Stranded Assets

Leonardo Maugeri is gloating these days, having warned over the last few years of the possibility that the massive increases in oil supply capacity “could lead to a glut of overproduction and a steep dip in oil prices” ("The Oil Crash: Why I Was Right," October 21, 2014). Maugeri, a former executive at the Italian oil company Eni and now a researcher at Harvard, detailed in his 2012 study, “Oil: The Next Revolution,” the huge increases in investments that were occurring worldwide:

From 2003 on, oil exploration and production (E and P) worldwide entered a new, impressive investment cycle, encouraged by ever increasing crude oil prices, private companies’ desperate need to replace their reserves, the re-emergence of Iraq as a major oil player, and the inaccurate but still widespread perception that oil is bound to become a rare commodity.

That cycle reached the status of a boom between in 2010 and 2011, when the oil industry invested more than $1 trillion worldwide to explore and develop new resources. According to Barclays’ Upstream Spending Review, 2012 might represent a new all-time record since the 1970s in terms of E&P investments, with a conservative estimate of slightly less than $600 billion. . . .

My field-by-field analysis suggests that worldwide, an additional unrestricted supply of slightly less than 50 mbd is under development or will be developed by 2020. Eleven countries show a potential outflow of new production of about 40.5 mbd, or about 80 percent of the total. After adjusting the world’s additional unrestricted production for taking into account risk-factors, the additional adjusted supply comes to 28.6 mbd , or 22.5 mbd for the first eleven countries – as shown in Figure 3.

 

Maugeri’s main conclusion was as follows (italics in original):

[T]he single most important issue that emerges from my analysis is that, from a purely physical and technical point of view, oil supply and capacity are not in any danger. On the contrary, they could significantly exceed world consumption needs and even lead to a phase of oil overproduction if oil demand does not exceed a compounded rate of growth of 1.6 percent each year to 2020.

 

More recently (October 21, 2014), he writes:

After a cycle of strong investments in oil and gas exploration and development started in 2003, since 2010 an investment super-cycle took shape: over four years, national and international oil companies spent more than 2,500 billion dollars just in the ‘upstream’ hydrocarbons sector (oil and gas exploration and production).

That was an absolute historical record for the sector, even in the presence of a specific inflationary pressure which more than doubled upstream costs in the course of a decade. Much of that investment has produced, or will produce, results with a considerable time-lag, since in the oil industry it takes years to bring a given field to production.

The result is that new production capacity, or simple resilient capacity from mature fields, is progressively made available just while oil demand remains weak due to a still gloomy economic outlook – and will continue to do so. Other factors contribute to worsen the situation. . . .[T]he overall effect . . . is that global oil production capacity has been growing too rapidly – and still does: It has already exceeded 100 mbd (including biofuels and natural gas liquids), whereas demand is hovering around 92-93 mbd.

In an essay at The National Interest  (“Frack to the Future”), published in March-April 2014, Maugeri insisted that the shale-oil boom was transformational and not a temporary bubble: “Even with a steady decline of crude-oil prices (for example, from $85 a barrel in 2013 to $65 a barrel in 2017), the United States could be producing 5 million barrels per day (MBD) of shale oil by 2017.” Taking together output of biofuels and natural gas liquids, “the United States could become the leading oil producer in the world by the end of 2017, with an overall oil production of about 16 MBD and a sheer crude-oil production of 10.4 MBD.” [The difference between "overall" and "sheer" presumably is made up by biofuels and natural gas liquids.] Shale oil requires intensive drilling. Maugeri notes that there were 45,468 wells completed in the United States in 2012, whereas the rest of the world (excluding Canada) only completed 3,921 wells. Given the long time required to build people-expertise and equipment in other countries, plus the very different tax and subsurface ownership regimes, Maugeri doubted that the shale revolution would be exportable, or at least that much would have to change to make it so.

Despite these cornucopian forecasts, Maugeri noted how it all might unravel. He explained in The National Interest that Saudi Arabia is “the central bank” of world oil production. Its choice was either to cut back production to maintain prices (as it did in the early 1980s) or engineer a price collapse (as it did in 1986). We now have the results of that Saudi deliberation in its decision to maintain production, with the resulting collapse in prices. That scenario, Maugeri noted, “would put in danger both U.S. shale oil and the more expensive Canadian oil sands. The final result would be highly detrimental to U.S. energy security.”

Though Maugeri saw, as few others did, the growing imbalance between supply and demand and noted that the oil sector would be vulnerable to a collapse in prices, his 2012 analysis of worldwide additional supply seems not to have been predicated on that scenario. Having seen the future of low prices, he did not integrate that into his analysis of worldwide production increases. In his 2012 exploration of production in the Western Hemisphere, for example, he noted, "The growing output of Canadian tar sands, the huge ultra-heavy oil resources of the Venezuelan Orinoco Belt, and the recent discoveries of Brazil’s ultra-deep offshore pre-salt formations, are all pieces of the unconventional oil mosaic that, by 2020, could deliver more than 10 mbd from the Western Hemisphere alone." He ought to have said that much of this effort would be deeply uneconomic and would pose a risk to the financial viability of firms and oil exporting countries worldwide. What he was really describing in the figure and table reproduced above was not the future of world oil production but the vast number of stranded assets that were looming on the horizon, made uneconomic by oversupply.

Joseph Schumpeter noted somewhere in Capitalism, Socialism, and Democracy that one of the great oddities (and virtues) of capitalism is that most entrepreneurs work for free. That is, most businesses fail after their originators devote untold efforts to making them successful. Something like this has occurred in the energy industry. $2.5 trillion in investments in the four years from 2010 to 2014 have brought low prices for consumers and losses to the companies responsible for them. The outcome is astonishing. Digesting its significance will take years.

Unplanned Oil Production Outages

These two charts from the Energy Information Administration (December 2014) show unplanned disruptions to oil production for OPEC and non-OPEC countries. Looking at these charts alone, one would surmise an upward rather than downward pressure on prices. 

* * *

Energy Information Administration, Short Term Energy Outlook, December 2014

Breaking Even in Oil Country

The collapse of oil prices (from $107 in June to $55 in December) has raised a big question of which marginal producers will survive the coming austerity. The share prices of energy service firms and off-shore drillers have practically been annihilated, with falls of 80 percent not uncommon among the smaller firms. In assessing the geopolitical fallout, much depends on the cost of production, not an easy matter to determine. Herewith a series of charts attempting to shed light on that question.

The first is from an August 2014 study, “The Economic Impact of the Permian Basin’s Oil and Gas Industry,” produced by a team of researchers in the department of Petroleum Engineering at Texas Tech University. It estimates that average breakeven costs for shale plays have declined by 10 percent since early 2012 and now average $55 a barrel.

 

The Wall Street Journal took up the question in October, before the rout in prices. It notes that many exploration and production companies have already “sunk millions into buying land and securing licenses and access to infrastructure,” making the “real benchmark for drilling . . . the return from that point on.” It cites Paul Goydon, a partner at the Boston Consulting Group, who argues that “production in the three big shale basins—Bakken, Eagle Ford, and Permian—breaks even at $60 a barrel or less.” Two years ago, the break-even price was $75. Canada’s oil sands are much more expensive. Though projects already underway can keep operating in the short term with oil at $40 a barrel, new projects require a break-even price of nearly $90 a barrel. (Surely this will have an impact on the economics of the Keystone Pipeline.)

Another estimate prepared by Morgan Stanley appears to give breakeven prices for North American shale at a higher level than the Texas Tech experts. This chart, reproduced by Business Insider, should be compared with one produced a few years ago by the French oil major Total, which showed estimates for oil shale at over $100 a barrel, well above oil sands and Arctic exploration. The estimates plainly are something of a moving target. 

The following chart, also from Business Insider, is even better, showing the breakeven cost for every international oil company project through 2020. (The chart was taken from a presentation by Ed Morse, an oil economist for Citigroup.) This plainly shows that oil cannot stay at $55 a barrel indefinitely, that price being well below the breakeven for most international oil company projects.

One more chart from the New York Times reinforces the message from the foregoing. About 80% of planned oil projects would be uneconomical with prices at $60 a barrel. Notes the Times: "A recent study by Goldman Sachs estimates that many large new oil and gas projects being planned around the world will not be commercially viable with oil at $70 per barrel. 'The shale revolution is making $1 trillion worth of new oil projects potentially obsolete,' said Michele della Vigna, a London-based Goldman analyst. 'The industry needs to reduce costs by 30 percent to go ahead with these projects at the current oil price.'”

Given the severity of the price decline, one might surmise that oil production and consumption is badly out of whack. Estimated in news reports at 1 to 2 million barrels a day, the imbalance between production and consumption is barely noticeable in this chart from the Energy Information Administration. The EIA explains: "EIA estimates that global consumption grew by 1.3 million bbl/d in 2013, averaging 90.5 million bbl/d for the year. EIA expects global consumption to grow by 1.0 million bbl/d in 2014 and 0.9 million bbl/d in 2015. Projected global oil-consumption-weighted real gross domestic product (GDP), which increased by an estimated 2.7% in 2013, is projected to grow by 2.7% and 2.9% in 2014 and 2015, respectively."

The breakeven costs are also reviewed in a Goldman chart that is (wittily) annotated by Tom Randall of Bloomberg. Randall explains: "The chart below shows the break-even points for the top 400 new fields and how much future oil production they represent. Less than a third of projects are still profitable with oil at $70. If the unprofitable projects were scuttled, it would mean a loss of 7.5 million barrels per day of production in 2025, equivalent to 8 percent of current global demand."

Another chart in Randall's piece shows the impact of $75 oil on shale production. It's not clear what $55 oil would mean for the America's shale revolution, but the $75 level shows only a 40% drop in growth, not an absolute decline.

* * *

For links to several of these charts, a tip of the hat to Mr. Cain Thaler, "My Worst Day in Three Years," ibankcoin.com, November 28, 2014

The 2C Red Line

This piece by Justin Gillis of the New York Times is part of a series on the most recent climate negotiations in Lima, Peru. The result of the meeting was preliminary language intended to keep warming from rising more than 2 degrees Celsius (3.6 degrees Fahrenheit) beyond the average global temperature at the beginning of the Industrial Revolution. Gillis explores where that figure came from, noting its emergence in the 1970s in the work of Yale economist William Nordhaus and its endorsement in the 1990s by the German government, the latter among the most active governmental campaigners for action on climate change. Gillis emphasizes the importance of the figure in relation to the melting of the Greenland ice sheet, and notes that some scientists believe that it is already beginning to break up.

* * *

. . . A decade of subsequent research added scientific support to the notion that 2C was a dangerous threshold. Experts realized, for example, that at some increase in global temperature, the immense Greenland ice sheet would begin an unstoppable melt, raising the sea by as much as 23 feet over an unknown period. Their early calculations suggested that calamity would be unlikely as long as global warming did not exceed about 1.9 degrees Celsius.

 “Risking a loss of the whole Greenland ice sheet was considered a no-go area,” said Stefan Rahmstorf, head of earth system analysis at the Potsdam Institute for Climate Impact Research in Germany. “We are talking about really sinking a lot of coastal cities.”

As the economic and scientific arguments accumulated, the Germans managed to persuade other countries to adopt the 2C target, turning it into official European policy. The proposal was always controversial, with African countries and island states, in particular, arguing that it was too much warming and would condemn them to ruin. The island states cited the potential for a large rise of the sea, and African countries feared severe effects on food production, among other problems.

But as a practical matter, the 2C target seemed the most ambitious possible, since it would require virtually ending fossil fuel emissions within 30 to 40 years. At Cancun in 2010, climate delegates made 2C one of the organizing principles of negotiations.

The talks culminating in Paris next year are seen as perhaps the best chance ever to turn that pledge into meaningful emissions limits, in part because President Obama has gone far beyond his predecessors in committing the United States, the largest historical producer of greenhouse gases, to action. That, in turn, has lured China, the largest current producer, into making its first serious commitments.

Yet even as the 2C target has become a touchstone for the climate talks, scientific theory and real-world observations have begun to raise serious questions about whether the target is stringent enough.

For starters, the world has already warmed by almost one degree Celsius since the Industrial Revolution. That may sound modest, but as a global average, it is actually substantial. For any amount of global warming, the ocean, which covers 70 percent of the earth’s surface and absorbs considerable heat, will pull down the average. But the warming over land tends to be much greater, and the warming in some polar regions greater still.

The warming that has already occurred is causing enormous damage all over the planet, from dying forests to collapsing sea ice to savage heat waves to torrential rains. And scientists realize they may have underestimated the vulnerability of the ice sheets in Greenland and Antarctica.

Those ice sheets now appear to be in the early stages of breaking up. For instance, Greenland’s glaciers have lately been spitting icebergs into the sea at an accelerated pace, and scientific papers published this year warned that the melting in parts of Antarctica may already be unstoppable.

“The climate is now out of equilibrium with the ice sheets,” said Andrea Dutton, a geochemist at the University of Florida who studies global sea levels. “They are going to melt.”

That could ultimately mean 30 feet, or even more, of sea level rise, though scientists have no clear idea of how fast that could happen. They hope it would take thousands of years, but cannot rule out a faster rise that might overwhelm the ability of human society to adapt.

Given the consequences already evident, can the 2C target really be viewed as safe? Frightened by what they are seeing, some countries, especially the low-lying island states, have been pressing that question with fresh urgency lately.

So, even as the world’s climate policy diplomats work on a plan that incorporates the 2C goal, they have enlisted scientists in a major review of whether it is strict enough. Results are due this summer, and if the reviewers recommend a lower target, that could add a contentious dimension to the climate negotiations in Paris next year.

Barring a technological miracle, or a mobilization of society on a scale unprecedented in peacetime, it is not at all clear how a lower target could be met.

Some experts think a stricter target could even backfire. If 2C already seems hard to achieve, with the world on track for levels of warming far beyond that, setting a tighter limit might prompt political leaders to throw up their hands in frustration.

In practice, moreover, a tighter temperature limit would not alter the advice that scientists have been giving to politicians for decades about cutting emissions. Their recommendation is simple and blunt: Get going now.

“Dealing with this is a little bit like saving for retirement,” said Richard B. Alley, a climate scientist at Pennsylvania State University. “All delay is costly, but it helps whenever you start.”

* * *

Justin Gillis, “3.6 Degrees of Uncertainty,” The New York Times, December 15, 2014

 

China's Global Reach in Agriculture

This article by a Chinese diplomat, Loro Horta, details China’s growing turn to overseas farming. These excerpts are from Yale Global Online, December 16, 2014

* * *

China is home to 22 percent of the world’s population, but possesses around 7 percent of its arable land – 334.6 million hectares. However, in recent years the county’s arable land has been shrinking as a result of serious environmental damage such as soil erosion, deforestation and pollution of rivers and lakes. In November Chinese officials reported that more than 40 percent of China’s arable land is suffering from degradation.

The combination of rising food demand and reduced arable land makes it difficult for China to feed itself in the not so distant future. In the past decade China has experienced hikes in food prices and shortages of certain products.

China has no choice but to turn to overseas farming. In 2013 China imported 4 percent of the world’s grain and this figure is likely to rise in coming years.

Several Chinese government officials have also talked about the overseas option as a complement to strengthening domestic production. In 2010, Chinese Minister for Agriculture Han Changfu said, “The time is ripe for the country’s agricultural companies to embark on a go outward strategy.”

In recent years Chinese investment in overseas agriculture and land leases has steadily increased. Chinese companies began investing in neighboring Laos and Cambodia farmland in the early 2000s and slowly ventured further afield. Chinese-owned or jointly owned farms are in several African countries including Mozambique and Ethiopia.

In Mozambique, a Hubei-based company has invested $250 million in a rice farm in Gaza province. In November 2013 the country’s state-owned newspaper Notícias cited Raimundo Matule, a director at the ministry of agriculture, reporting that several Chinese conglomerates were expected to invest up to $2.5 billion in the country’s agricultural sector. In Angola Chinese state-owned giant CITIC pledged to invest $5 billion in agriculture in addition to its current lease of 20,000 hectares of land in the former Portuguese colony.

Mozambique and Angola in particular are large countries with immense tracks of fertile land and a small population. Angola has a land area of 1.24 million square kilometers and a population of 16 million.

China’s ongoing tensions with its Southeast Asian neighbors make other parts of the world even more attractive, and Africa could emerge as a major provider of agricultural products to China in coming years.

Chinese business interests have also leased tracts of land in Brazil, Peru Argentina and Mexico. China is also reported to be acquiring land in the sparsely populated Russian Far East just across the border from heavily populated northern China. Chinese companies are reported to have leased 1 million hectares of land through Russia. China’s most ambitious investment in the sector is a land lease deal with Ukraine for 3 million hectares to produce grain and raise pigs. In 2010 Chinese companies were reported to have requested the lease of 1 million hectares from the Kazak government to plant soybeans and wheat. In 2010 China was believed to have leased or bought over 2 million hectares of land abroad. In 2011 China’s largest agriculture group, Heilongjiang Beidahuang Nongken, announced that it was investing $1.5 billion to develop 300,000 hectares of land in Rio Negro province in Argentina .

However, the overseas option China is pursuing carries risks as well as promises of reward. As shown by recent events in the Ukraine, once a relatively stable part of the world, nothing is guaranteed. Land is a sensitive issue that touches upon our most primordial fears. In Kazakhstan there is widespread concern, sometimes bordering on paranoia, that China is grabbing the country’s vast and sparsely populated land by bribing local officials. In Brazil several officials including former Minister of Agriculture Delfin Netto have accused China of carrying out a stealth land grab. 

In Mozambique a Chinese land lease in the Limpopo valley is reported to have displaced 80,000 people, while in Cameron tribal chiefs and local NGOs have protested against land acquisitions by Chinese companies. In Angola there have been allegations of physical assault against African farm labors by their Chinese managers, while such incidents have been isolated cases. Angola has bitter memories of Portugal’s brutal plantation system in which the chicote, or whip, was widely used.

China is not alone in its interest for African farmland. Brazil, Japan, South Korea and several Gulf States have leased large tracks of land in Africa. Brazil seems to have been far more successful than China, at least in Mozambique, having acquired 500,000 hectares of land in the country’s north. Brazilian land deals have been far less controversial than Chinese ones and elicited less suspicion. Brazilian companies are reported to be producing soybeans in Mozambique, and for several years, Brazil has been main supplier of this product to China. It seems that the Brazilians have stolen a march on the Chinese.

Despite these risks Chinese investment in overseas agriculture is likely to continue. China has little choice but to turn overseas to sustain its growing food needs.

However, one must be cautious not to see Chinese acquisitions of overseas farms as a mere land grab. The issue is far more complex. China has invested hundreds of millions of dollars in agriculture research centers throughout Africa that have greatly increase rice and other crops production and alleviated food shortages. Hundreds of Chinese agriculture scientists are working in Africa and elsewhere to improve efficiency. While Africa and other parts of the world are supplying China with products such as grain, soybeans and meat. China may also contribute to consolidating food security in Africa and other regions with its investment and expertise. China’s long-term strategy may be to boost Africa’s capability to produce agriculture surplus, both addressing the continent’s chronic food shortages and China's demand for imported food.

Chinese investment in overseas agriculture can bring significant benefits provided such investments are done in an open and transparent way and with respect for local communities. Indeed, certain countries – particularly Angola and Zimbabwe, to mention a few – are keen on such investments. China and the host countries for such investments can benefit tremendously – if both sides have the imagination to build mutually beneficial partnerships. 

* * *

Lora Horta, Chinese Agriculture Goes Global, Yale Global, December 16, 2014

Oil Bust

The collapse in oil prices since the summer of 2014, accelerating over the last month, promises to have lasting affects on international politics. Provoked by Saudi Arabia's determination to drive down the world price, the oil price collapse is sending out rippling waves that touch the entire planet. Herewith a series of charts intended to put what has happened into perspective.

First off, the fall in prices itself. This chart shows West Texas Intermediate Crude, the benchmark U.S. price. Brent (traded in Europe) was a few years ago at a spread of over $20 dollars a barrel, but the spread is now only 3-4 dollars. Here is a twenty year chart of the price of U.S. oil, followed by a two year chart

Recall that only a few years ago the cost of the marginal barrel of oil was approaching $100, and one gets a sense of how many projects are rendered uneconomic by a price at $55 a barrel. For projects already underway, of course, on which the capital has already been spent, the marginal cost of operating a well is far lower. The longer a low price regime lasts, paradoxically, the greater is likely to be the spurt upwards when it occurs (since future supply will be reduced by the paring back of investment programs in the here and now).

The following chart from the Financial Times (December 15, 2014) shows the dollar cost of net imports and exports from selected countries. The data, though labeled as 2014, comprises totals for the previous four quarters as of the third quarter of 2014. As most of the price drop has occurred in the fourth quarter of 2014, this will dramatically affect the amounts reported in the chart.

Probably the average price of oil over the next year (from the 4th quarter of 2014 to the 4th quarter of 2015) will be higher than $55, but it would not be unreasonable to forecast that revenues for exporters and costs for importers will be some 60-70% of the figures reported above.  Even if prices have rebounded six months from now, the interim period will throw the entire sector (and many countries) into crisis. It is in the nature of markets to overshoot; it is not inconceivable (though I think unlikely) that the lows of late 2008 ($35 a barrel) will again be tested.

More to come.