Twilight of Big Energy

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Ezra Sutton
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1 Volume XXXIV, No. 7 July 2017 Twilight of Big Energy HHI for Global Crude Oil Exports: History and Possible Future under Middle Eastern Dominant Control HHI 3,500 3,000 2,500 HHI possible if low-cost Middle East producers cooperate 2,000 1,500 1,000 Historical HHIs Source: PKVerleger LLC. 2017, PKVerleger LLC. All rights reserved. ISSN Reproduction of The Petroleum Economics Monthly in any form (photostatically, electronically, or via facsimile), including via local- and wide-area networks, is strictly forbidden without direct licensed permission from PKVerleger LLC. Contact Dr. Verleger at 300 Glencoe Street, Denver, CO or phil@pkverlegerllc.com. [Publication Date: 9/3/2017]

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3 Table of Contents Summary... 1 Twilight of Big Energy... 3 Scrapping Drilling Rigs... 7 Embrace the Short Cycle Squishy Numbers The Needed Price War Restoring Market Power The Role of Shale The Role of Inventories Glossary Statistical Appendix List of Figures Figure 1. US Natural Gas Spot Prices at the Henry Hub, January 2005 to July Figure 2. Number of Offshore Wells Drilled Outside of North America, Monthly Data, 1982 to Figure 3. The Oil Consumption Growth Gap: Y-o-Y Growth in Global GDP vs. Y-o-Y Growth in World Oil Consumption Figure 4. Projections for US Electricity Sales as Published in 2008 and 2017 EIA Annual Energy Outlook Figure 5. Total US Electricity Supply Projected to Come from Renewables by EIA in 2008 and Figure 6. Oil Production by Mideast Low-Cost Producers, History and Two Scenarios Figure 7. HHI for Global Crude Oil Exports: History and Possible Future under Middle Eastern Dominant Control PEM XXXIV, July 2017 i

4 List of Tables Table 1. Simple Schematic for Comparing the Construction Cycle Times, Costs, and Efficiencies of Large Generating Plant and Oilfield Projects... 6 Table 2. Views as to When Global Crude Oil Demand Will Peak and Strategic Response Table 3. Views Regarding the Likelihood of a Japanese-type Slowdown in Significant Portions of the World Table 4. The Conundrum: Uncertain Outlook for Low-Cost Middle Eastern Oil-Exporting Nations Associated with Uncertainties Regarding Future Outlook Table 5. Estimates of Cash Flow for Five Key Middle Eastern Oil-Exporting Countries under Two Scenarios PEM XXXIV, July 2017 ii

5 Summary Big energy has lost all credibility. The bankruptcy of Westinghouse, the cancelation of almost all nuclear power construction, the multibillion dollar overruns on LNG projects in Australia, the Kashagan oil field, and the nuclear plants being built in United States and Europe have left the reputations of large energy companies and the engineering and construction firms that support them in tatters. Short-cycle energy has won according to the pundits. Renewable generation, an afterthought ten years ago, now accounts for more than nine percent of US generation. Some European nations have gone days without needing electricity produced from nuclear fission or hydrocarbons. Renewables seem to have triumphed. But renewables are but one nail in big energy s coffin. In oil, the survival of frackers and the surge in their output confirms that small projects are the future. Big projects are finished. This should not surprise anyone. As we note below, the first commercial nuclear power plant was built in three years in 1960 at a cost of $250 million in today s dollars. The project came in thirty percent under budget. Offshore wells could be built in a year or two in Today, it takes at least a decade and $5 billion or more to complete large energy works. Metaphorically, the fleet-winged red Pegasus that once was Mobil Oil s marque and a symbol for a nimbler industry has been replaced by a lumbering green dinosaur: Dino, the logo of Wyoming-based Sinclair Oil. The oil industry s transformation has led many experts to write OPEC off. A recent Citibank report asserted that shale s responsiveness to prices now severely limits producers ability to target oil prices. 1 The Citi authors conclude that the oil market has become competitive and that OPEC s ability to control prices is over: At the end of the day, the spread of shale to other countries, with or without a significant curtailment in the growth of oil production globally, should make a return to a world with a significant oil market regulator capable of reducing consumption to maximize its resources impossible. 2 Citi buttresses this view by presenting calculations of the Herfindahl-Hirschman Index (HHI) of market concentration, suggesting oil producers today have no power. The authors present the HHI as if they have introduced something new to oil market analysis. Sadly, their use of the index is sophomoric and is occurring very late in the game. We presented the first use of HHIs in oil market analysis thirty-one years ago in the November 1986 Petroleum Economics Monthly. That report showed that the market s HHI had collapsed into the range considered to be that of a competitive industry. Thus, we suggested the market had become competitive. History proved us wrong. Over the last thirty years, we have revisited the topic several times. We do so again here. One conclusion from our research relates to how best to measure the market s HHI. The Citi 1 Citibank, Energy 2022: The New Sultans of Swing: Part III Shale Is Winning the Battle against OPEC and Russia, August 22, Citibank, p. 14. PEM XXXIV, July

6 analysis uses oil production. This measure is probably wrong because some countries the United States, for example consume all domestic production internally (or did until recently). A better way to measure competition is to focus on exports. The cover graph shows the HHI computed using export market shares. This calculation lifts the value from the 700 computed by Citibank to around An HHI of 1000, though, still indicates a competitive business. Note, though, the HHI of 3300 in the upper right-hand corner of the cover graph. This level denotes a highly concentrated market, one comparable to those of Apple, Alphabet (Google), and Microsoft, firms that enjoy great pricing power. As the graph suggests, oil exporters can also reach this level. Collaboration among the seven low-cost oil producers in the Middle East (Iran, Iraq, Kuwait, Oman, Qatar, Saudi Arabia, and the UAE) would produce this HHI. We estimate that these countries could double their income to more than $1 trillion dollars between 2018 and 2022 if they could put political differences aside and cooperate. 3 This cooperation would require them to first increase output to maximum levels, forcing prices down to perhaps $20 per barrel. The successful implementation of a strategy to raise income (and even return oil to $100) requires that prices first be taken to levels low enough to force the scrapping of much of the world s deepwater drilling capacity and to dramatically lower investment and production in countries such as Brazil, Canada, Mexico, Norway, Venezuela, and even the United States. These outcomes would allow the low-cost producers to raise prices and dictate the rate of increase. As an integral part of their strategy, the Middle East low-cost producers having market power must bankrupt many of the large energy companies. What happened to Westinghouse provides the model. In doing so, the producers would be following the timeworn approach of driving prices down to put competitors out of business. After the shutdowns, they would have a free hand to raise prices. The suggested price war would not disable shale producers permanently. Shale is a shortcycle process and so would recover when prices rose again. The goal of the suggested price war is to end the megaprojects that have been so popular. These pose a serious threat to low-cost producers because, once finished, they continue to produce regardless of the price level. Short-cycle projects like shale, in contrast, can stop and start. Furthermore, shale and exports from nations such as the United States become relatively unimportant if the seven Middle Eastern producers or a smaller grouping of four or five operate as one. Under that circumstance, oil producers could exercise market power and reap the profits, just like Apple, Alphabet, and Microsoft have done. Will this strategy be adopted? We offer no predictions. However, the numbers are so transparent we have to believe producers will consider it. If nothing else, announcing such a strategy would certainly help boost the amount raised from any IPOs involving their national oil companies. 3 There are other combinations of countries for example, Russia, Iraq, Kuwait, and Saudi Arabia that would have the same market power. PEM XXXIV, July

The Petroleum Economics Monthly

The Petroleum Economics Monthly Philip K. Verleger, Jr. Volume XXXII, No. 4 April 2015 Where is the Oil? Million Barrels per Day 4 3 2 1 0 (1) (2) History and Projections of Global Crude Oil Stock Change