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Tuesday, November 25, 2003

Oil depletion and economics - part IV.

Part IV

This is the final post on oil depletion and economics. It covers two areas – investment and international flows. The first lays out some of the difficulties investment will have to overcome to counteract depletion. The magnitude of the investments required raise questions about the impact on finance markets and international flows.



There are many investment choices that could counteract depletion. There are some common attributes that make investment opportunities less attractive.

* Scale – In order to fully realize the economies of scale, the projects tend to be large. This isn’t necessarily a problem, but it does decrease the likelihood that the project can be funded from existing revenues. Scale also means that the projects take longer to develop.

* Time –It can be years to more than a decade before a project starts producing revenue. In addition to making risks more difficult to assess, it also introduces a maturity risk. Ideally, the sources of finance (project liabilities) would have the same duration as the revenue streams (project assets). In many cases, companies have to tap outside capital in order to fund a project at the needed scale. However, financial instruments tend to have a much shorter duration than the project’s revenue stream. Although, there is a market for long-term corporate debt, it isn’t as liquid and tends to command a higher premium as a result.

* Risks – These include oil price volatility, political instability, interest rate swings and currency shifts. The longer the project’s duration is, the greater the uncertainties and the higher the premium will be.

* Incentives – The higher the price of oil, the better the return. But the long lead times mean that the relevant variable is not the current price but the future price. In part III, it was mentioned that the market’s history had resulted in the long-term expected price to be sticky and largely unresponsive to gyrations in the spot market.

It’s important to note that some market participants *desire* a sticky price: OPEC makes up about a fifth of world production but has around three fifths of world reserves. It has a strong incentive to keep the expected price low. Otherwise, the price signal would spur investment in other producers and alternative technologies. In turn, this would reduce the value of their reserves. OPEC’s goal is to have current prices as high as possible without raising the long-term expected price. Its ability to perform this balancing act has been aided by a few factors:

Commercial inventories (in terms of days of consumption) are near all time lows.
Several nations have been adding to their strategic reserve. This has masked the decline in commercial inventories and propped up demand.
Suppliers are running close to capacity. The little excess capacity that does exist resides mainly in OPEC, specifically Saudi Arabia.

Because OPEC controls the excess capacity, its pricing power is much greater than its market share suggests. The limited spare capacity means that increasing supply is going to require investment, either in more production or in substitutes.


Investment in production

The arguments above assume that the required investments are beyond the reach of current producers. Considering that the oil super-majors rank among the largest companies in the world (in terms of capitalization), this seems a bit bold. Their ability to raise capital will depend on their investment rate of return (IRR). The ability to fund further production from current revenues can be gauged by looking at their current exploration and production (E&P) expenditures. The numbers aren’t encouraging.

Somewhere around 90% of current E&P expenditures are used to keep production from falling. The remainder is relatively small, which has both good and bad aspects. The bad news is that a price crash means maintaining capacity entails running an operating loss. The good news is that a relatively small increase in price has a magnified in earnings. The additional earnings could be used to increase production. It could also be used to improve the shareholders return.

In recent years, the IRR has been around ~12%. This is with relatively high oil prices and low interest rates. The number is even more dismal when the factors mentioned above (risks, time) are taken into consideration. The relatively low IRR makes raising capital, in either the debt or equity markets, expensive.

Attracting the investment is only part of the problem. The other issue is the diminishing return on capital. This is understandable since the most economical deposits are exploited first. Deepwater and heavy oils are more expensive to develop than conventional oil.

In summary, even under favorable conditions, oil companies are barely able to maintain production levels. To make matters worse, their IRR and other factors make additional capital very expensive.


Investment in substitutes

Substitutes range from efficiency enhancements to alternative fuels. There has been significant progress in some areas and little in others. Despite the time and money put into developing substitutes, demand for oil has continued to rise. It raises the question on how much more money would be required to keep demand steady, much less reduce demand to match depletion.

Efficiency improvements can help by either reducing the amount of energy required to support a given income, or by reducing the amount of energy required to build the infrastructure for a modern society. Sometimes, technological advances allow a developing country to skip an energy-intensive step entirely (e.g. wireless vs. land line telephones). Along similar lines, legacy capital stock needs to depreciate before switching to a more efficient solution becomes financially viable: If the incremental prices are low enough, a technology will be adopted faster in a less developed country. This is sometimes called leapfrogging.

Alternative fuels have seen less success. Arguably the biggest single problem, above and beyond those already mentioned, is the inability to properly internalize ALL of the costs of a fuel. For example, coal is cheap until its environmental costs are factored in. Similarly, the disposal and safety aspects of nuclear aren’t included in the price. It’s obvious that this subsidy is a detriment to traditional renewable fuels. A bit less obvious is the harm it does to its supposed beneficiaries: Why invest millions in a technology that will reduce coal’s sulfur emissions 60% if the minimum turns out to be a 95%?

There has been progress in the development of substitutes. Despite this progress oil demand has risen and oil’s virtual monopoly as a transportation fuel is intact.


The overall investment picture

A number of institutions have weighed in on how much investment is required to meet future oil demand. Over the next decade, the amount is on the order of 2-3 trillion USD. There are some estimates that are a little less than a trillion, and others that are substantially above three trillion. Taking the middle case, this works out to be 200-300 billion USD a year. Barring very large (200%+) increases in oil price, this is not going to come out of oil companies’ cash flow. The world capital markets are very deep but this amount is not negligible: To put it into perspective, the FDI in China in 2002 was on the order of 60 billion USD. Furthermore, the oil industry will not be the only competitor for the world’s savings.


World savings

A consequence of inelastic demand involves the trade balance: Increased prices mean increased expenditures. This will have a negative effect on the trade balance for oil importing countries. The result is a decrease in the world savings. The shift in the supply and demand for savings would put upward pressure on the cost of capital, interest rate.

[This wouldn’t be true if exporters saved all of their additional earnings. Alternatively, if world growth were fast enough then enough savings would be generated to satisfy the additional demand for capital. However, my sense is that neither of these seems likely.]

The U.S. is the largest importer of oil and has a very low elasticity of demand. A rise in oil price implies an increase in the current account deficits (CAD). The U.S. CAD is presently around 5% of GDP. A number of economists have questioned how long a CAD of this size can be maintained. How much would the CAD change with rising oil prices?

The U.S. imports about ten million barrels of crude oil a day. At current prices, this works out to about US $100 billion/year – a bit less the 1% of GDP. So, even if prices were to double, the CAD would only increase by < 1% of GDP. However, U.S. oil production is in decline. If demand remains inelastic then imports must increase. Thus, even if prices remained constant, the value of oil imports would increase. When coupled with price increases, the overall effect would be a strong ‘headwind’ that the U.S. would have to counter just to keep the CAD from increasing. To exacerbate matters, natural gas – a common oil substitute, is coming close to ‘peak’ in North America. This would lead to further increases in oil demand. Although there is no hard limit on the size of the CAD, it does raise serious questions about how sustainable the status quo is.


Investments in additional production or substitutes are unattractive for a number of reasons. To make matters worse, the sticky price assumption could end up delaying the market signal required to spur investment. This delay is particularly worrisome since many projects have long lead times. This could lead to severe instability in the short-term market. This situation would last for years until the projects came online. Even if the capital markets were spurred to fund them, the increased demand for world savings could heighten other global imbalances.


I’d summarize my view on oil depletion as follows: Initial conditions matter. The short-term market matters. The long-term market solution is not a fixed point that the market magically converges to. It is the interplay of a number of market (and non-market) forces that evolve over time. Because of this, severe instability in the short-term market can have long-term effects.

I’ve tried to make the case for depletion and to describe factors that raise questions about the short-term stability of the market. I’m curious to know what you think.

- Chris Anderson

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