Oil Industry I (Readings): Prices, Fundamentals, and Big Oil Futures
Needless to say oil prices are occupying everybody's mind right now - particularly since you can't go down the street without seeing $4/gal gasoline prices. Congress is holding hearings to chastise the speculative excesses with "inside baseball" players using the correlation is causation argument to prove widespread evil-doing. My favorite bloggers (BigPicture, CalculatedRisk) and financial writers (Jubak, Mauldin) have all put together excellent summaries recently that are worth reviewing. And of course the MSM (WSJ, NYT, et.al.) is covering the issue extensively. So here's our collection which we've been putting together for a couple of weeks now, and for which the time seems ripe.
The basic argument, which we plan in expanding into an analysis in a follow-on Part II, is the fight between fundamentals and speculators. As you skim over the readings below you'll find a wide sampling of sources and informed opinions but here's our take. Of the ~ $150 price/barrel target price the long-term fundamental price is in the $80-100 range. Another big chunk of that target is caught up with geo-political risk factors. And a third with speculative feedback on short-turn prices. Let's say that the proportions are roughly 60% fundamental, 20% risk and 20% speculation.
Except for one thing. The basic structure of the oil industry is that the major cost drivers are exploration and production; then distribution and processing (refining). As oil has gotten more scarce in inexpensive and readily (politically) accessible areas of the world there are non-linear rising costs to the two fundamental drivers. That's lead to a fundamental and long-term supply-demand imbalance as new oil production hasn't been keeping up with new oil demand and consumption. A partial result of that long-term dynamic of skating on the margin is that the system has been and is increasingly vulnerable to shocks as its' fragilities grow.
That's been the basic dynamic for at least three decades only it's gotten much more pronounced in this century. HOWEVER....there is another fundamental shift well underway that is greatly exacerbating all these innate structural characteristics.
Not only are new oil sources in increasingly hard to get to areas but the bulk of the world's known and potential reserves are no longer market priced nor controlled by private companies. Rather they are controlled by national oil companies or other political entities. Who's priorities are NOT long-run profit maximization.
Worse yet for those reserves controlled by political entities they are milking existing reserves to fund socio-political priorities and significantly under-investing in maintaining current flows while not developing new ones.
There are two bottomlines here:
1) oil is likely available but is getting increasingly scarce at prices we're comfortable with; i.e. the $80-100 baseline structural price, which shifted up from $40-50 in the last ten years, is likely go toward $150+. 20% X $150 = $60. 2 X $60 = $120. $150 + $120 ==> ~ $300 oil !
2) because oil is depletable and demand is growing there is a long-term scarcity premium that's being increasingly reflected in the base (cf. Prof. Hamilton's discussions below). In other words there is a rising scarcity rent being built into l.t. prices that's feeding speculation.
So below you'll find readings on the short-term and long-term pricing factors as well as the impacts on gas prices and the survivabilities of the refiners, or refining operations. You'll also find some fundamental re-thinking about the future prospects of Big Oil as we know. Which is pretty good though it generally doesn't reflect these deep structural changes evolving in the fundamentals of the industry....yet....other than by symptom.
The next steps of course are diagnosis and treatment....otherwise known as a National Energy Plan. Yeah, right.
Short-term Pricing Factors
Oil: Key players and movements The rising oil price, which topped $130 a barrel this week, risks pushing the global economy into a deep and prolonged slowdown. As long as demand from leading developing countries such as China and India remains strong, the price is likely to stay high. A combination of other forces, including the weakening US dollar and geopolitical tensions, is driving prices higher. Our map examines the world’s largest oil producers, consumers, and how oil flows around the world.
- · Whither the Price of Oil? Why has the price of oil risen so much in the past few months? Is it a supply and demand issue as some believe; or is it because of an out-of-control futures market driven by the proliferation of commodity index funds and rampant speculation, as everyone tries to get in on the rise in commodity prices? This is a very complex issue, with a lot of emotion attached to it. This week I try to give you an understanding of why oil prices have risen and whether they are likely to stay at such lofty heights or maybe even fall! And we look at a very odd statistic: where are all the tankers? There are some very unusual things happening in the oil patch. If you are currently exposed to the energy or commodity markets, or are thinking about it, I believe you will find this letter of interest.
Blame Wall Street for Oil at $135 a Barrel as Traders Cover Wrong-Way Bets Oil's rally to a record above $135 a barrel came as traders bought crude to cover wrong-way bets that prices would decline, according to data from the New York Mercantile Exchange. The number of outstanding futures contracts, known as open interest, fell 8.1 percent in a week to 1.36 million at the same time that prices rose 2.6 percent, the data show. Falling open interest and rising prices are signs that traders are buying to exit so-called short positions that would profit if oil fell, and lose money as they rose. Oil prices have closed at record highs on 27 days so far this year, prompting OPEC oil ministers including Saudi Arabia's Ali al-Naimi to declare that the rally is led by investors, rather than a shortage of supply. U.S. oil executives told Congress yesterday that prices should be between $35 and $90 a barrel. John Hofmeister, president of Shell Oil Co., the Houston-based subsidiary of Royal Dutch Shell Plc, pegged the proper range ``somewhere between $35 and $65 a barrel.'' Saudi minister al-Naimi said in March when oil was trading near $100 that prices were unlikely to fall below $60 or $70, representing the cost of producing alternatives such as biofuels or tar sands.
Soros, Ghanem, Tanaka, Chalabi's Own Words on $135 Oil May 22 (Bloomberg) -- Crude oil rose to a record $135.09 a barrel, an increase of 19 percent in the month of May, on supply concerns. This report compiles comments on the outlook for oil prices and factors affecting demand from International Energy Agency head Nobuo Tanaka, Chairman of Libya's National Oil Corp. Shokri Ghanem, billionaire investor George Soros, Fadhil Chalabi of the Centre for Global Energy Studies in London, Ashley Heppenstall, chief executive officer of Lundin Petroleum AB, Manoj Ladwa, a derivatives broker at TradIndex, Rachel Ziemba, an analyst at RGE Monitor, and Kevin Daly, a portfolio manager at Aberdeen Asset Management.
Long View: Classic films shed light on commodities boom Instead, the debate is narrowing around two explanations. The Jean de Florette thesis is that supply is being tightly constrained. The Trading Places thesis is that the new speculative money moving into commodity futures has distorted the market. The former leads to tragedy – a return to the 1970s, with commodities fuelling inflation while imposing a brake on growth. But the latter does not have ahappy ending. Instead, commodities’ new investors could lose their shirts as the bubble bursts. How does the evidence for the two hypotheses stack up? UBS details the constraints that are stoppering up the supply of oil. The big oil companies have made their plans on the assumption of $60 per barrel oil, it takes time to develop new supply, and so there is little relief in sight. According to UBS, 72 per cent of new global supply in the foreseeable future will come from just eight companies. Neither story explains everything. Tim Bond of Barclays Capital says many commodities that cannot be traded via futures and are closely held, such as tungsten and cobalt, have risen as much as mainstream commodities. Speculators have nothing to do with this.
- The Oil Speculation Debate , Speculators & Oil Price Spikes, Part II, The Short View: Commodity speculation
Long-term Structural Factors
IEA May Slash Oil-Supply Estimate The world's premier energy monitor is preparing a sharp downward revision of its oil-supply forecast, a shift that reflects deepening pessimism over whether oil companies can keep abreast of booming demand. The Paris-based International Energy Agency is in the middle of its first attempt to comprehensively assess the condition of the world's top 400 oil fields. Its findings won't be released until November, but the bottom line is already clear: Future crude supplies could be far tighter than previously thought. A pessimistic supply outlook from the IEA could further rattle an oil market that already has seen crude prices rocket over $130 a barrel, double what they were a year ago. For several years, the IEA has predicted that supplies of crude and other liquid fuels will arc gently upward to keep pace with rising demand, topping 116 million barrels a day by 2030, up from around 87 million barrels a day currently. Now, the agency is worried that aging oil fields and diminished investment mean that companies could struggle to surpass 100 million barrels a day over the next two decades. The decision to rigorously survey supply -- instead of just demand, as in the past -- reflects an increasing fear within the agency and elsewhere that oil-producing regions aren't on track to meet future needs.
What the Export Land Model Means for Energy Prices To understand the importance of exports when discussing peak oil, ask yourself the question, "What's more important: the fact that global oil production is falling ... or that the oil-exporting nations are cutting off their exports?" The basic thesis is that, to fully appreciate the impact of peak oil, you cannot look only at the production declines so presciently anticipated by MK Hubbard in 1956. You also have to look at the rate of local consumption and the effect of that consumption on the ability of a country to export its oil. Mexico provides about 14% of the oil the US imports. On any given day that makes it either the #2 or #3 leading source for US oil imports after Canada and Saudi Arabia. Given that the US currently imports close to 70% of its oil needs, the Mexican oil is critical. But here's the thing. Using straightforward ELM calculations, Jeffrey Brown is confident that Mexico will ship its last barrel of oil to the United States -- or anywhere else, for that matter -- about 6 years from now, in 2014. In my interview, I also asked Jeffrey to share his thoughts on the situation globally. Here's his response. "Global production peaked in 2005, and we're now into the third year of decline. And the critical point to keep in mind is, our model and case histories show that the decline rate accelerates, year by year. Using the Lower 48 in the United States as an example, you can see the annual declines going 2%, 3%, 5%, 7%, 10%, 15%, 20, on and on. So it's an accelerating decline rate." Underscoring Brown's concerns: On April 15, 2008 the Russians, the world's second largest oil exporter, announced that their oil production appeared to have peaked, with production in the first quarter of this year declining for the first time in a decade. If they have indeed peaked then, based on the ELM, the world could lose Russia's current ~7 million barrels a day in exports within 6 to 9 years. Echoing the baseline premise of the ELM, Herman Franssen, president of International Energy Associates, projects that Iran, the world's fifth largest exporter, may consume an amount equal to their exports by 2015. Most concerning, this April Saudi Arabia's King Abdullah announced they were not going to raise oil production above 12.5 million barrels a day.
Understanding crude oil prices How would one go about explaining what oil prices have been doing and predicting where they might be headed next? This paper explores three broad ways one might approach this. The first is a statistical investigation of the basic correlations in the historical data. The second is to look at the predictions of economic theory as to how oil prices should behave over time. The third is to examine in detail the fundamental determinants and prospects for demand and supply. Reconciling the conclusions drawn from these different perspectives is an interesting intellectual challenge, and necessary if we are to claim to understand what is going on. In terms of statistical regularities, the paper notes that changes in the real price of oil have historically tended to be (1) permanent, (2) difficult to predict, and (3) governed by very different regimes at different points in time. From the perspective of economic theory, we review three separate restrictions on the time path of crude oil prices that should all hold in equilibrium. The first of these arises from storage arbitrage, the second from financial futures contracts, and the third from the fact that oil is a depletable resource. We also discuss whether commodity futures speculation by investors with no direct role in the supply or demand for oil itself could be regarded as a separate force influencing oil prices. In terms of the determinants of demand, we note that the price elasticity of demand is challenging to measure but appears to be quite low and to have decreased in the most recent data. Income elasticity is easier to estimate, and is near unity for countries in an early stage of development but substantially less than one in recent U.S. data. On the supply side, we note problems with interpreting OPEC as a traditional cartel and with cataloging intermediate-term supply prospects despite the very long development lead times in the industry. We also relate the challenge of depletion to the past and possible future geographic distribution of production. Our overall conclusion is that the low price-elasticity of short-run demand and supply, the vulnerability of supplies to disruptions, and the peak in U.S. oil production account for the broad behavior of oil prices over 1970-1997. Although the traditional economic theory of exhaustible resources does not fit in an obvious way into this historical account, the profound change in demand coming from the newly industrialized countries and recognition of the finiteness of this resource offers a plausible explanation for more recent developments. In other words, the scarcity rent may have been negligible for previous generations but is now becoming significant.
Brazil Oil Trapped by 500-Degree Heat, Salt Barrier Brazil's plan to become one of the world's biggest oil exporters hinges on exploiting crude six miles below the ocean surface in deposits so hot they can melt the metal used to carry uranium to nuclear plants. Tapping what may be the biggest oil finds in the Western Hemisphere in three decades will require equipment that can withstand 18,000 pounds per square inch of pressure, enough to crush a pickup truck, pipes that can carry oil at temperatures above 500 degrees Fahrenheit (260 Celsius) and drill bits that can penetrate layers of salt more than one mile thick. Petroleo Brasileiro SA, the state-controlled oil company, is betting on the Tupi and Carioca fields to become one of the world's seven biggest crude exporters. Until the tools needed to exploit the reservoirs are invented, the crude will remain locked under the sea, said Matt Cline, a U.S. Energy Department economist.
- Powering Brazils Economy Petrobras, Brazils state-controlled oil producer, is rapidly emergin as a major player in the global energy empire, with Jose Sergio Gabrielli de Azevedo, Petrobras CEO and CNBCs Maria Bartiromo.
Gas Prices and the Refining Industry
AP IMPACT: What makes up the price of gas? So how exactly are gas prices set? What determines the hair-pulling figure you see displayed in large electronic or plastic numbers? Why is a gallon of gas, say, $4.11 -- not $4.10 or $4.12? Why is the price different across the street? It all starts with oil. The biggest factor in the skyrocketing price of gasoline is the historic ascent of crude oil, which has surged from $45 per barrel in 2004 to more than $135 this past week, setting new record highs all the while. In the first quarter of this year, based on a retail price of gas that now seems like a steal -- $3.11 a gallon -- crude oil accounted for all but about a dollar, or 70 percent, of the cost, according to the federal government. The rest is a complex mix of factors, from the cost of turning oil into gas to taxes to marketing costs to, sometimes, nothing more than the competitive whims of your local gas station owner.
Brough Expects `Huge Demand' for Oil Exploration Stocks May 23 (Bloomberg) -- Andy Brough, who helps oversee about $6.5 billion at Schroder Investment Management Ltd., talks with Bloomberg's Sara Walker in London about the impact of higher oil prices on his strategy for stocks and billionaire Warren Buffett's plans for acquisitions in Europe. Halliburton Co., the world's second-largest oilfield contractor, offered to buy Expro International Group Plc for 1.71 billion pounds ($3.4 billion), topping a 1.61 billion-pound offer by Candover Partners Ltd.
Oil Refiners See Profits Sink as Consumption Falls While drivers are facing sticker shock at the pump these days, here is a bigger shock: high prices are putting a strain on oil refiners. After last year’s stellar profits, American refiners are going through a traumatic period. In a time of record gasoline prices, some of them actually lost money in the first quarter, and for virtually all refiners, profits are down sharply. Experts say the refiners are caught in a double bind. The price of their raw material, oil, is rising because of strong global demand. At the same time, consumption of gasoline in the United States is falling as a result of slower economic growth and consumer efforts to conserve. However much the companies would like to raise gasoline prices enough to pass along the full increases in oil, analysts say they have been unable to do it. Oil prices doubled in the past year, while wholesale gasoline prices rose a mere 39 percent.
Chevron Plans to Fire Up to 1,000 Refining Workers After Profit Drops 84% Chevron Corp., the U.S. oil company that reported an 84 percent drop in quarterly refining profit, said it plans to fire as many as 1,000 employees in its refining, marketing and transportation divisions. About 300 workers, mostly located outside the U.S., received termination payments in the first quarter, according to a regulatory filing today by the San Ramon, California-based company. Most of the firings will occur this year, and the restructuring program is forecast to be completed in 2009, the filing said. A call to the company wasn't returned. Chevron, the second-biggest U.S. oil company after Exxon Mobil Corp., said on May 2 first-quarter net income rose to $5.17 billion, or $2.48 a share. Per-share profit was 8 cents higher than the average of 18 analyst estimates compiled by Bloomberg. Record crude prices in the quarter pared refining earnings because gasoline failed to rise as fast, narrowing profit margins. Chevron's refining earnings dropped 84 percent from a year earlier to $252 million.
Big-Oil Futures
Time for big oil to explore places it would rather avoid In fact the best-performing oil companies globally have been the ones that have had exploration success, such as Petrobras in Brazil. Rising costs and taxes, and limited access to new supplies help explain why BP and Shell have performed so badly and underperformed US peers ExxonMobil and Chevron. But other factors have been at work, such as the fatal accident at BP's Texas City oil refinery and the reserve misreporting scandal at Shell. Analysts estimate that underlying operating costs and capital expenditure across the oil industry are increasing 10 to 20 per cent a year. Taxes have also been rising. The Labour government has increased corporation tax on North Sea oil profits from 30 to 50 per cent in the past few years. Another way to look at rising costs and taxes is the impact on returns. Return on average capital employed at Shell was 24.5 per cent in the first quarter of 2008. That is only 10 percentage points higher than a decade ago. Yet in that time oil rose by $80 a barrel. Finding oil is also more difficult, and big western oil companies are forced to explore in places they would rather avoid. One of Shell's big projects is extracting oil from tar sands in Canada, and BP is drilling in ultra-deep waters in the Gulf of Mexico. In these large, complicated projects costs per barrel are high. Production at Shell has almost stood still in the past 15 years and BP's first-quarter figures showed production flat at 3.9m barrels of oil equivalent per day. A step change in output at both companies is not expected until 2011 when new but risky projects come on stream. Big oil is also facing lower returns in projects that are already running. Oil-rich nations no longer feel they have to call in one of the large integrated oil companies to exploit natural resources. They can buy expertise in large project management direct from oil-field services companies such as Schlumberger. This puts host governments in a very strong position to demand better terms from production-sharing contracts.
Is ExxonMobil's future running dry? Are we witnessing the death of ExxonMobil ? Strange question to ask with oil above $120 a barrel and ExxonMobil reporting $11 billion in first-quarter profits? Not if you understand that ExxonMobil's management has bet the company. If that bet is wrong, over the next 15 years or so, investors will get to watch the gradual disappearance of ExxonMobil. In one scenario, the company disappears as a public company, going private by 2018 after buying up all its public stock. In another, the company simply liquidates as it distributes its cash to shareholders until there's nothing left. Far-fetched? Not at all. The warning signs were pasted all over the company's May 1 earnings report. Yes, revenue for the quarter was up 34%, to $117 billion, from the first quarter of 2007. And, yes, net income climbed 17%, to $10.9 billion. But production of oil and natural gas was down almost 6%. All the evidence argues that the company will report lower oil and natural-gas production for all of 2008, even though new projects are scheduled to come on line in the second half of the year. Looking just at oil, the company's production will not grow at all through 2012. But falling production is only part of the problem, the consequence today of a longer-term problem that seems to worsen each year. You see, not only is production likely to stay flat or fall through 2012, but proven oil and gas reserves are declining. Proven oil and gas reserves fell by 3.1% at year-end 2007 from the end of 2006, according to Standard & Poor's. What's going on here? If any oil company in the world should be able to find more oil and natural gas, it's ExxonMobil, with its immense reserves of both engineering skills and cash resources. Today, though, the positions of the Western and national oil companies are reversed. Now the national oil companies control about 80% of the world's proven and probable reserves, and they're keeping the most promising geologies for themselves. As a result, Western oil companies with the cash reserves of an ExxonMobil, a Chevron or a Royal Dutch Shell simply don't have enough places to put their cash to work. Further, that money doesn't go as far as it used to when it comes to finding new reserves. The places Western oil companies can put their money to work are among the world's most hostile environments and most challenging geologies: in Siberia or beneath a mile of water and a mile of salt, for example.
Big Oil's big 'problem' While many Americans struggle to fill their gas tanks, big U.S. oil companies are making so much money that they literally don't know what to do with it. Instead of reinvesting more of their newfound wealth to increase supplies or develop emerging technologies that might one day reduce energy costs, they are giving much of the loot to shareholders already enjoying outsized gains. In a capital-intensive business, giving cash back to shareholders is often the equivalent of throwing in the towel. It's saying "we can't do anything with this money to improve our business." And it certainly doesn't address the oil crunch that consumers pay for every day at the pump.
A family affair The Rockefeller family confronts the board of Exxon Mobil. THE involvement of the Rockefeller family gives added piquancy to one of the two most significant shareholders- versus- board battles of this year's proxy season. Exxon strongly opposes the resolution and has tried to stem growing enthusiasm for it ahead of its annual meeting on May 28th by writing for a second time to shareholders urging them to vote no. Exxon says that its board is better placed than shareholders to determine its leadership structure, and that it wants Rex Tillerson to continue as both chairman and chief executive. The Rockefellers worry that Exxon does not spend enough time analysing risks to the business, such as climate change and the need to replace reserves as countries are becoming more nationalistic about their natural resources.