The Drop in Oil Prices Signifies a Paradigm Change

April 30, 2015 Energy

In this post we will defend the idea that the drop in oil prices is not due to an increase in supply, but rather to 9 years of stagflation resulting in a decrease in the market. The drop in oil prices signifies that we have entered the contraction phase of oil production: a paradigm change.

We begin by recalling some data and literature. Between 1998 and 2005 the price of oil doubled from its 20th century average and production rose by 14%. Between 2005 and 2013, prices doubled again and production rose by 3%. Steven Kopits has estimated the upstream capital costs between 2005 and 2012 to have been about 130% greater than the capital costs between 1998 and 2005. We thus put the beginning of the stagflation phase of oil production to be 2005. The increase in price of oil was predicted in 1998 by Campbell and Laherrère [2] when they correctly predicted a peak in conventional oil production in 2005-6, and thus the end of cheap oil. Campbell and Laherrère founded the Association for the Study of Peak Oil and Gas (ASPO) in 2002. ASPO gave rise to Uppsala Global Energy Systems (UGES) which has predicted a peak in global oil production excluding Light Tight Oil (LTO) between 2010 and 2014. Since LTO represented about 3.5% of global production in 2013, the UGES prediction is consistent with data through 2013. UGES predictions for future fossil fuel production are significantly lower than predictions made by organizations that governments and the International Panel on Climate Change (IPCC) use to make policy decisions such as the International Energy Agency (IEA) or the Energy Information Administration (EIA). We believe the drop in oil prices signals that the contraction phase of oil production has begun including LTO.

Empirically, peak production is often associated with low prices. For example peak U.S. production occurred in 1970 (when the U.S. was the worlds largest oil producer) at a local minimum in price. The U.S. attained a secondary peak just before the Soviet Union (then the worlds largest oil producer) achieved peak production in 1987, again during a local minimum in price. North Sea oil production peaked in 1998 just one year before a local minimum in price. This is quite natural. Oil production is characterized by an increasing decline rate. The greater the production, the greater the annual decline in production the greater the investment needed to prevent a decline in production. Low prices decrease investment in the oil sector allowing decline in production to exceed the amount of new production coming on line resulting in a decline in production.

Our first point is that oil production has not risen significantly during the stagflation phase. Jean Laherrère has repeatedly remarked that official production numbers are not accurate. There are no penalties for faulty reporting. The numbers are in fact estimates, and the means of estimating is often opaque. Official sources for oil production vary by as much as 3% at any given time.

Jeffrey Brown has pointed out that production of the most expensive oil on the market today by density (25-38 API) probably peaked in 2005. His point is that the new LTO production coming on line is much lighter oil (43 to 60 API). This cannot be affirmed with certainty because official numbers usually group crude oil (heavy oil) with condensate (much lighter hydrocarbons) but it is quite probable because without LTO, oil production is about what it was in 2005. What is clear is that an increase in LTO production cannot explain a decrease in the price of denser grades of oil because they do not compete in the same market. Blaming a decrease in the price of Brent on an increase in LTO production is like blaming a decrease in the price of potatoes on an over production of apples. Very little distillate can be produced from a barrel of LTO. Distillate is used to produce diesel and aircraft kerosene. It is for this reason that Matt Mushalik [5] noted that the increase in LTO production in the U.S. did not effect imports of heavy oil from the Middle East. Only imports of light oil decreased. An increase in LTO production can be blamed for the increase in spread between LTO and Brent. For example on April first, N. Dakota sweet was selling for $34 per barrel while WTI was selling for $46 per barrel.

The decrease in price in oil has been accompanied by a decrease in price of all commodities. For example the price of Australian coal was down 40% in late 2014 from the price in 2011. The decrease in the price of oil is too broadly based to be attributed to any possible increase in oil production.

Our second point is that stagflation, or historically high prices with stagnant production decreases the market for oil over time. It is well known that oil is relatively inelastic with respect to short term changes in prices. Empirically we see that the oil market becomes more elastic over longer periods. For example even though the U.S. did not sign the Kyoto protocol and increased oil production by about 40% between 2005 and 2013, according to BP, U.S. oil consumption peaked in 2005 and was about 10% below the peak in 2013. Oil is inelastic short term because people who use oil to work have few choices when the price of oil rises. However over longer periods, people can make choices that reduce the market for oil: they can insulate their homes, they can substitute energy sources when the time comes to upgrade capital, they can organize ride sharing, etc. These are proactive ways of decreasing the market for oil. But there is also the simple effect of stagflation. Indeed a salient characteristic of stagflation is low wages resulting in increased wealth inequality [8,6]. This diminishes the market for oil because median income declines relative to a constant high price of oil lowering standards of living.

In view of the effects of stagflation on the economy, the surprise was that oil prices stayed persistently high in the face of shrinking demand in the U.S., Europe, and Eurasia. The reason is of course that demand in China and India increased to take up the slack. The current drop in price is a signal that stagflation has at last reduced demand in China and India. If our analysis is correct, the price of oil will stay at present levels until supply contracts by something on the order of 4%.

Since November 2014, the price of oil is below production costs for a large proportion of LTO producers [1,4]. Note that this price is the same price that stimulated a sharp increase in capital spending in the oil industry in 2005, so what was considered a high price 10 years ago is now considered a low glut price. When oil production is unregulated, oil producers tend to over produce, that is they tend to invest in production until the market price for oil falls below a significant proportion of production cost causing business cycles that were deemed detrimental to both consumers and producers. For this reason in the 1930's the Texas Railroad Commission was given the authority to impose quotas on oil producers preventing them from overproducing to the approbation of both oil consumers and producers. In the 1970's the role of the Texas Railroad Commission was assumed by OPEC. In November 2014, Saudi Arabia declined to reduce production to defend prices. It is at this point that prices fell dramatically, and today oil producers are in an unregulated environment. The IEA's Medium Term Oil Market Report 2015 published in February suggests that producers of LTO (produced via hydraulic fracturing or ``fracking'') are poised to become the new swing producer. The reasoning for this conclusion is that LTO production is expensive, investment cycles for LTO production are short compared to other methods of oil production (6 months versus as much as a decade for deep water production), and LTO production has very high decline rates. Thus LTO producers should be able to ramp production up and down quickly. This reasoning is flawed.

Even with high oil prices, LTO producers have never generated any free cash flow [1,4]. LTO producers have optimized capital inflows and production increases rather than profits. SEC rules do not stipulate evaluating the value of producing assets. An oil well that produces a given volume of oil per year is an asset that produces the value of that volume of oil. The value of a non producing asset is evaluated by the amount of oil it is expected to produce minus the cost of producing that oil. The expected price of oil is estimated using the average value of oil over the preceding 12 month period. Assets are reevaluated in April and October of each year. The simplest way to hide the fact that a non producing asset is marginally profitable, or unprofitable on a balance sheet is to transform it into a producing asset. Because of the high decline rates of LTO wells (half of total production occurs during the first two years of production), to maintain the illusion of highly profitable assets, LTO producers increased production exponentially to always have a large percentage of new wells in the asset mix.

The optimal strategy for LTO producers would be to halt investment until production fell enough for the operations to become profitable. LTO producers do not have the luxury to implement this strategy because they have debt to service so they must prioritize cash flow even at a loss. LTO producers have reacted to low oil prices by cutting capital spending by 30-40%, cutting costs, and issuing as many new shares as possible before the April reassessment of asset values. With a smaller percentage of new wells and 6 months of oil prices below production prices, the balance sheets of these companies will be less alluring than in the past. As a consequence, their revolving credit will be diminished and investment will continue to be depressed. The proceeds from new issues will be used to service debt and increase cash flow. LTO producers also face growing headwinds for environmental reasons from organizations like Americans Against Fracking. Fracking was banned recently in Brenton, Texas. Growing water scarcity is also a difficulty in ramping up LTO production. The first companies to suffer from low oil prices are oil service companies. In our view, unless prices rise significantly, LTO companies will attract short sellers attentions by November 2015.

In 2005, global decline rates were estimated at approximately 6% per year. In 2013, the EIA estimated global decline rates at 9% per year. With increasing decline rates and decreasing investment, eventually production will fall enough for LTO to become profitable. The longer this takes, the less able the LTO producers will be to increase production. Creditors will demand the return of their capital before production is ramped up. Therefore LTO producers will be very slow moving swing producers and we can expect volatility in the oil market in the coming years.

Globally, the costs of oil producers continue to rise. Debt among oil producers as increased to the point that some fear repercussions throughout the financial sector [3]. During the expansion phase of oil production, high prices caused increases in production and low prices caused increases in the market for oil. During the contraction phase, high prices will cause the market to contract and low prices will cause production to contract. It is for this reason that peak oil is a low price problem, not a high priced problem.

This change of paradigm is of course excellent news for climate change. Note that 2014 was the first year since the start of the industrial revolution in which carbon dioxide emissions did not increase according to the IEA. Whether or not the paradigm change is good or bad for the economy depends to a large extent on how long it takes for people to recognize the change in paradigm. The city of Güssing, Austria which switched entirely to renewable energy in 2001 will be insulated from the coming turbulence in the oil markets. Transition towns that are becoming less dependent on fossil fuels will also be insulated. Funds currently pouring money into the oil sector will probably be disappointed. The best way to halt global warming is to join the transition mouvment reducing the market for fossil fuels. Joining the movement will also provide the best return on capital.