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On July 27th Prince Alwaleed bin Talal publicly opened Pandora’s Box, by releasing an open letter to the Saudi Minister of Petroleum, Mr Ali Al-Naimi, voicing his concerns about the longer-term implications on the Saudi economy of the US shale gas boom. The concerns are both real and relevant – in fact it is something that we have been thinking about for a while.
Global oil markets are a weird hybrid of capacity constraints, government control, long lead times and massive investments in energy systems that – once done – are designed to support you for decades to come. Someone might want to add politics, but let’s just drop that for now.
This is how it works: Everyone on the planet that owns an oil field or an oil well does his/her best to maximize production today. The reason is simple: every discounted cash flow (DCF) model will show that the value of the resources in the ground will yield its highest net present value (NPV) the faster it is produced, hence the 99% utilization rate for basically all producing capacity outside of the OPEC-cartel. OPEC, and in particular Saudi Arabia, is very different. With its enormous resource base of relatively cost-advantaged reserves, the Saudis are well aware that its longer-term benefit lay in maximizing the uplift between production cost per barrel and the price it can realize these barrels for.
So when looking at the incentive structure, at first sight it can seem pretty obvious for a low-cost producer such as Saudi Arabia – or any producer for that matter: Highest. Possible. Price.
And short term this is true: if the Saudis would cut world supply, the shape of the demand curve (inelastic) would push up price. We all know the story – price can jump dollars on a simple rumor that the very delicate global supply- and demand balance would be disturbed on the supply side. This is of course beneficial for producers that are still selling in the market in the short term, as substitution of fuels are relatively speaking a longer term issue. Few energy systems have what we could describe as “direct switching capabilities” from one energy source to another.
But longer term you do! Remember those lectures in microeconomics 101, when oil was always brought up as the example of a commodity or a good with very inelastic demand curve? That is true – in the short term. History however has shown that given the right price incentives – or spreads between oil and its closest alternative – demand can be destroyed, never to return even in a low-pricing regime. The first time this happened was with the US and European fuel oil markets, which was almost exclusively used for power generation. In the low cost regime up until the first and second oil crisis in 1973-74 and 1979-81, we experienced strong growth for fuel oil in the West. Oil was abundant, cheap and convenient to integrate as base load in our power generating energy systems. Look at the two graphs below, clearly showing this effect and also the lag between experiencing a high price, and being able to transition your energy systems to a new regime (natural gas).
In the years leading up to the first oil crisis the West saw consistent growth in fuel oil demand for power generation. When price spikes in the 70s and early 80s, utilities start looking around for an alternative and finds natural gas. But it takes a few years to start the larger transition. Post 1982 the trend is very clear – not even low prices can save demand from becoming a victim of fuel oil to natural gas-switching. The demand – despite low prices – is lost forever.
This taught OPEC an important and very valuable lesson: Yes, oil in power generation was the most substitutable demand source, and if we play our cards right we can achieve what we want – long-term growth in the demand for oil with relatively high prices. But not too high – then we will again experience the dreadful fuel switching.
This is the game that has been played by OPEC, and especially Saudi Arabia, ever since these days. Luckily for them, we have been moving steadily along with solid growth in oil as transportation fuel. Electrification oil the global vehicle fleet has proven difficult due to the cost of investments to add the amount of generating capacity required to substitute the oil-based energy system to one fuelled by nuclear, coal, gas, hydroelectricity and renewables.
But the question now is if we might see new clouds in the sky for OPEC, and its not the recent bonanza surrounding North American liquids production but the much lighter methane, or CH4, molecule that is being produced at an ever increasing rate in North America – shale gas.
Lets first take a step back. Take a look at the graph below that shows the relationship between consumption and money spent on gasoline as share of disposable personal income; no surprise there with a downward sloping demand curve. However, we have yet to experience the crushing demand destruction that we saw in the fuel oil markets post 1973 on the back of high prices. The reason is simple – transitioning energy systems take time, it requires enormous investments and also a price spread to alternative fuels that would incentivize this transition to happen. During the last decades, there has always been at least one piece in this puzzle missing – until now.
Check out the graph below here. It shows the global average price for oil – on an energy equivalent basis – and the range of prices between various major global gas markets (Japan LNG, German border prices, UK NBP, US Henry Hub, Canadian AECO). The spread has been fairly low, basically because producers in Europe and Japan tied their gas prices to oil (minus a discount) to make the fuel oil to gas switching possible in the 1980s. In the US, it was a fairly similar story where analysts believed the price to continue to trail global LNG – which are oil linked – prices, in order to attract imports of massive amounts of Middle Eastern and Russian LNG, in order to cover for growing demand.
This was five years ago, an eternity in any market but hydrocarbons where things tend to move slowly and steadily. But when the late George Mitchell cracked the code that was horizontal drilling and multi-stage hydrofracking roughly 15 years ago, he opened up the Pandora’s Box that was US shale gas plays. All of a sudden North America was a washed by cheap natural gas with full cycle break even costs not exceeding USD 5/mmbtu – a third (or even less) of the price for the same amount of energy in crude oil.
And this resource is not controlled by anyone but a bunch of capitalists whose DCF models show exactly what OPEC doesn’t want to see: the value is higher the quicker they can produce the resources they have already scrambled together. So instead of an unholy alliance with oil-linked gas prices on a global basis with producers such as RasGas (Qatar) and Gazprom (Russia), brute American market forces are moving OPEC from the driver seat to the passenger seat. The aim for the planners at Aramco and OPEC will from now on be to keep a very close eye on what the potential switching point could be, where the transportation sector is going in terms of moving away from its current 95% oil penetration.
Conclusion:
Cheap US shale gas is disturbing for the OPEC oil cartel and its most important member, Saudi Arabia. Growing price spreads between oil and natural gas will incentivize already struggling motorists to look into alternatives, most likely natural gas in one form or another (CNG or electricity). Response from OPEC in order to avoid longer-term fuel switching and to protect value of reserves longer term will be to narrow spread to natural gas by allowing oil prices to go lower. Consequences for IOCs and more leveraged petrodollar welfare states will be profound. For global consumers and economy this is a positive trend.
This is also why the Saudis long-term are much more concerned about a fuel source that is out of their control and dictating their next move (shale gas), than one that is a mere substitute to their cheap supply (shale oil) but doesn’t risk to flip the market.