Oil, down from its stratospheric highs pre-Crisis, seems stuck in a permanent doldrums. Edward Morse, global head of commodities research at Citigroup, is one of the world’s pre-eminent experts on oil (and a noted skeptic of the stability of those sky-high prices). He explains the mechanics keeping supplies high and prices low, why he does not see them changing in the medium term, and where opportunity remains to be found.
Octavian Report: What's your outlook on oil? Where do you see it going in the intermediate term?
Edward Morse: By intermediate, I assume that means 2022 or 2023. The oil market entered a new world order in 2014 as a result of the shale revolution in the U.S., the exploitation of oil sands in Canada, and the coming-of-age of deep water oil and gas exploration. And as a result of the exploitation of these three kinds of hydrocarbons, there has been a significant erosion of the market pricing power of OPEC in general — and Saudi Arabia in particular. Markets are now prevailing in a way that they have not before.
There are two significant aspects of this new order. One is that with shale there is a very short cycle from the decision to drill a well to getting oil out of the ground. It's basically a nine-month process, not a five-year, let alone 10-year process. So the advent of short cycle oil and gas — which is now largely only in the United States, but is spreading around the world at a rapid rate — means there's a rapid response to a higher price: bringing more supply in.
When we look at oil sands and deep water, there is an infrastructure in place that doesn't have to be rebuilt from scratch. That makes what were five- and 10-year projects now two- to five-year projects. That's the background of what our outlook is for oil in this rearguard action for OPEC, Russia, and some other producers. As they rebalance the markets, they spur on production from other countries. That puts a lid on prices. You can make a judgment about what the lid is, but it's certainly there.
Our judgment is that at a price not higher than current prices — $65 Brent — enough oil can be brought to the market within a year to undermine the efforts of producers to rebalance the market and get to a higher price. So our number really is $65 to $70 on the high side, with $40 as a kind of very soft floor.
I think for the next five years, we're definitively in a basically $40 to $65 price environment. The higher the prices go, the lower they'll go thereafter. And the lower they go, the higher they'll go thereafter. They should be wobbling in this band. We think average prices in 2019 will be $40 to $45 Brent. And the reason for that is that prevailing prices are bringing enough oil into the market to satisfy all of global demand growth. Yet there are these countries (among them Saudi Arabia and Russia) that have pulled a million barrels a day out of the market. And there's not much room for them to put it back in. So prices almost inevitably have to go down as these countries take oil that has been off the market and put it back into the market.
OR: What drove the Saudi decision not to cut production when the price started collapsing?
Morse: The most critical factor from a Saudi perspective is that in 2014, U.S., Brazilian, and Canadian production growth was overwhelming. These three countries added 2.3 million barrels a day of supply — a good 40 percent higher than global demand growth.
And in addition to that, the Atlantic basin had been a deficit environment for oil and natural gas. We had surplus countries — Russia, Caspian producers, and Middle East producers — and markets they could move oil into. But 2014 marks the time when, permanently for all practical purposes, the Atlantic basin became a surplus oil and gas environment. Meaning that the only place that existed for growing market share was the Pacific basin.
The Saudis, over the course of 2014, discovered a big existential problem in the oil market. They had in 2013 been able to export about 1.7 million barrels a day to the United States and 1.2 million a day to China, the two largest markets in the world. At some point in 2014, their access to the U.S. and the Chinese market fell by 50 percent due to the factors I just outlined. So they decided to put more oil into the market, sell it more liberally, and bring prices down. They triggered a price collapse in 2014 that they thought would be very short-lived. They thought that they would quickly bankrupt U.S. producers. That the bubble of U.S. shale production would evaporate. They also believed that Russian production was very high-cost, and they hoped that they would be able to stem the growth of Russian supply and even reverse it. They were predicting a million-barrel-a-day decline in Russian production by 2017 as a result of lower prices.
That was the economic side of the existential problem they were confronting. It speaks to the political side as well, because they thought that by hitting Russia hard on the oil front they would reduce the ability of Russia to intervene in various countries in the Middle East. They also, in 2014, thought that Iran would be seeing the end of sanctions. They thought it was going to be in 2015, it turned out to be 2016. But they saw it ahead. They wanted to erode the possibility of Iran getting into the China market. They wanted to increase their position in it. They also wanted to bring prices down, so that Iran would have less ability to intervene and support the Houthis in Yemen.
These two existential crises in the Kingdom caused them, at least in the beginning, to bring prices down. Then they reversed themselves when they realized that there was a drain on their rainy day bank account, and they needed to stem the losses and find a way to bring prices up.
OR: What do you see the impact of renewables on oil and gas being generally? How does the rise of the electric car play into prices?
Morse: The rise of renewables has had a dramatic impact on the power-generating sector. Not much of an impact yet on the transportation fuels market. But if we take a snapshot of actually measurable power generation around the world over last two years, virtually all of the increment of grid-provided electricity has come out of renewables, not out of fossil fuels. At the moment, renewables are the preferred incremental source of supply. That is likely to continue.
The other issue is transportation fuel. Incrementally, oil is used more and more for transportation fuel. For the last five years all of the oil demand growth in the world has been for petrochemical feedstocks, for gasoline, and for jet fuel. All other uses of oil have gone down. The world at the end of 2016 was consuming less fuel oil and less diesel than the world was in 2011.
Oil's monopoly, so to speak, is really restricted to petrochemical feedstocks and transportation. But there are problems there as well. Increasingly, the pet-chem feedstocks have been not naphtha coming out of an oil pool in a refinery, but rather propane, butane, or pentane-plus coming out of natural gas liquids. About 30 percent of total world liquids demand actually comes from natural gas now, rather than from oil — further restricting on the increment where oil can be used.
That's where your other question comes into play. Oil is being challenged in its one remaining monopoly area: transport fuel. Natural gas is eating into that monopoly, too. If you go to Boston, most of the taxi fleet runs on propane. In cities in emerging markets, compressed natural gas and even LNG are used in the transport fleet. Increasingly in China, trucks are driven not by diesel but by LNG.
Then there's electricity, where there is a big debate. Not so much about whether there will be an erosion of transportation fuel demand from oil, but when this will happen — when the penetration of electric vehicles is likely to be such as to not just put a cap on gasoline demand but to start reversing that demand. There are people who believe it can happen as early as five years from now. There are people who think it's going to be closer to 2040. Bloomberg sees the tipping point at around 2028, plus or minus a couple of years.
OR: Do you see oil and gas as being a much smaller portion of energy long-term?
Morse: I do. We have produced a series of reports called Energy Darwinism. We look at the evolution of energy alongside the evolution of man. They point to a significant erosion of the place of fossil fuels in primary energy. Certainly sometime in this century. Before the century gets to midpoint, in all likelihood.
That doesn't mean that the cyclicality of commodities in general or the cyclicality of oil and gas in particular is coming to an end. Rather, it means that it's muted compared to where it has been recently. We don't think $100 oil is plausible again. Nor do we think it's plausible to think about $12-per-million-BTU natural gas again. We think the numbers cap it, but they could be volatile: low prices mean low revenue for petrostates. I would define those as states where more than 50 percent of government revenue is sourced in oil and gas as a commodity.
They are challenged by having revenue capped and challenged by the need to diversify. And this has created significant failures of petrostates that have led in the last 20 years to very radical changes in prices as a result. In 1998, four countries (which have subsequently become fragile) were looking fairly exuberant: Venezuela, Nigeria, Iran, and Iraq. They had plans to increase their collective production by 10 million barrels a day over the next 10 years.
By February 1999, The Economist had a front-page story: “Five-Dollar Oil Forever.” And part of what was driving that notion was the explosion of supply in these countries. Already in the winter of 1998 and ‘99, we saw the price of oil collapse to $10 a barrel from over $20. That 50 percent collapse was accompanied by political upheaval. These four countries by 2003 were producing 50 percent of what they were in 1998, rather than moving towards doubling their production by 2008.
So the high prices of the last decade were really engendered by a significant failure of petrostates. So too with this decade. 2011 started in the early months with a 1.6-million-barrel-a-day supply disruption from Libya. There were failures in Nigeria, in Yemen, and Sudan. They added up to a lot — even as recently as the late spring of 2016, 4.1 million barrels a day of oil were offline. Not all of it coming from failed petrostates; a big chunk of it was Canadian wildfires closing Canadian oil sands production.
But we are in the era of the failure of the petrostate. And even though production has come back in Iran, Libya, and Nigeria recently, there still are around 2 million barrels a day of oil that could be, should be on the market, but aren't. That number, in a fiscally constrained environment for oil-producing countries, is more likely to go up than go down.
We don't know what would happen if there were to be failures to produce across multiple countries right now. But there are some big producing countries that are undergoing domestic political challenges that could see disruption to supply. Then the price would pop — and it would take longer than nine months to get short-supply oil to replace, potentially, that lost production.
OR: Is there a G-Zero world in oil right now? And what do you make of the recent events in Saudi Arabia?
Morse: It's hard to take the G-Zero World and apply it to oil, but certainly there is something in it. The world of oil and natural gas superpowers overlaps with what we generally think of as political superpowers. The intriguing aspect of it is that whether you look at oil or gas, China is not part of the triumvirate that dominates the supply side. And yet the Chinese economy may be the one clear winner from a world where the superpowers don't have the the price-making power they once had.
More directly to your question, the Saudi government has two things happening. One of which is something that was going to happen eventually, and is happening now. The governance of the Kingdom has been based on one brother of the founder of the place passing the mantle of king from brother to brother to brother. And finally they ran out of brothers. So there had to be a consolidation of power in fewer hands than was the case before.
And the other part was that there was recognition when it came to the end of the line of brothers — recognition at the same time that change had to come. I’d say that recognition predates Vision 2030. Because even under King Salman's half-brother's governance before he died, the need to diversify the economy and change the education system from one run by clerics to one run by laypeople was recognized. So it's unfolding, and it lays the basis for more transformation than could've happened under Salman's leadership. Those are the two critical issues.
To some degree I think the commentary on what's happening in the Kingdom is misguidedly focusing too much attention on the consolidation of power, and too little attention on the creation of a basis of reform that could actually be the longer-term salvation of the country, which otherwise would slip into the problems associated with a full blossoming of the resource trap.
OR: What would an open Saudi-Iran war mean for the oil price?
Morse: It would mean a lot for the oil markets. That doesn't mean it's highly likely. If there were a disruption of supply coming out of the Arabian or Persian Gulf, depending on which side of it you're on, it would have a fairly dramatic impact on oil prices. You want to get back to $100 oil? That would do it, given the amount of oil in the world that flows through the Strait of Hormuz.
But I think it's highly unlikely for bunches of reasons. Not the least of which is that the memory of a devastating war with Iraq is still present in Iran’s collective memory, and it's probably the last thing that the leadership of the country wants to ever have repeated in terms of a loss of people and economic growth and space in the world.
I think there is a premium in the oil price that I imagine is of the order of magnitude of $5, at least every way we measure it. Undoubtedly part of that is coming from the Iranian missile from Yemen that nearly hit the Riyadh airport. Also the explosion on the pipeline at Buri in Bahrain is part of it — that pipeline brings hydrocarbons from Saudi Arabia to Bahrain. So there are a bunch of fuses that could trigger something, including naval battles, but I imagine they will all likely be short-lived.
OR: Where do you see short and medium-term opportunity in this space?
Morse: The fact of the matter is that there have been these radical changes in the oil and gas world since the middle of this decade. And the trend they outline is not readily reversible. If anything, the productivity gains that have been unfolding are continuing — even if they're not continuing at the same high rate of growth of productivity. That was the case through 2016 and 2017. But where there is unconventional material, and where there is willingness to take risk, there are real opportunities.
I'll give you some examples. Argentina is booming at the moment when it comes to shale, oil, and gas exploitation. It took a change in the government in the country to enable the country to offer competitive terms to private-sector companies from abroad, but they rushed in. And it looks as though they are sustaining more than 20 percent per annum growth in hydrocarbon production. That might well accelerate.
If the Vaca Muerta, which is the main play in Argentina, is like the Permian Basin here, it could be producing five million barrels a day of oil. It's currently producing half a million barrels a day of oil. So they could have a tenfold increase in production, which spells real opportunity.
Argentina is not the only country where this is the case. Mexico has reopened for the first time in three-quarters of a century. The appetite of small and large companies is clear. Their discovery rate in 2016 was remarkable.
Deep water is also not off-limits now. The biggest example of that is the Johan Sverdrup field in the Arctic that was discovered by Statoil at the beginning of the decade and was shelved in 2014 when oil prices fell. The full-cycle breakeven for it was deemed to be around $65 a barrel. It was taken off the shelf again in 2016 when Statoil announced that it could be developed for substantially less than a price of $40. And when they went actually to phase two in early 2017, they said the breakeven price was $25 a barrel.
The cost deflation is not just from productivity gains in shale, but it's in deep water as well. So there are a lot of opportunities in the world. There would be more opportunities in Russia if it were not for sanctions. I don't see them being lifted anytime soon. The North Sea is booming again. The Gulf of Mexico is booming. Offshore Brazil is booming. The Canadian companies that have consolidated control in the oil sands are also booming.
Edward Morse is the global head of commodities research at Citigroup.