HERE COMES $75 OIL / BARRON´S COVER

Barron's Cover

SATURDAY, MARCH 29, 2014

Here Comes $75 Oil

By GENE EPSTEIN

Lower energy costs will have a salutary effect on the U.S. economy. Not so Russia, where oil provides 50% of government income.

The long-term outlook for global oil prices is lower, perhaps much lower, giving a strong boost to the U.S. economy while potentially crippling the economy of Vladimir Putin's Russia. Vast new discoveries of oil and natural gas in the U.S. and around the globe could drive the oil price to as low as $75 a barrel over the next five years from a current $100.

The demand side, too, will put pressure on the supremacy of petroleum. For the first time in its 150-year history, the internal combustion engine can be run efficiently on alternative fuels from a number of sources, including natural gas. As these alternatives are increasingly introduced, global consumption of oil will slow its growth and flatten out.

Citigroup's head of global commodity research, Edward Morse, believes the combination of flattening consumption and rising production should mean that "the $90-a-barrel floor on the world oil price over the past few years will become a $90 ceiling." Within a new trading range with a $90 ceiling, Morse sees an average of $75 as plausible.

That's a far cry from the old paradigm, promoted in the past 40 years, which posited ever-greater demand for petroleum as developing economies grew, and a slowdown on the supply side -- the looming prospect of "peak oil," whereby global production maxes out and falls into decline. To the contrary, unconventional sources of crude oil totaling more than a trillion barrels -- the equivalent of more than 30 years of extra supply -- have been discovered in the past five years. The majority is recoverable at $75 or less, and much is now being tapped.

Within the next five years, growth in U.S. production of oil should make this country a net exporter, ending a pattern that has persisted since World War II. "While this country will still be importing plenty of medium and heavy crudes, most of the imports will come from Canada and Mexico," says Morse. "So the U.S. will no longer have to worry about disruptions in supply that might disrupt economic activity. That's why we call it the era of North American energy independence."

British economist Alfred Marshall famously likened supply and demand to the blades of scissors, and the blades are also poised to cut oil prices in the rest of the world. On the supply side, unconventional sources of oil are being tapped in countries that include India, Bahrain, and Uganda. On the demand side, a third of the auto fleet in Brazil can already run on fuel other than petroleum.

THE RECENT AGGRESSION by the oil-and-gas exporting nation of Russia reminds us of the fragility of global energy supplies. At the same time, the oil-and-gas abundance in this country has influenced concrete proposals for dealing with Russia. Energy consultant Philip Verleger has publicly proposed as a "meaningful response to Russian aggression" that the U.S. sell the nearly 700 million barrels in its Strategic Petroleum Reserve as a way to "drive oil prices down and impose significant harm on Russia," since the SPR is "no longer needed for national security." And an editorial in The Wall Street Journal recently proposed that the Department of Energy "approve immediately the 25 applications for liquefied natural gas…export terminals," since "every dollar of U.S. gas is one less dollar flowing to Mr. Putin's economy."

Such proposals would have been unthinkable as recently as five years ago, when the old paradigm was still dominant and domestic supplies of oil and gas were a source of worry.

Over the next five years, the effects of the global oil-and-gas boom should prove a grim object lesson for the Russian economy on the downside of the "resource curse." Russia's economy "largely depends on energy exports," according to a study from the U.S. Energy Information Administration. That works well when prices are high, but quite badly when prices fall.

Oil-and-gas revenues account for 70% of Russia's total exports and more than half the income of its federal government. Russia exports more than seven million barrels of oil a day, second only to Saudi Arabia. One key difference between Russia and the No. 1 exporter is that more than 60% of Russian oil is produced in Siberia, where costs are much higher. A fall in the world price to $75 from $100 would therefore have a much greater impact on the net revenues that Russia earns from oil than is earned by the Saudis.

The downside of the resource curse could also be felt in Russia's reliance on sales of natural gas. About 75% of Russia's natural gas exports go to Western Europe, providing 30% of its requirements, at prices that are two and three times the price in the U.S. That enormous premium stems from the fact that there is no world market for natural gas, given the prohibitive cost of shipping it in its unaltered state. Hence, the argument for accelerated approval of liquefied-natural-gas export terminals. With abundant natural gas now available in so much of the world -- including Australia, South Africa, Brazil, and Argentina -- within the next five years, something resembling a global market in liquefied natural gas will likely develop. That would break the local monopoly of the Russians in their market, enabling Europeans to buy from other sources, and weighing on the premium Russian gas now commands.

AMY JAFFE, EXECUTIVE DIRECTOR for energy and sustainability at the University of California, Davis, co-authored a recent study with Rice University economics professor Mahmoud El-Gamal predicting that barring a "war that destroys physical installations for the production and/or transport of oil," the oil price will "fall precipitously over the medium term of three to five years."

Jaffe believes the average price could fall below $75, based in part on her view that oil-production costs are not fixed. "Research shows that costs track oil prices and not the other way around," she observes. As oil prices move lower, demand for drilling rigs and related equipment falls, lowering the cost of drilling. And that's bad news for Putin.

"The Russian government's budget is expected to need an oil price of over $100 to stay balanced between now and 2020," Jaffe says. "A $75 average could make the ruble's recent tailspin look trivial by comparison."

Steve Briese, publisher and writer of the Bullish Review of Commodity Insiders newsletter, is currently projecting an imminent plunge in the oil price to the $70 region. His bearish outlook is based on the recent peak in the net short position of businesses involved with oil. These businesses, also called "commercials," use futures and options on West Texas Intermediate crude traded on the New York Mercantile Exchange as part of their business strategy.

The futures and options market in WTI crude is actively used by refiners that would naturally take long positions in these derivative contracts to hedge against a price rise, and producers who would naturally take short positions in order to hedge against a price decline. The fact that the net short position of these commercials recently set a record indicates that refineries are lightening up on their long positions. While this leaves them exposed to a price rise, it also means they will benefit if the price declines.

Briese uses published data from the Commodity Futures Trading Commission to track the bets of these bona fide hedgers with an eye to betting accordingly. In his view, since they are in the oil business and therefore close to the scene, they are the true insiders, whose consensus outlook is better than anyone else's. Perhaps these insiders recognize that the new paradigm is here to stay.

THE GAME CHANGERS on the supply side are the three new types of oil production that have not been counted as part of the oil supply until recently: deepwater oil, shale oil, and oil sands. Each of these sources of oil has been estimated at more than 300 billion barrels, totaling more than one trillion barrels in all. That's a huge addition to previously estimated reserves of some 1.5 trillion barrels. According to Citigroup energy analyst Eric Lee, a good proportion of the extra trillion barrels could be recoverable at $75 a barrel or less. In fact, he notes that a $75 cost estimate could even be on the high side, as production costs for shale and even deepwater can continue to fall over time.

Deepwater oil has been tallied at 317 billion barrels by the Norway-based oil-and-gas source Rystad Energy. Of that total, Rystad estimates that 53 billion barrels are recoverable off the shores of North America.

What slowed development of deepwater drilling was the 2010 disaster in the Gulf of Mexico involving BP (ticker: BP), which killed 11 people and spilled millions of barrels of oil. But two weeks ago, the Environmental Protection Agency lifted the ban on BP's right to bid on oil leases in the Gulf of Mexico. A few days later, BP bid successfully on 24 leases in the Gulf in an auction held in New Orleans. Elsewhere, activity had already picked up in regions that include East Africa (63 billion barrels) and the Asia-Pacific region (32 billion barrels).

Shale oil, recoverable mainly through hydraulic fracturing, or fracking, has been estimated by the U.S. Energy Information Administration at 345 billion barrels, of which 58 billion barrels are recoverable in the U.S. The EIA report of June 2013 estimates that the 310-million-barrel increase in U.S. oil production in 2012 over 2011 was "largely attributable to increased production from shales and other tight sources."

Oil sands, according to the BP Statistical Review, are found in just two countries: Canada, at 167.8 billion barrels, and Venezuela, at 220 billion. In the oil-sands case, it is not clear whether production would continue with $75 oil. But as Citigroup's Morse points out, "While current investors might be discouraged by $75, other companies would be open to investing, including state-owned companies in the Far East, since the cash flow would be robust for 40 years or so." Investors with a 40-year outlook might not be deterred by a $75 average price if they are bullish on a long-term basis.

Meanwhile, at current prices, the BP Statistical Review reveals 25.9 billion barrels of Canadian oil sands as "under active development."

On the demand side, petroleum's monopoly of the transportation market is being challenged by abundant natural gas recoverable from shale. According to estimates by Advanced Resources International, an energy consulting firm that compiles data in conjunction with the EIA, shale-gas resources in the U.S. amount to a staggering 1,161 trillion cubic feet, compared with 285 trillion cubic feet in Russia, and a world total of 7,795 trillion cubic feet. On a British-thermal-units basis, 7,795 trillion cubic feet of natural gas is the equivalent of 1.4 trillion barrels of crude oil.


AS THE NEARBY CHART SHOWS, domestic oil and natural-gas prices used to track each other fairly closely. The reason for the correlation: Oil drilling invariably produces natural gas as a byproduct. By 2009, however, the correlation began to break down, with natural-gas prices moving to a steep discount to oil prices, as gas production soared. A barrel of oil contains the energy-equivalent of some 5.55 million BTUs. At the current natural-gas spot price of $4.30 per million BTUs, a barrel at $75 buys nearly 17.5 million BTUs-worth of natural gas -- more than three times as much.

This multiple is already being exploited. In a major study, Citigroup's Morse, together with a team of other analysts, has calculated that there is huge potential for savings if trucks, buses, ships, and ultimately passenger vehicles are run with natural gas rather than petroleum fuels. The study also notes that the conversion is well under way. Waste Management (WM) has made it known that 80% of the trucks it buys are fueled by cheaper natural gas. Cummins (CMI) and joint-venture partner Westport Innovations (WPRT) sell an engine that runs on both liquid natural gas and compressed natural gas. Westport Innovations specializes in retrofitting engines with natural-gas components.
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According to the Citigroup study, the low-hanging fruit lies in commercial fleets setting up refueling stations along routes of 400 miles or less. In the U.S., that includes heavily trafficked routes in the Northeast and in Southern California. Intracity traffic that includes passenger buses and other short-haul vehicles can also shift to natural gas.

Transportation accounts for nearly half of the oil the world consumes each year, and trucks alone use nearly one of every nine barrels consumed. Also ripe for natural-gas substitution is the consumption of oil for industrial uses -- accounting for more than one in five barrels consumed -- and for electricity generation, which still accounts for one in 18 barrels consumed worldwide. Moreover, when mixed with petroleum, fuels that can be made from natural gas, like ethanol and methanol, can help meet ever-more-stringent Corporate Average Fuel Economy, or CAFE standards, being mandated over the next several years.

Taken together, these trends should be more than enough to cause global consumption of oil to slow its growth over the next several years and then flatten out. There is even the potential for global oil demand to begin declining. Yossie Hollander, co-founder of the Fuel Freedom Foundation, a nonprofit dedicated to breaking the world's oil addiction, argues that passenger vehicles can run economically on methanol and ethanol made from various sources, including natural gas.

"Methanol can be made today competitively with existing technology, from energy resources with which the United States is well endowed -- natural gas, coal, biomass, garbage, or any other organic material," Gal Luft, an advisor to the Fuel Freedom Foundation, argues in Petropoly, co-authored by Anne Korin. "In the future, perhaps even recycled carbon dioxide could be commercially converted into methanol, providing an elegant solution to the otherwise seemingly economically irresolvable issue of fossil-fuels-derived greenhouse-gas emissions."

THE OIL AND GAS BOOM is not welcome to environmentalists, although it should be. The replacement of coal with natural gas for electricity generation has reduced carbon-dioxide emissions, and emissions of sulfur dioxide and nitrogen oxides fall as natural gas replaces petroleum. Also, lower energy prices confer disproportionate benefits on people of modest means, who spend a larger share of their income on energy than do richer folk.

But the dangers of deepwater drilling and of fracking, and the use of fossil fuels for decades to come, are already provoking pushback from the greens. In the end, however, as Trevor Houser of the Peterson Institute remarks, "Provided that industry accepts reasonable levels of regulatory oversight, the oil-and-gas boom is unlikely to be stopped by environmentalists."

"The history of mankind," observes Morse, "at least since the invention of the wheel, is a history of cheaper and cheaper energy. Modern civilization would be impossible without cheap energy. I believe we are entering another period of cheaper energy that should last 50 years or more."