Financial Planning for an Uncertain Energy Future

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1 Financial Planning for an Uncertain Energy Future December 16, 2014 by Richard E. Vodra Advisors hearing optimistic forecasts of plentiful new supplies of oil that may last for decades may be encouraged to make aggressive projections for their clients. It is critical to understand the role oil plays in the economy and the factors that will affect future supplies. Advisors should drill down beneath the slogans to see both risks and opportunities upon which to base their recommendations. This article reviews the state of global oil supplies. World crude oil extraction outside the US and Canada has actually declined since 2005 from 67 to 64 million barrels per day, despite much higher prices until recently. The U.S. fracking boom faces many challenges. Net energy from oil declines faster than gross production, and it is the net number that determines the strength of the economy. It is very likely that the U.S. will never again be a net oil exporter or even energy independent in terms of oil. The recent decline in oil prices to levels first seen in 2007 has reshaped the conversation about oil. For advisors helping clients, here is what you need to know. The long-term oil picture has not changed, but this oil-price shock the second in less than 10 years challenges the conventional wisdom. Americans have assumed that we could produce all the oil we could and someone else (OPEC, or more precisely, Saudi Arabia) would manage oil prices, keeping them high and stable. This was important because oil from fracking in the U.S. and tar sands in Canada is some of the most expensive to produce in the world. High stable prices allowed the debtbased financing of new production to expand through bank loans and junk bonds. We have now been reminded that oil prices are volatile and fragile when nobody is willing to assume the role of gatekeeper. It is hard to persuade others to cut their production, so any rise in fear or fall in demand lowers prices quickly. This is common to most commodities, but no other commodity is so crucial to the world economy. Last March the head of Chevron said that they expected prices to continue to rise from a base of $100, but now few expect prices to return to that level for five years. The truth is, nobody knows. Unless there is a deal to raise prices again and don t rule that out many new projects will be deferred and some companies will cease operations. The current short-term supply surplus will last for 1 Page 1, 2018 Advisor Perspectives, Inc. All rights reserved.

2 a year or two as existing wells continue to produce and new wells that have been started or funded will be completed. Since shale wells have a rapid decline rate and yield nearly all of their oil within their first three years of operation, expect a significant decline in US oil extraction rates as early as Even before the recent price drop, major oil companies had announced cuts to their exploration budgets, reflecting rising costs and disappointing results. These companies focus on massive projects that take years to complete but create decades of productions. Additional price-related cancellations will result in further reductions in production before the end of this decade. Remember that the quoted price of oil is for spot purchases and can be quite volatile when no one is trying to control the price. Much of the current production is pre-sold at fixed prices, so the immediate impact of a price drop is hard to determine whether it boosts oil consumers or burdens the oil companies, banks and other lenders who financed them. Over time, prices tend to fall to the cost level of the marginal producer unless there is (as there usually is) a controlling force like OPEC that can regulate extraction amounts and thus support prices. On the upside, prices are limited by what consumers can afford and by the marginal cost of new sources of oil (like U.S. shale) or alternativeenergy processes. If prices stay low, within a year the flow of new money to new high-cost wells will fall. Expect a cutback in current investments and fewer opportunities for new investments. Longer term, for those with deep pockets and patience, there may be an opportunity to acquire assets at fire-sale prices that could recover by the end of the decade. A climate-change agreement over the next year could change the energy picture in other ways. Because of the growing urgency of controlling CO2, methane and other climate-altering compounds, a global agreement to limit fossil fuel use could emerge soon. If that happens, the future value of reserves of oil, coal and natural gas will decline, and new ways of doing almost everything will be developed. That outcome faces major obstacles and is by no means assured (or even likely), but it would certainly lead to updating all of our long-term plans and expectations. Why oil supplies matter to you and your clients Whether we will have adequate supplies of affordable oil and other energy supplies is one of the critical questions of our time. Ultimately this question will be answered by the realities of the physical world. There is a substantial risk that the U.S. and the world will not have the abundant supplies of inexpensive energy that many people assume. Planning by individuals, communities, businesses and governments should take that risk into account. The prospect of the U.S. becoming the world s largest extractor of crude oil, passing Russia and Saudi Arabia in the next few years, is held out as proof that our energy worries are behind us. Right now we are extracting approximately nine million barrels of crude oil per day (mbd), according to the U.S. Energy Information Agency. Another two mbds would bring us ahead of the two current leading countries and break the previous American record set in This is certainly possible. Our imports of crude oil, however, remain about seven mbd. No credible source is projecting that American extraction will rise to and remain at a level high enough to eliminate the need for significant imports. Page 2, 2018 Advisor Perspectives, Inc. All rights reserved.

3 The truth is that the U.S. has been an importer of oil since the early 1950s, even during years when we were clearly the world s top producer. Being number one may be the goal for a football team, but it does not assure energy independence for the U.S. When it comes to developing new sources of energy, the investments and time frames are substantial. It can take billions of dollars and a decade or more to turn a newly discovered oil field into a flow of actual oil. Refineries and pipelines, export terminals and new technologies require major commitments, not just by the companies making the investment, but by the communities affected and all of society. Overly optimistic projections and talk of energy independence by people whose economic and political interests require assumptions of plenty will lead to terrible long-term impacts that the rest of us will have to pay for in years to come, especially if the hoped-for cheap energy never appears. The oil supply story in brief Understanding how we use oil and where it comes from illustrates why Americans should be concerned about the future of oil supplies. The outline below presents the most essential of these reasons. Energy, especially oil, is the key to all economic activity. The economy as a measure of real-world activity is based on energy and natural resource use, not finance. The value that energy provides, less the cost of the energy, makes growth possible, and can be considered energy profit. (Think of moving a car twenty miles or more in a few minutes on less than $3 worth of gasoline, and consider the many things that ability then makes possible.) Attempts to manipulate the economy with fiscal and monetary policy cannot succeed if affordable real resources are not available. In particular, our water supplies and agricultural economy are very dependent on oil and other fossil fuels; energy production requires a lot of water, especially for cooling power plants. There are no long-term examples of economies growing without expanding their use of energy. Actually, we have two energy systems, not one. Nearly all transportation around the world is powered by petroleum. There are few substitutes for oil, so high-prices reduce other economic activity before slowing oil consumption directly. People cannot drive 85% of the way to work, so they have to cut other spending when fuel is expensive. When oil prices fall or incomes rise, Americans resume their driving: September 2014 set a record for the month in vehicle miles traveled, and SUV and truck sales are growing again, locking in greater future demand for gasoline for the lives of these new vehicles. The cost of obtaining oil has risen over 10% per year since 2000, growing faster even than average prices. The newest oil sources tend to be the most expensive tar sands, tight oil (fracking), deepwater fields and places with political instability like Nigeria and Venezuela. Despite the apparent glut of oil, new sources of affordable oil are not as abundant as is commonly claimed. In the last decade, two substantial new sources of oil have emerged in North America. One is the Canadian Tar Sands in Alberta, which currently yields about 1.5 million barrels per day of Page 3, 2018 Advisor Perspectives, Inc. All rights reserved.

4 bitumen, a product that can be refined into oil. However, the growth rate of extraction has been slower than forecast as production costs are rising. The environmental impact of tar-sands oil production is substantial, and transportation and pipeline decisions will affect the economics of future production. The other new source has been light tight oil, extracted from shale deposits with fracking technologies, mostly in a few counties in North Dakota and Texas. While this oil has reversed the long trend of declining American extraction rates, studies analyzing the histories of individual wells show rapid decline rates (often 40-60% per year, compared to a few percent with traditional wells) and relatively small areas (or sweet spots ) where fracking efforts are economic, leading to the prediction that the shale oil boom will be short-lived. More money is being spent on new wells than is being generated by cash flow from the oil, requiring a steady flow of outside capital to keep development going. Efforts to use fracking technologies for oil extraction in other states and countries have not yet been economically successful on a substantial scale. The International Energy Agency expects growth in American extraction to stop within this decade. While oil extraction rates have increased in the U.S., this growth has been largely offset by declines in extraction and exports in other nations. Global oil extraction rates outside of North America fell from 2004 to 2014, even though oil prices tripled during that period. Last year, 2013, was the first year since 1903 that there was no discovery of a giant oil field, one with at least one billion barrels of oil. Mexico s oil extraction is one-fourth lower today than in Brazil and Kazakhstan are having great trouble starting major new projects. Nigeria, Libya, Venezuela, Sudan and Iraq are all facing domestic unrest that challenges export levels. Oil extraction from deep-water sources is proving more difficult, more expensive and slower to happen than many expected or promised. This is especially the case in the Atlantic Ocean near Brazil and from the Arctic Ocean. The Macondo (Deepwater Horizon) disaster in the Gulf of Mexico in 2010 was the result of the complexities that are a necessary part of pursuing difficult-to-extract oil. If oil prices continue to fall, investors will not get the return they need justify new drilling efforts, and many new projects will be abandoned or delayed. The largest oil companies and many of the major exporters (including the State of Alaska) need prices from $100 to $130 per barrel to meet their financial goals. Another factor has reduced the amount of exports of oil in world trade and thus contributed to supply pressures: Oil exporting countries often increase their consumption levels faster than extraction rates, and consumption may continue to rise even if extraction falls. China, Indonesia, Great Britain, Egypt, Vietnam, Argentina and Malaysia have all changed from exporters to importers in the last 20 years, increasing the competition for oil in world trade. Volatile prices and difficulty in raising extraction rates call for creative responses throughout society. Any significant future growth in oil availability and therefore, growth in the global economy depends on sources that are not currently identified or under development. Existing oil fields deplete by more than 5% per year, so new sources are constantly required. America s current optimistic oil policy is based on the hope that somebody will come up with something. A more realistic policy should be based on the assumption that we are at or near the maximum rate of production of affordable oil for a modern economy, and must develop responses appropriate to that future. If we find new supplies equivalent to shale oil, we should treat them as a Page 4, 2018 Advisor Perspectives, Inc. All rights reserved.

5 one-time bonus to be used to pay for the transition to whatever is next. Many opportunities exist for creative responses to these challenges. Some responses, like more efficient automobiles, support our current way of life, while others, like localization of food production, community building and information technology, help transition to a new economy. Since high or volatile oil prices make transportation more expensive, there are advantages to changing our transportation systems and functions, including electrification, mass transit and transit-oriented development. These actions require capital, vision and lots of time to have their fullest impact, but offer opportunities for advisors and their clients. Contrary to some claims, there is little evidence that the demand for oil is declining for reasons unrelated to price or that we are moving away from oil. The need for moving people and goods remains active, as shown by the number of new airports around the world, the increase in car sales in China, India and the Middle East and the doubling of the size of the Panama Canal. There has been much discussion but little action toward electric cars and natural-gas-powered trucks and trains, and those technologies remain more expensive than gasoline and diesel-powered vehicles. The IEA reports that if all nations meet their goals for electric cars, they would still represent less than 1% of the global car fleet by The key question is how long we will have enough oil available at prices that allow us to operate and grow the economy and society. We may never run out of oil, but soon (within a decade) the rate of extraction of oil that is cheap enough to support economic growth will decline, and the energy profit we enjoy will decline much more than most people are expecting. Richard E. Vodra, JD, is the president of Worldview Two Planning in McLean, VA. He is also a board member of the Association for the Study of Peak Oil and Gas USA. He can be reached at rvodra at worldviewtwo dot com. 1. People commonly discuss oil production, but oil is not produced by nations or oil companies; it is extracted. The actual creation of oil takes millions of years, starting with algae trapped underwater and subjected to massive pressure and just the right geology. We extract oil from the ground, and that phrase reminds us that we are draining a fixed and limited resource. Page 5, 2018 Advisor Perspectives, Inc. All rights reserved.