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Are global oil prices headed down to $75?

Citigroup’s Edward Morse thinks so, and he might not be wrong

Jul 14, 2014

by Max Fawcett

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Illustration Jack Dylan

Remember Jeff Rubin? He’s the former CIBC chief economist who quit his job in 2009 to publish a book that, among other things, predicted that oil prices would hit $225 by 2012. That prediction was predicated on the idea that a combination of continued economic growth and falling global crude supplies would drive oil prices through the roof, and make things like cheap airfares and 99 cent avocados a thing of the past. Well, so much for that. But while Jeff Rubin may be something of a laughing stock among energy sector insiders for his wildly inaccurate call on global oil prices, at least his was a prediction that they could afford to laugh about. The recent one offered up by Citigroup global head of commodities research Edward Morse that was the subject of a Barron’s cover story in late March? It’s not nearly as funny.

That’s because Morse and Citigroup have staked out a position at the opposite end of the spectrum when it comes to forecasting the future price of oil. He thinks it could come all the way down to $75 a barrel, driven by technological advances in extraction and flat-lining demand – essentially, an inversion of the formula that Rubin used to forecast global oil prices of over $200 a barrel. “The history of mankind, at least since the invention of the wheel, is a history of cheaper and cheaper energy,” Morse said. “Modern civilization would be impossible without cheap energy. I believe we are entering another period of cheaper energy that should last 50 years or more.”

The scenario he presents in support of his forecast is, like Rubin’s, internally consistent and theoretically plausible. Rising domestic production, particularly in plays unlocked by new technologies, is fundamentally changing the supply picture for oil. Meanwhile, the recent disconnect between oil and gas prices created end users with an arbitrage opportunity that many of them are apparently taking up. As Ross McCracken, the editor-in-chief of Platts’ Energy Economist, wrote last October, “The ratio of natural gas in the U.S. to oil prices was 9.47 in 2006 and rose steadily to a huge 33.26 in 2012. The small recovery in U.S. gas prices in 2013 and a halt in oil’s rise have reduced this ratio to 26.29 as of mid-September, but oil’s comparative price in relation to gas is still much, much higher now than in the past.”

The continued spike in natural gas prices that’s taken place so far in 2014 has driven that ratio down closer to 20, but that’s still well beyond traditional norms – and still an open invitation for continued substitution. And because a growing proportion of global oil production is coming from politically safe jurisdictions like Canada and the U.S., there’s both less room for the political manipulation of prices and a lower probability of conflict either disrupting or destroying key sources of supply. “Taken together,” the Citigroup report says, “these trends should be more than enough to cause global consumption of oil to slow its growth over the next several years and then flatten out. There is even the potential for global oil demand to begin declining.”

And now for the multibillion-dollar question, as far as Alberta’s energy sector is concerned: is Ed Morse actually right? Arc Financial’s Peter Tertzakian certainly doesn’t think so. “I could buy into a scenario where $75 [oil] can happen,” he says. “It just wouldn’t last very long.” He notes that those with more skin in the game than Citibank – international supermajors like Chevron and ExxonMobil, for example – are planning their operations around triple-digit oil prices. “The rest of the world, even at $110 oil, is struggling to bring on production in meaningful quantity.” That, Tertzakian says, is because the costs associated with finding and developing oil reserves are nearly as high. He recounts his experience at a recent trade show, where energy service giants like Schlumberger were showing off their newest toys that will help producers tap into increasingly complicated offshore formations. “It’s a little bit like the medical business: we can keep you alive for longer with incredibly technologies, but those technologies are also incredibly expensive.”

It’s not just the technologies that are pushing up costs, he says, but also the operational and political difficulties associated with doing business in places where the government’s priorities aren’t always aligned with those of a free and open market. “Whether it’s the Saudis or the Russians, many places in the world need that higher price. They have no interest in flooding the world with oil. The incremental growth from Canada and the United States is very notable, but let’s not forget that world oil consumption is ­growing – still – and the decline rates are steepening.” All told, Tertzakian says, it adds up to a scenario in which the risks associated with the price of oil – or, if you’re a producer, the rewards – are concentrated on the upside. “There’s a whole series of arguments, maybe not one of which is compelling. But when you put them all together, it suggests that the price of oil is not going to $75. And even if it did it wouldn’t stay there for very long.”

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AIMCo CEO Leo de Bever, on the other hand, isn’t so sure about that. And on behalf of his thousands of shareholders in Alberta, he’s put a little bit of money to work investing in technologies that would both profit from a lower oil price and protect the margins of the energy companies that AIMCo already has much, much more money invested in. “There’s a lot of technology out there that can make us perform better on any number of fronts, and all that will do is make us more viable no matter what happens to oil prices. And being able to survive $75 oil is a really smart thing to do.”

Why? Because, in his view, it might be coming sooner than we think. “You’ve got the conservation element kicking in, and the supply of alternatives is still ramping up. Maybe there’s going to be a bit of a glitch in terms of the 20 to 25 per cent growth rate of alternatives slowing down a bit in the next couple of years, but it’s going to be a fact of life. And you’ve got more supply of conventional and non-conventional oil – fracking has brought on more gas, and even places like Mississippi are finding the equivalent of oil sands. I don’t know how long it’s going to take for anybody to do anything with that, but the central point is that supply is being enhanced by more efficient exploration technology.”

In his view, rising supply will eventually meet a demand curve that’s being eroded by substitution – Morse’s very formula, in other words. And while de Bever isn’t ready to predict the imminent arrival of cheap oil, he seems to think it’s more a matter of when, rather than if, it comes. “We’re being hammered from a number of different directions, and I think that will eventually drive down the price. Now, demand in the Far East might keep it up here longer than you might think, but even those economies are finding new supplies. My feeling is that unless we can live with $75 oil, we might be in considerable difficulty. That’s the bottom line.”

Platts’ McCracken is right there with him. “Compressed natural gas users in Asia, Tesla Model S drivers in the United States and Norwegians buying LNG-powered ships may seem like a disparate bunch, but they all have one thing in common; they are early adopters, driven by supportive regulatory frameworks and the economic fact that the ­unconventional oil and gas boom has not delivered cheap oil,” he writes. “At some point the oil industry may have to confront the possibility that even if it has the capacity to grapple with the supply-side issues that dominate pricing in an international market, it is the slow-burn demand-side revolution that proves to be their real undoing.”

And while McCracken noted that it usually takes disruptive technologies decades to truly wreak their particular form of havoc, the fact that investors pushed shares of Tesla Motors past $250 in early 2014 (from under $40 a year earlier) and awarded it a market capitalization of more than $25 billion suggests that time frame might be conservative. “Disruptive technologies tend to follow an S-curve, in which rates of adoption are low in the early years as infrastructure and manufacturing capacity is built out, allowing a later, steeper acceleration in uptake. Judging by its market cap, investors seem to think Tesla is close to this point.” Meanwhile, the high oil prices that allow companies to tap new and previously inaccessible reserves also encourage end users to move away from the crude that they’re planning to liberate. “High oil prices mobilize capital in support of new production,” McCracken writes, “but they also sustain the investment conditions for substitution.”

Oil price forecasts tend to be the stuff of rich data and complex mathematics leavened with the occasional speculative ­assumption about particular geopolitical outcomes. But there’s also a human factor in the market for oil, just as there is in every other market on earth. De Bever thinks that’s getting overlooked. Yes, triple-digit oil prices may seem like the new normal but new normals, he says, rarely end up lasting long enough to become old ones. “This is human nature – we assume that the future is going to be as the immediate past was, and most of the time that’s not true. People are getting too comfortable. If you’re in the middle of a corporation and you’re just trying to keep the lights on and keep everything producing, the strategic thinking about outlier events isn’t there. People manage to the middle, and they don’t protect their flanks. But in a business like mine you’re always looking for the extreme events, because when you hit one of those it’s going to kill you.”

Same, only different

If there’s one thing that energy analysts can agree on, it’s that they don’t agree at all on what kind of long-term impact the growth of U.S. shale oil will have on global oil prices. Some think it’s a temporary phenomenon, and that the longer-term trend of rising prices (due to declining supplies of cheap and easily extractable oil) will remain in place. Others think that it’s a true game-changer, and that it will fundamentally alter the shape and slope of the supply curve. In its most recent survey of those who make their living studying the economics of oil, Reuters found that the sum of their disagreements added up to a forecast of $95 by 2020 – or $80 in real (inflation-adjusted) terms. But, as you can see, the outlier forecasts could make things very interesting for bears and bulls alike if they come to fruition. Source: Reuters

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