies through 2000-2012 to date is relatively predictable and logical: the most recent peak year was 2008, before falling about 33% in 2009, staying flay in 2010, and making an uncertain recovery since mid-2011. Oil prices hit a peak of $147 a barrel in 2008 before falling to $35 a barrel in 2009. Gas E&P was unrelated to this price-elastic profile, again for a host of reasons, including the sheer size of new gas discoveries, and despite the crash of gas prices in the US.

Another oil price crash will almost certainly cause another oil E&P spending crash, with the inevitable result that global oil supply will only show the slightest growth of net production capacity - and perhaps even a decline. But as already noted, global oil demand growth is now very close to zero and can dip into contraction not only through recession - but through the surge in non-oil energy supply and the rapid progress in energy saving and efficiency raising technology development and application, both in the OECD and Emerging economies. Separating which of these factors is the driver - declining supply or declining demand for oil - is a chicken and egg question.

The recent and ongoing determination of Saudi oil minister al-Naimi to "steer" prices down to about $75 for Brent, and only slightly less for WTI, signals the above arguments have been received 20/20 with this readout for producers: prices have to be brought down and held down - to prevent the retreat from oil by world energy users and consumers becoming a rout. Russia's stance on the oil price issue can be gleaned from Gazprom's Medevedev "airing the idea" that oil indexing should be dumped for global gas pricing, and gas pricing might in future be related to renewable energy prices.

The crux of the energy pricing issue is easy to summarize. Currently, prices are unrealistically wide ranging and unrelated - they will converge, not diverge further. Oil, for a short while longer still fetches $85 a barrel for WTI and near $100 for Brent, gas prices range from under $17 per barrel equivalent (boe) in the US, more than $85 per boe in Asia and close to that price in Europe, coal prices are around $30 per boe but declining, and renewable energy prices are set in the most extreme possible range from levels as low as $10 per boe to over $200 per boe.

Anybody outside the energy industry and energy analyst community looking at these prices can only scratch their head - but the future is mapped. Prices are set to converge, and oil prices have to fall. The biggest drivers of change are the energy demand side and gas-plus-renewables on the supply side. Both are in rapid change, even mutation and for renewable energy the German concept of "Energiewende" or energy transformation is the keyword.

The old time model of periodic oil panics driven by fast-growing oil demand in lockstep with fast economic growth, and occasional oil-politics crises and supply cutoffs, is disappearing from view. Global interest in and commitment to the new keywords clean energy and energy saving are of course heavily infiltrated by hype of the global warming crisis type, but the process of energy change is under way. The simplest changes in critical oil using sectors - starting with gas energy in transport - can now accelerate this process, and literally transform world energy. Taking road and marine transport, currently using an estimated 11 to 13 billion barrels-per-year (on a world total of 32 bn bbl/year), as much as 25%-33% of this could be eliminated by the 2020-2025 horizon, given the right policies, financing and commitment. The technology and infrastructure barriers are low or very low.

Unappreciated by nearly all commentators, the oil producers can only accelerate this process. If they act to maintain high prices (defined as over $75 a barrel) through production cuts and quotas this will intensify the competitiveness of energy alternatives and energy saving; if they heavily cut back on oil E&P spending this will reduce the rate of supply capacity replacement, oil supply will stagnate or fall faster than global demand, and prices will rise through the $75 ceiling. Either way, the producers accelerate the oil decline and wipeout process.

This iron logic will drive the oil-versus-other energy changeover and transition process, with sure and certain outrider signals that the logic is finally understood.

These signals already exist in growing numbers. For the past decade but accelerating since 2005, the former "oil majors", sometimes called "supermajors" and variably defined by membership (BP, Chevron Corporation, ExxonMobil, Royal Dutch Shell, Total, ENI, ConocoPhillips) have all made a gas shift shown by the simplest possible indicator: the ratio of their oil energy output to gas energy output on an annual basis. Most are now at or close to 50-50 while some like Shell now produces more than 55% of its annual energy output as gas, not oil. This process is certain to continue, at the same time as the "supermajors" and the large, growing national oil corporations in Emerging economy countries also move into coal, renewable energy, electric power production and downstream value added activities - including energy saving and substitution technology and services.

This is hard to answer, but the betting is no. The current OECD-source economic recession is itself a major driver of stagnant or falling energy demand and the move away from oil, firstly through economic decline and deindustrialization, which have a major impact on oil prices. Stock exchange crises are not the friends of long term, big ticket investing in high priced oil, and asset collapses will hit oil like any other speculative commodity. When oil falls to prices of $50 or $60, the claim that we face Oil Armageddon becomes even harder to take seriously: only high oil prices can feed panic-theory.

Given that natural gas prices, outside the US will fall, coal prices are set to at best stagnate or decline, and renewable energy prices are in some cases on a steep downward slope - while global energy demand is set to grow at slower and slower rates - the potential for oil shock is low. Another oil panic is of low credibility, outside purely political driven oil crisis in the Middle East or possibly Africa.

The real crisis, for oil producers is noted above. They are set in a pincer where replacing oil production capacity lost through depletion is high cost and needs prices near $75 a barrel, but prices will rise if they take avoiding action in the shape of production limitation, and will rise if they let total oil supply fall away too fast, that is faster than global oil demand shrinks.

The ex-oil majors, rapidly becoming Gas Majors have already made a de facto choice to move away from and out of oil, despite the windfall profits when prices spike, which sets the betting to the second scenario, above, of global oil supply falling away too fast and resulting in a Peak Oil nexus of too little supply and too much demand, which the IEA sets as a major threat and likely by 2017, but this is completely dependent on the demand side holding up. What we can be sure of is that trends continued of the past are most surely and certainly not the future trends - meaning that old style oil shocks now include the surprising rate of decline in global dependence on oil and the surprising trend for oil prices going forward.

By Andrew McKillop


Former chief policy analyst, Division A Policy, DG XVII Energy, European Commission. Andrew McKillop Biographic Highlights

Co-author 'The Doomsday Machine', Palgrave Macmillan USA, 2012

Andrew McKillop has more than 30 years experience in the energy, economic and finance domains. Trained at London UK’s University College, he has had specially long experience of energy policy, project administration and the development and financing of alternate energy. This included his role of in-house Expert on Policy and Programming at the DG XVII-Energy of the European Commission, Director of Information of the OAPEC technology transfer subsidiary, AREC and researcher for UN agencies including the ILO.

© 2012 Copyright Andrew McKillop - All Rights Reserved Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.

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