The New Economics of Oil
What if everything you thought you knew about oil was wrong? That is the idea behind the paper published last week by Spencer Dale, BP’s Chief Economist.
New Economics of Oil takes the key principles and beliefs we think underpin the operation of the oil market and reveals their underlying flaws. Dale lays down what he considers to be the market’s new basic assumptions, which allow some sense to be made of the current turmoil.
Our understanding of the oil market relies on four basic principles which are taken as a given in the oil industry. We believe oil is an exhaustible resource, that the commodity is extremely price inelastic, that oil flows from east to west, and that OPEC serves as a market stabilizer. As is evident from the current state of the industry, this approach is no longer valid, and we should consequently update the set of principles with which we regard the market.
Various factors contribute to the need for a new industry analysis toolkit. The most significant change stems from the US shale revolution, which can in part be held responsible for last year’s collapse in oil prices. Shale oil has an attractive production cost compared to deepwater and oil sands, with most estimates placing it in the middle of the aggregate cost curve, as can be seen below. The second major change comes from growing concerns surrounding climate change. Although the latter does not impact the industry in as dramatic a way as shale oil does, its effect is slow but sure. The worries are not new, but their prominence is, with all major economies seeking to curb carbon emissions, and implementing measures to this effect.
To illustrate what he means by the “New Economics of Oil”, Dale revisits the four basic principles and explains how recent developments affect them.
When claiming that oil is an exhaustible resource, we are effectively using Hotelling’s law to analyze the situation, which assumes that the price of oil will increase over time, relative to the price of other commodities. The problem with this approach is that this law does not allow for the possibility of new discoveries or for uncertainty when it comes to the volumes that can be extracted from a particular reservoir. Hotelling assumes we know the total stock of recoverable oil resources, but the reality is that total proved reserves of oil are almost two-and-a-half times greater today than in 1980. For each barrel of oil consumed, two have been discovered. Be that as it may, Dale believes that environmental concerns may never allow us to find out the volume of oil our planet holds. In other words, and according to the author, there is no reason to believe that the relative price of oil will increase over time. It now follows the same rule as most other commodities, obeying the laws of supply and demand. While the global economic slowdown led by China is decreasing demand, shale oil has removed all supply difficulties from the agenda.
Let us now consider the steepness of oil supply curves. The limited responsiveness of conventional oil supply to price fluctuations comes from the time lag between investment decisions and production. Shale oil has a much shorter time to production, as the same rigs and processes can be used to drill various wells in similar locations. The time lag is measured in weeks, not years. In addition to this, shale wells also have a starker production decline rate than conventional wells, meaning investment and production are much more closely linked than previously. This, combined with low-fixed costs means that production could decrease if demand dropped, limiting exposure to fluctuations in oil prices. Dale expects oil to be more responsive to demand variations than previously.
Another common belief is that oil flows from East to West. Once again, the traditional pattern is changing. There are two things to consider when it comes to the West. First of all, demand for oil is falling. It reached its peak in Europe and the US about ten years ago, and has been decreasing ever since. Consumption in the US now stands at US$18 million b/d, down almost US$3 million b/d from 2005. In a large part, this decrease is because of tightening regulations and improvements in technology. BP’s Energy Outlook 2035 expects that oil consumption in 2035 will return to levels last seen in the late 60s, even though GDP will have quadrupled. The second factor relates to the oil flow direction. Over the past decade, North America has become a major player among global energy suppliers, with US oil imports dropping dramatically as a consequence of domestic shale oil production. The East is also experiencing changes, particularly in the growth levels of its major economies. China and India are ever more dependent on imported energy, as can be seen below, and are expected to account for nearly 60% of the global increase in oil demand over the next 20 years. This change of pattern in energy flows also has far-reaching implications for energy markets, financial markets, and geopolitics, a fact which Dale considers in depth.
Finally, the paper focuses on OPEC’s role as a market stabilizer. Many commentators believe the organization has lost all power to act as a price stabilizer. Dale, however, disagrees with this approach, and argues that the role of OPEC has not fundamentally changed over the past 20-30 years. He claims that the belief that OPEC would always stabilize the market was never correct. The organization’s power comes from its ability to alter supply, increasing it or decreasing it from one period to another, as a response to shocks or fluctuations. It has the power to stabilize the market in response to temporary shocks. In truth, OPEC succeeded in stabilizing the market during the 2008-2009 great recession, the Arab Spring, and the Asian financial crisis. Although the organization can still tackle temporary changes, as it accounts 40% of crude oil production, shale oil poses a challenge. It reflects a change in the industry structure, and not a temporary bump. Just like OPEC could not do anything if suddenly our entire car fleet was replaced with electric cars, its power in relation to shale oil is very limited. In the current climate, OPEC does not have many other viable options than the one they have adopted: maintaining the 30.1Mb/d production target. It is not to say that the market is left unregulated. OPEC still plays a prominent role, and the greater responsiveness of US shale oil will also help stabilize the market.
This new toolkit to analyze the oil and gas industry should help make sense of what is currently happening, and help predict future trends. From now on, we should expect the supply and demand relation of oil and its impact on price to behave in a similar way to other commodities, in addition to oil prices being more responsive to demand. We should also prepare for major changes in the global oil flows and financial markets, and stop expecting OPEC to make the market return to earlier conditions. The new economics of oil are in place.
What does this mean for Mexico? According to Dale’s analysis, the country’s best option would be to invest in shallow waters and onshore fields, both of which have a price below US$30 per barrel, and are thus profitable in the current environment. Shallow water fields were tendered in Round One L-02, while onshore fields, comprising Chicontepec’s tight oil, are part of the imminent third phase. In spite of considerable initial investment requirements, Mexico could also reconsider the freezing of the phase tendering unconventional blocks. Shale oil production is here to stay, with US production levels expected to rise by 650,000b/d next year. Moreover, it will be interesting to see how attractive Round One L-04 turns out to be, given the current climate.