In April 2012 I published this post about World Crude Oil Production and the Oil Price (in Norwegian) which was an attempt to describe the developments in the sources of crude oils (including condensates), tranches of total life cycle costs (that is [CAPEX {inclusive returns} + OPEX] per barrel of oil) and something about the drivers for the formation of the oil price.
Rereading the post and as time passed, I learnt more and therefore thought it appropriate to revisit and update the post as it in my opinion contains some topics from what I have observed, learned and discussed that have been given poor attention and appears poorly understood.
I will continue to pound the message that oil prices are also subject to the reality of;
- “Demand is what the consumers can pay for!”
Figure 1: The chart above shows the developments in the oil price [Brent spot] and the time of central banks’ announcements/deployments of available tools to support the global financial markets which the economy heavily relies upon. The financial system is virtual and thus highly responsive.
The chart suggests causation between FED policies and movements to the oil price.
The four big central banks, BoE, BoJ, ECB and the Fed expanded their balance sheets with $6 – 7 Trillion following the Lehman collapse in the fall of 2008. These liquidity injections are about to end.
Since 2008 most of the advanced economies’ credit expansions originated from the central banks, the lenders of last resort. Central banks are collateral constrained.
The consensus about the oil price collapse during the recent weeks is attributed to waning global demand and growth in supplies.
- Any forecasts of oil (and gas) demand/supplies and oil price trajectories are NOT very helpful if they do not incorporate forecasts for changes to total global credit/debt, interest rates and developments to consumers’/societies’ affordability.
For more than a decade, I have carefully studied the forecasts (and been involved in numerous fruitful [private] discussions) from authoritative sources like the Energy Information Administration (EIA) and the International Energy Agency (IEA) including the annual outlooks from several of the major oil companies and I did NOT find that any of these takes into consideration changes to global credit/debt [growth/deleveraging], levels of total global credit/debt and interest rates.
What determines the oil price may generically be expressed as;
f (oil price) = (supply/demand balance, direction and pace of global activity, developments in consumers affordability, the health of oil companies balance sheets, oil companies exploration results and the profitability of their resource portfolios, fear, greed, risk aversion/taking, speculative effects, total global credit changes [growth/deleveraging], effects from total global debt levels, austerity measures, monetary policies [like QE], interest rates [treasuries, bonds, nonfinancial corporations, households], geopolitical tensions and events, competition from credible alternatives [if any], mandated policies aimed at reductions of GHG emissions, OPEC’s strategies, ….just to name some)
In my post The Crude Oil Price and Changes to Total Global Private Credit/Debt I continued my attempts to draw attention to the growth in total global debt levels and the central banks’ low interest policies which incites both demand and supplies and also supports affordability for a high(er) oil price.
Price evolves from the arbitrage between demand and supplies and a growing supply gap will put downward pressures on the oil price.
Changes in demand need to be viewed in the context of changes in total global debt levels (or money stock) and interest rates. The usual suspects of oil analysts favored by the MSM (Main Street Media) touts their concurrent and simplistic views about weaker demand, improved supplies or whatever the theme du jour as reasons for the recent collapse (or any movement) in the oil price.
Few (if any) of these analyst ventures beyond and try to explain those mechanisms (monetary/financial/fiscal) that really create demand and supplies.
Simplisticly described; demand originates from the total global money stock and changes to this stock (and its circulation velocity). A major portion of the global money stock is credit created over several years (decades) that circulates within and between the economies.
Almost all of this money stock (total credit) has been/is created through simple commercial banks’ book entries [the money is created “ex nihilo”] and as this process slows and/or reverses [a reversal is commonly referred to as deleveraging] it takes money out of this stock (and thus circulation). This is deflationary. The total global amount of money and its circulation velocity becomes the source of demand.
A deleveraging [which may be introduced through austerity policies, defaults, down payments of debt and more] lowers economic activity as it lowers the stock and circulation of money and will thus also affect demand for oil and its price.
Central Banks’ Balance Sheets and Interest Rates
Figure 2: The chart above shows [left panel] how advanced economies’ central banks in concerted efforts lowered their interest rates following the Global Financial Crisis (GFC) in 2008.
The middle panel shows the relative growth (expansion) of the balance sheets (assets) for US Federal Reserve (Fed), European Central Bank (ECB), Bank of England (BoE) and Bank of Japan (BoJ) post the GFC.
The right hand panel shows the development in long and short term interest rates together with the twenty year average.
Chart from p 24 in BIS 84th Annual Report, 29 June 2014.
The expansion of the central banks’ balance sheets since 2008 (“creating money out of thin air”) has in reality been a subsidy of our consumptive lifestyles. This happened as the private and public sector had run out of room on their balance sheets and thus had little remaining capacities to take on more debt.
Most households and some companies have experienced a decline in their real disposable income which shrinks their debt capacities.
Norway: High Oil Price = High growth in Private Sector Debt
Norway has been and still is a major world exporter of oil and natural gas.
While countries importing oil have been using credit/debt to sustain/grow imports and put up with a higher oil price, there has been a strong growth in private credit/debt in Norway which shows good correlation with the oil price.
This is a feature of the Norwegian economy that is little recognized and which explains much of its recent growth success. Refer also to my post Norway’s Petroleum Economy struggles with declining Debt productivity.
Figure 3: The chart above shows Norwegian households’ [blue columns], non financials [orange columns] and municipalities [grey columns] 12 Months Moving Totals (annualized) change in debt plotted against the rh scale. The green dots connected by black lines shows the development in the nominal oil price (Brent spot) plotted against the lh scale.
Figure 3 illustrates that for Norway the growth in credit/debt during the recent 2 decades has (with a time lag) correlated closely with the oil price.
Norwegian crude oil extraction peaked back in 2000/2001 and is down more than 50 % from its peak and will continue to decline.
The chart above creates the impression that the Norwegian non financials have myopically looked at the oil price and its recent history as a proxy collateral from which to assume more debt and not being aware of the decline in the extraction of crude oil.
The decline in and a sustained lower oil price will set Norway up for a triple whammy;
- Total revenues from the petroleum production will decline from the combinations of lower price and declining extraction.
- The oil company’s capital expenditures are being curtailed and/or deferred due to a lack of profitable prospects/discoveries to invest in and the companies have little room left from the shrinking potential on their balance sheets for further debt expansion.
- Households, municipalities and non-financial corporations are responding to this reality by slowing down their debt accumulation.
With this backdrop the Norwegian Government expects a GDP growth of 2% for fiscal year 2015.
World Supplies of Crude Oil (and Condensates)
Figure 4: The chart above shows world supplies of crude oils and condensates split on conventional sources (green columns), bitumen (oil sands) from Canada (black/grey columns) and Light Tight Oil (LTO) from Bakken and Eagle Ford [blue columns and rh scale. NOTE rh scaling] together with the developments in the oil price [Brent spot and lh scale] since 2002 and as of 2014YTD (June 2014).
The chart shows that recent years’ growth in global supplies of crude oil has come from more expensive sources.
Sources for expensive crude oil and condensates;
- Oil (bitumen) (primarily from Athabasca; Alberta, Canada) has according to several oil companies and analysts a break even price of US$70 – 90/Bbl.
- Light Tight Oil (LTO) now dominated by the Bakken in North Dakota and Eagle Ford in Texas has breakeven prices in the range of US$50 – 90/Bbl (the spread is due to a wide range of wells’ productivities).
- Oil extraction from areas where combinations of water depth, geological formations, access to infrastructure and markets, size (estimates of recoverable reserves) requires a break even of US$50/Bbl and above.
- Oil from developments in their late extraction phase, which had their economic life prolonged thanks to the high(er) oil price and which will continue their oil extraction as long it is economic, refer also to figure 6.
Figure 4 shows that supplies of crude oil from conventional reservoirs has been on some plateau since 2005. There are/have been temporarily interruptions from some supply sources due to social unrests (Libya, Sudan). The green columns also include expensive sources for oil like deep water, Arctic, small conventional discoveries that became commercialized with a higher oil price and lots of legacy developments in their late extraction (tail) phase that had their economic life extended thanks to the higher oil price (refer also figure 6).
Various institutions/analysts have estimated that worldwide (primarily within OPEC) there are some spare capacities/potentials and these estimates show a big spread and are also widely contested.
Full Life Cycle Costs Tranches for Crude Oil
Figure 5: The chart above shows a conceptual description and approximation in the developments of full life cycle costs tranches [ CAPEX {inclusive returns} + OPEX] for global crude oil production [rh scale] together with the oil price [Brent and lh scale]. 2014YTD (June 2014).
The full life cycle costs tranches should not be confused with operating expenditures (OPEX). It is as OPEX surpasses gross revenues the operation becomes unprofitable and producing installations/wells becomes shut in, plugged and abandoned, refer also to figure 6.
Figure 5 illustrates how the growth in the oil price gradually brought tranches of costlier oil to the market. The figure also illustrates that there is a time lag from when a higher sustained oil price materializes until more expensive oil is brought to the market. The timing and contribution from the more expensive tranches are, if not accurate, believed to be very close to actual developments during the recent decade.
There is in addition a tiny sliver of oil supplies with full life cycle costs above $80/Bbl. Full life cycle costs should not be confused with estimates of what oil price the oil companies need to become cash flow neutral.
The market does not care about the costs for the incremental barrel of oil. The oil price results from the dynamics of the supply and demand balance in the market.
As the cheapest tranches of oil depletes and declines the resulting and gradual price growth made it profitable to develop more costlier oil (illustrated in figure 5 by the cost tranches). Oil companies do normally not sanction developments based on the market price, but applies a margin for financial resilience, that is developments are sanctioned with a price expectation of say 15 – 20% below the expected future market price.
A sustained oil price at/below $80/Bbl will, likely and with some time lag, slow down/halt/reduce flows of oil from the most expensive tranches. This while the oil supplies from the cheaper costs tranches are being depleted and continues to decline.
Authoritative organizations like the EIA and IEA publish regularly projections of developments in the oil price and there is ample reason to believe that most companies and public institutions applies these projections for their planning.
Expensive Oil from Legacy Developments late in their Economic Life Cycle
One source of expensive oil that appears to be flying under most radars comes from developments long in their teeth. These developments had their economic life prolonged thanks to a higher oil price.
Figure 6 is based upon actual data as of summer 2014 for an oil field in Norway and describes this dynamic.
Figure 6: The chart shows the actual (as of July 2014) and forecast (towards 2020) extraction of petroleum, as stacked columns, (green; crude oil, light blue; NGL, red; natural gas in Barrels of Oil Equivalents per day [BOE/d]) from a field in Norway (North Sea); the left hand scale. The chart also includes the development in price for Brent spot (annual price), black dots connected by a red line. The chart shows estimates for the actual breakeven oil price (yellow circles connected with a black line and its projected trajectory towards 2018).
Note how the growth in the oil price increased extraction in 2008 and that the sustained higher oil price (from 2011) did not affect the extraction rate. Some have suggested that a high oil price stimulates accelerated extraction.
In Norway the oil companies recover their investment during a period of 6 years after it has been done. The recovery of the investment is exempt from taxation. The economic rent on on the profits from the Norwegian petroleum extraction totals 78%, and the tax structure favors investments in profitable discoveries.
Figure 6 describes conceptually a petroleum development in its later economic life that allows for supplies of expensive oil (as long the price allows), but at the same time is vulnerable to an abrupt shut down (and thus loss of supplies) should the price and/or flow of oil drop below the field’s economic threshold. In figure 6 the field will produce as long as the oil price remains above the field’s breakeven oil price.
I have estimated that for crude oil extraction in Norway, based on data from the Norwegian Petroleum Directorate (NPD) that a sustained crude oil price at US$80/Bbl will during a short period (within 12 months) cause some of the fields, now in their tail phase, to be shut down thus reducing the flow with an additional estimated 10 kb/d or around 1% of present total flows in Norway. A sustained oil price below $80/Bbl will cause more flows to be shut down. This will manifest itself through an acceleration in the decline rate.
The above illustrates the mechanisms following a low oil price that will take out some of the present expensive oil supplies from legacy developments.
A lower oil price will impair the oil companies’ financial capacities [through lower net organic cash flows] and thus impair their investment abilities for new capacities/developments even if the developments show a low break even price.
World Oil Supply and Price, what may lie ahead
The recent collapse in the oil price is caused by a growing gap between supply and demand. The more profound reasons for this is a slowdown in the global economy from less credit expansion (reduced growth in total global debt levels; which some refer to as the most telegraphed correction in history).
How far the oil price will come down and for how long it will stay “low” is now anyone’s guess. A declining price results from weakening demand while supplies are improving.
As the effects of this slowdown works its way through the systems, it should be expected that the costlier to extract oil will become shut in, and costlier developments become deferred while oil companies targets financial performance and resilience improvements of their balance sheets to offset the effects of lower oil prices.
The theory is that a lower price stimulates demand/consumption. A global oil demand/consumption that remains tepid with declining oil prices is a worrisome indicator about the true state of the global economy. A sustained lower oil price continues the depletion of and declines in oil flows from the world’s “cheap” legacy sources, refer also figure 5.
A lower oil price impairs the abilities of the oil companies, whose task it is to supply oil to societies, to invest in new capacities.
At some point in time demand and supplies will rebalance, thus establishing a foundation for renewed growth in the oil price. Oil companies respond to the price signal with their resource portfolios, return requirements and the health of their balance sheets.
What remains to be seen is when and at what level of global oil supplies this happens, and if the resulting price growth allows for oil companies with healthy balance sheets and resource portfolios to timely develop sufficient new oil supplies that meet their return requirements, the world’s evolving demands and not least consumers’ affordability.
This time I have found it appropriate to repeat and expand on the statement from the start of this post:
- Any forecasts of oil (and gas) demand/supplies and oil price trajectories are NOT very helpful if they do not incorporate forecasts for changes to total global credit/debt, interest rates and developments to consumers’/societies’ affordability.
- Complete oil (energy) supply considerations should include the health of the oil companies’ balance sheets, their resource portfolios and their requirements for return.
..
“The best place to hide something from a fool is to put it in a book.”
- Unknown origin
