Importance of Oil and The Crucial Role it Plays
This is the part of the note on the importance of oil and the crucial (and somewhat under-appreciated) role it has played in human development over the last two hundred years. This week we cover the role of U.S. fracking, the link between productivity and the price of oil and finally a forecast on future oil prices based on Jeremy Grantham’s quarterly note as well as a recent article by the economist Anatole Kaletsky. To summarise:
-The development of U.S. fracking has been remarkable, demonstrating the advantage of the American approach to engineering – a rapid trial and error risk-taking approach - but also highlighting the strong influence which the energy industry has over the U.S. government, with the latter deregulating such a rapidly growing and potentially dangerous activity. There are few constraints on what chemicals go into a fracking well and on the emission of methane, which is 86 times more potent as a greenhouse gas than CO2. This has given the U.S. fracking industry a huge advantage over other more regulated parts of the world.
-U.S. fracking has produced, in addition to lots of natural gas, about 4 million barrels per day of additional oil which is close to 100% of the increase in global oil production over the last eight years, without which oil prices would have been significantly higher. Remarkably, U.S. fracking continues to produce more oil and it should rise by another two to three million barrels per day before peaking. U.S. production is creating a temporary surplus of oil as global growth has slowed, resulting in increased storage and lower oil prices thereby providing a short-term boost to the U.S. economy relative to other economies.
-However, U.S. fracking is a red herring as it does nothing to change the fundamentals in the long run, as the costs of extracting traditional oil continue to go up and the major oil producing nations like Saudi Arabia, Russia and Venezuela continue to get squeezed. In addition, the fracking industry as a whole does not show much positive cash-flow, which is surprising given that the best parts of the best fields are drilled first and most of the oil flows out in the first two years, indicating that the costs have been underestimated by the industry.
-Given that fracking reserves run-off in two years, and are exploited very quickly, the reserves should be viewed more like oil storage reserves rather than a traditional oil field which yields for 30 to 60 years. We have been exploiting very quickly, what should be an emergency reserve, and may eventually regret not having such a reserve which can be drawn on quickly.
-By contrast, traditional oil has become increasingly more difficult and expensive to find – despite spending $700 billion globally last year (up from $250 billion in 2005) – the global oil industry found just 4 1/2 months of current production which is a 50-year low. This is likely to continue to put pressure on resource prices over the long run.
-This will continue to put downward pressure on global growth, with is unlikely to exceed 3.5% with the developed world growing at 1.5%, and the risk being more on the downside. While hard to prove, oil at over $40 per barrel since 2006 is likely to have been the main cause for the drag on global rather than the $150 (’08) or the $115 (more recently) oil spikes. This is likely to continue unless alternative energy provides cheap oil (below $50 per barrel on a sustainable basis).
-Looking at the impact of oil on productivity (see graph below), in 1940 the hourly U.S. manufacturing wage level could buy 20% of a barrel of oil (approximately 8 gallons), and as we saw last week, a gallon of oil is equivalent to about 200 to 300 man hours of labour, this equates to a significant economic surplus.
-This was then surpassed substantially in the ensuing years until 1972, by when an hour’s work controlled 1.1 barrels – a five-fold increase since 1940 – creating the greatest increase in real wealth in U.S. history.
-However by 1979, following the second oil shock, oil affordability reached a new low after which it rose erratically driven primarily by falling oil prices, eventually reaching an astonishing high in oil affordability of 1.2 barrels at a oil price of $16 per barrel (in today’s prices). Since then until today, oil affordability has declined right back to the level prevailing in 1940 – a remarkable round trip.
-This has had a significant impact on productivity, with the period until 1972 evidencing productivity growth of an unprecedented 3.1% per annum driven by increasing oil affordability and intensity usage per person. Since then, with falling oil affordability and usage per person, productivity has fallen to 1.1% a year which is a very large decline over time ($1 compounded over 100 years at 3.1% is $21 versus $3 if compounded at 1.1%). Productivity since 2000 has fallen even further to 0.80%.
-Oil prices in the long are dependent on the cost of producing oil (which continues to rise), but this is relationship can break down in the short-run due to a temporary supply/demand imbalance (as is the case now). Rising oil prices reduce economic growth as more capital is used per unit of oil discovered, thereby limiting capital for other economic opportunities. Temporary falls in oil prices have a limited impact on the whole economy over time as they merely shift income from oil producers to consumers of oil, in a largely zero-sum game, even though in the short-term it can provide a boost as oil consumers tend to spend more and save less than oil companies. But reduced profits at oil companies forces them to cut back on investment and expenditures, thereby reducing future oil production leading to higher prices.
-Partially offsetting the rising cost of oil, is the accelerating progress in oil replacement technologies which includes areas such as rapid recharge batteries, improvements in the cost and efficiency of large-scale energy storage, and progress in self-driving vehicles. It is expected that in 10 to 15 years the reliance on the gasoline engine will be significantly lowered (with China leading the way), paving the way for removing oil demand for surface transportation – leaving chemical feedstock, air and sea transportation and road surfacing which will take many more decades to replace.
-So on one hand we have the steady long term rising cost of extracting and delivering oil which is reducing economic growth, and on the other the accelerating progress in developing technologies to utilize alternative energy sources. Add to this the temporary impact of oil from U.S. fracking, and what we have is a very complicated picture for forecasting oil over the longer term.
-Hazarding a best guess, he expects oil to be volatile around a level of around the level of $70-80 (the marginal cost of oil extraction) over the next 10 to 15 years (as the two factors described work against each other), with one or more 2008-type spikes in oil prices, followed by a plateau and then a decline as oil’s remaining uses are replaced.
-Brilliant research, providing fascinating insights into the key role that oil has played in producing a significant economic surplus over the last two hundred years, underpinning development in a wide variety of areas including science and engineering (part 1). Part 2 addresses some widespread misconceptions about the role of U.S. fracking, and making a convincing case that this is likely to be only a temporary phenomenon, and that the continuing rapid development of new technologies to replace demand for oil with alternative energy sources will hold the key to an eventual decline in oil prices.
-Regarding forecasting oil prices, his view that they bounce around the marginal cost of extraction seems reasonable, and the potential for a spike in oil prices remains as the impact of U.S. fracking tapers off and growth in China, India and other emerging markets stabilizes. While growth in China will be lower going forward, as its economy matures and transportation plays a larger role in the economy, its demand for oil will continue to increase.
-An alternative view on the future for oil prices has been recently suggested by Anatole Kaletsy, economist and financial writer, arguing that the real price of oil is likely to stay in a range of $20 to $50 going forward. His rationale is based on the argument that the oil market has gone through three different pricing eras since the formation of OPEC in 1974 (see graph below):
-from ’74 until ’85 the price of oil (in today’s money) fluctuated between $50 and $120.
-from ’86 until ’04 the real price of oil fluctuated between $20 and $50 (with two brief spikes).
-from ’05 until ’14 the real price of oil fluctuated between $50-$120 (also with two brief spikes).
-The first era was marked by monopolistic pricing by OPEC/Saudi Arabia, while the second era featured the breakdown of OPEC and competitive market pricing following North Sea and Alaskan oil development. The third era from ’04 until ’14 was marked by the rapid rise in demand from China, creating a shortfall in supply, thereby allowing OPEC to reassert its monopolistic pricing power.
-The fourth era has started recently with Saudi Arabia relinquishing its role of being the “swing producer” in the face of increased competition from U.S. shale oil, with the objective of preserving its status as the dominant oil producer by allowing oil prices to drop to a level which forces a drastic reduction in U.S. shale oil production. Going forward real oil prices are likely to stay in a range of $20 (the marginal cost of conventional oil fields) and $50 ( the cost for most shale fields), with shale oil producers shutting-down or ramping-up production in response to changes in the global demand/supply conditions.
-Interesting view-point, but I find Grantham’s case for oil prices being volatile around a $70/80 price range to be more persuasive based on a more plausible estimate of the current marginal cost of tight oil production, and the tendency for the occasional spikes to continue as the production of shale oil wanes. The other key input to monitor is the 5-year forward price of oil as suggested by Jim O’Neill (the former chief economist of Goldman) because it is less affected by temporary shortfalls and gluts in oil production, which remains at around $68.
Happy Investing
Source : Internet
