December 20, 2014

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.

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