A Top Analyst: North America Heading to Energy Independence June 26, 2012 by Robert Huebscher Is North America on the verge of energy independence? At least one analyst thinks so. Ed Morse, a managing director of Citigroup Global Markets, said last week that by the end of this decade the US and Canada will have a surplus of oil, leaving it with no room for imports. But the longer-term picture is far less certain, as extraction moves from conventional wells to newer sources, such as deepwater fields and shale-based oil. Morse contended that oil prices rose over the last several years because of a lack of supply, brought on by the oil industry s insufficient investment over the last decade. Now, he predicted, with the development of new technologies, such as fracking, a cyclical phase of higher supply and lower prices has begun. Most of the other speakers at the Oil Supply and Demand Symposium, held in New York on June 19, viewed the decline in oil prices with gasoline now below $4.00 per gallon as temporary. Mark Lewis, a managing director in commodities research at Deutsche Bank, was among those with a less sanguine view than Morse s of the prospects for cheap oil. Oil consumption in OPEC countries is rising faster, on a percentage basis, than anywhere else in the world, Lewis noted. Those countries need oil prices of $90 to $100 per barrel to balance their internal budgets, providing an effective floor going forward that is already above the current Brent price of approximately $91 per barrel. The fundamental question is clear: Are we at the end of the era of cheap oil, or will oil prices vary cyclically, as supply and demand shift in response to varying market conditions? Economic growth is constrained by energy availability, so answering this question is critical. Let s look at the analyses presented at last week s conference. A glut of crude US production is now at 6,000,000 barrels per day, and Canadian production adds another 3,000,000 barrels daily, according to Morse, who said those numbers could increase by 10%. He also expects positive surprises from Mexico in terms of increased production. Global crude oil production (not Page 1, 2018 Advisor Perspectives, Inc. All rights reserved.
including natural-gas liquids, unconventional oil, biofuels or refinery gains) is approximately 75 million barrels per day. By 2020, Morse expects a surplus of oil in the combined US and Canadian market, the result of significant capital expenditures by the oil industry over the last decade. He also predicted an incredible slowdown in China s economy, with growth decelerating at a much more rapid rate than we think. China s investments in fixed assets, which have been the main driver of commodity demand, will slow significantly, he said. Adding to the pressure on prices is a buildup of oil inventories, Morse said, especially in Saudi Arabia, which is creating a buffer to allow for a potential disruption in supply in the event of further escalation in the conflict with Iran. The Saudis did the same thing in 1997-1998, to protect against disruption from the Asian crisis. Ultimately, Morse said, the US will need to reconsider its policies with respect to oil production on federal land. Export of that oil is banned, as is exporting oil that has been transported on interstate pipelines. A glut of crude will lead to calls for US to export its surplus. That glut, Morse said, will keep prices below $95 per barrel and potentially lower over the remainder of this decade. He did not say, however, whether that price was in nominal or real terms. The alternative view Lewis was more pessimistic about the potential for lower oil prices. His prediction focused on global supply and demand, rather than conditions within North America. Over the second half of the last decade, the supply of petroleum liquids (which includes oil and liquid petroleum that is the byproduct of natural gas production) rose by only 1.3% on an energy-adjusted basis, according to Lewis. Indeed, he said that production fell for four of the world s largest producers over that period: Saudi Arabia, Iran, Kuwait and the United Arab Emirates. Demand pressures will keep prices high, he said. China s demand had the largest absolute increase of any country s over the last decade, with Saudi Arabia second and India third. Demand in the Middle East comes from increased electrical consumption, as both air conditioning and desalinization technology, which is very energy-intensive, have spread widely in recent years, he said. A 5% annual growth in electricity demand would double the internal consumption of oil in the Middle East over the next decade, Lewis said. Lewis doubted whether OPEC can keep prices in check, particularly in an environment of slow global growth. He said that OPEC has a good track record of controlling prices, but only when global growth exceeds 2.5% annually. Page 2, 2018 Advisor Perspectives, Inc. All rights reserved.
Javier Blas, the commodities editor for the Financial Times, said that OPEC is in a strong financial position. Its revenues this year will equal those in the entire decade of the booming 1990s, and he doubted whether developments such as shale oil or deepwater drilling could really diminish its power. Blas noted that a key variable that governs oil prices is Saudi Arabia s spare production capacity. He said that the Saudis currently produce about 10 million barrels per day and could increase that by 25%, but it would take four to five weeks to bring that capacity online. Ray Leonard, a geologist who is president and CEO of Hyperdynamics Corporation, added some additional concerns about the potential for new sources of oil extraction to increase supply. Leonard said that supplies of conventional oil (which includes land-based wells and those in water at depths of less than 400 meters) peaked on a global basis in 2005. OPEC has 73% of the reserves; the rest of the world accounts for a far greater percentage of demand relative to its reserves. That imbalance, he said, will ensure ongoing volatility in oil prices. Deepwater oil (found in wells drilled at depths of more than 400 meters) is concentrated in the Atlantic Basin, Leonard said, and is unlikely to be found elsewhere, due to the geological science (plate tectonics) that that governs where oil deposits form. About half the available deepwater oil has been discovered, mostly in the Gulf of Mexico, off the coast of Brazil, and in the basins of the Niger and Congo rivers. Production for deepwater oil will peak around 2020, Leonard said, and will rapidly fall off after that. Unconventional oil production such as natural gas liquids, heavy oil obtained from tar sands, and shale oil produced by fracking is unlikely to make up for decreases in conventional and deepwater sources over the long run. Heavy oil production, mostly from Venezuela and Alberta, is now approximately six million barrels per day, and Leonard said it could triple by 2030. Canada and Venezuela export approximately 1.2 and 1.7 million barrels per day, respectively. Production of shale oil will be a worldwide phenomenon, Leonard predicted, but he said that will take another 10 years. It is limited by well production that falls off quickly, after an initial period of high output. At $90 barrel, Leonard said shale oil will be marginally profitable. Oil and the economy Jim Hamilton, an economics professor at the University of California at San Diego, addressed the question of how oil shortages will affect global economies. A 5% decrease in the supply of oil, he said, would trigger a recession. That was the case in 1973 (the OPEC embargo), 1979 (the Iranian revolution), 1980 (the Iran-Iraq war) and 1990 (the first Gulf war). Of the 11 post-war recessions, he said that 10 were preceded by a spike in oil prices. Page 3, 2018 Advisor Perspectives, Inc. All rights reserved.
Hamilton cited econometric studies to show that consumer spending falls off significantly but gradually when energy prices increase. It is most evident in spending on durable goods and automobiles, and has been accompanied by a big drop in consumer sentiment, as measured by the University of Michigan surveys. About half of the slowdown in consumption at the time of the 2008 financial crisis owed to energy prices, he said, and that finding was consistent with historical data. Europe is more vulnerable to oil prices because of the weakening of the euro relative to the dollar, Hamilton said. Hamilton warned that a major conflict with Iran could have three times the impact on oil prices, as compared to the worst events (like the OPEC embargo) that have historically proved disruptive to the oil supply. Since 20% of all the world s oil goes through Iran s neighboring Strait of Hormuz, a deeper conflict with Iran could be far disruptive than, for example, the Iranian revolution and Iran s production capacity still hasn t recovered from that event, he said. No clear answers With the current focus on the sovereign debt crises in Europe, it is easy to let one s focus wander from the key role energy plays in economic growth. Steven Kopits, Managing Director with the energy advisory firm Douglas Westwood, noted that most of the energy consumption growth in China and other emerging economies came not from production increases, but from cutbacks in consumption from OECD members (the advanced economies). He referred to the OECD excluding oil producers Norway, Canada and Australia as donor countries. He noted that 85% of incremental oil consumption in the emerging markets came not from oil producers, but from a transfer of consumption from donor country consumers. The principle source of incremental Chinese oil imports is not Saudi Arabia, he noted, but the US consumer. This means the advanced economies have been and will be under chronic pressure to reduce oil consumption, with the result that their economies tend to struggle. Kopits said that the US and European economies slow as the global price of oil exceeds $90 per barrel, while China and other emerging economies can afford to pay as much as $115 per barrel. Thus, at $100 per barrel, wealth and consumption move from the West to the East. But Morse doesn t see it that way. And because cheap energy is critical to growth, especially with respect to transportation, then if Morse is correct, the US economy should fare well, at least over the next decade or so. In achieving energy independence, the US would effectively be isolated from international markets. That state of affairs would in turn create a polarized global economy; the US would prosper internally, but it would struggle to export to stagnating economies overseas. Few of the presenters addressed the longer-term supply of oil and energy, or the environmental impact of non-conventional extraction methods, such as deepwater wells and fracking. Lewis cited one interesting fact, which is that solar-generated electricity is now only about 30% more expensive than Page 4, 2018 Advisor Perspectives, Inc. All rights reserved.
oil-fired power. Improvements in solar technology or a spike in oil prices could eliminate that gap very quickly. Nuclear energy is considerably less expensive than oil today, but that is only a result of government subsidies. Morse may be right about North American energy independence, but he was also sounded a note of caution when it comes to the unpredictable nature of the energy industry. It s very difficult to anticipate change, he said. Page 5, 2018 Advisor Perspectives, Inc. All rights reserved.