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The US Energy Revolution - Confluence Investment Management

July 30, 2013 | About:
Canadian Value

Canadian Value

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In March 1971, the Texas Railroad Commission (TRC), which allocated oil production for the state of Texas, announced that producers in the state would be allowed a “full allocation.” This was the first time the TRC had allowed Texas producers to supply an unlimited amount of crude oil since WWII.

The TRC spearheaded America’s “swing producer” role in managing global oil supplies. The oil market, more often than not, has been cartel-controlled. From Standard Oil to the TRC and currently OPEC, the oil market has tended to have some producer or group of producers who keep some production offline to maintain prices. Because oil finds tend to be “lumpy” and demand inelastic, a new elephant field can cause a collapse in prices. At the same time, a sudden withdrawal of output due to accident or war can lead to a dangerous spike in prices. The cartel usually acts to adjust excess capacity to lower price volatility. For this reason, governments tend to support an active cartel in the oil markets. Although market purists object, the critical nature of oil tends to bring cartels. On the aforementioned fateful day in 1971, the United States not only publicly admitted it could no longer provide this service to the world market, but it also began the steady process toward losing energy independence.

Energy dependence has been painful for the U.S. Two oil embargos in the 1970s led to crippling price increases. The U.S. has expended significant military and diplomatic resources in the Middle East in an attempt to secure oil supplies from this region. America has fought two wars in this area and was involved in protecting oil supplies in a third conflict. Every president since Nixon has called for policies to deal with this energy dependence. To date, none have been successful; however, President Obama may be close to addressing this perennial problem.

In this report, we will discuss the importance of oil, especially focusing on the military requirements of the commodity. From there, we will offer a short graphical examination of the North American oil and gas revolution. An analysis will follow of how the increase in net supply offers the opportunity for the U.S. to dramatically change its foreign policy position. We will conclude, as always, with market ramifications.

The Importance of Oil

On July 1, 1911, a German Naval vessel, the Panther, steamed into the harbor at Agadir on Morocco’s Atlantic coast. Kaiser Wilhelm had sent the German ship to probe French influence in the region and to investigate if this region of Africa would be conducive to German colonization. Germany was rapidly becoming a world leader; its GDP had grown to British levels and it was clearly expanding its power. The struggle for European hegemony was a major historical problem that lasted from the Dark Ages until the end of WWII. Britain was actively trying to contain Germany and was looking for ways to maintain its hegemony.

Britain was primarily a naval power. Although it had an accomplished army, its power projection came from its ability to control global shipping. If Germany was building a navy, given its potent land forces, the country would be a major threat to Britain’s empire and its global superpower role.

To counteract Germany’s rise, Winston Churchill, who was First Lord of the Admiralty, made a bold decision. Churchill ordered the Royal Navy to convert its ships to oil from coal. Oil offered advantages to coal. Oil has much greater energy content compared to its weight. Ships carrying the same weight of oil compared to coal could travel farther and faster. Refueling depots could be farther apart. Ships can also refuel faster using oil compared to coal.

However, there was one obvious risk to making this switch. Britain had ample coal reserves; at the time, it appeared to have virtually no oil (of course, some fifty years later, commercially accessible oil was discovered in the North Sea). Churchill was converting the navy to a fuel for which his nation had no indigenous supply. Britain did control portions of modern-day Iran (then known as Persia) and had discovered oil there in 1908. Britain could also buy oil from Russia and the United States. Essentially, Churchill decided that having numerous sources of supply made the risk of switching to oil worth the improvement in performance.

Although oil clearly is important to normal economic operations in peacetime, a modern war cannot be conducted without it. This fact became obvious during WWI as mechanized units, moved by internal combustion engines, replaced horses and coal-powered rail locomotives.

However, it was in WWII that it became abundantly clear that oil had become the deciding factor. The Roosevelt administration had implemented an oil embargo on Japan, threatening its ability to project power. In response, Japan bombed Pearl Harbor to buy it time to capture the Dutch East Indies and the oil it produced. The surprise attack on the U.S. naval base in Hawaii was designed to prevent the U.S. from interfering with Japan’s move to the south. In Europe, one of Hitler’s objectives in attacking the Soviet Union and breaking its successful non-aggression pact with Stalin was to capture the oil production in the Caucuses. The Nazi thrust into North Africa was a direct threat to British oil supplies in Iran; if the Suez Canal had fallen to Germany, Britain would have been dealt a severe blow because it would have affected its ability to secure oil from Persia. By stopping Germany’s advance at the Battles of El Alamein, the Allies were able to maintain control of the Suez Canal and access to Middle Eastern oil. At the end of the day, the United States, due to its massive oil reserves and production, was able to provide enough energy to win the war.

After WWII, there were two incidents that highlighted the power of oil. First, the 1956 Suez Incident, where the Eisenhower administration forced the British and the French to “stand down” and retreat from their goal of retaking the Suez Canal after Egypt expropriated the waterway, spelled the end of the European empires and made clear that the U.S. was the leader of the free world. Even more important, European nations would now be forced to rely on the U.S. Navy to ensure that oil shipments came to the continent. Second, the aforementioned end of the U.S. swing oil producer role made OPEC and especially the Middle East critically important. The uncertainty caused by this development has led to repeated and mostly fruitless efforts for the U.S. to gain energy independence. It has also caused the U.S. to become heavily involved in the Middle East as losing control of this region would mean the U.S. could not only suffer economically, but it would no longer be able to fight a major global war. Although the U.S. has been able to maintain access to the Middle East and oil flows have been maintained, it has come at a high cost.1

The Energy Revolution

The end of U.S. oil hegemony in 1971, as we have noted above, was a significant economic and geopolitical event. In this section, we will use several graphs to highlight not only the changes from 1971 but the recent turn of events.

This chart shows U.S. oil output.

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The blue line on the chart shows monthly production while the red line shows production on a rolling yearly average. The peak in production in the early 1970s is obvious. However, it is worth noting that there were other periods where it appeared that a zenith had been reached, only for new finds to bring higher production. In the 1920s, it was commonly believed the U.S. was near peak production and that a steady slide in output was imminent. The East Texas oil discoveries in the 1930s ended that discussion. There were also worries of a similar nature in the late 1950s but new techniques, including offshore drilling and Alaska’s North Slope, led to new peaks. However, after 1970, oil production did not recover to earlier highs. We did see some increases in production in the 1980s but this lift occurred in a period of high prices. As oil prices plunged in the mid-1980s, U.S. oil production began what appeared to be a secular slide…at least until 2005.

Although the existence of large oil deposits, locked in tight formations and shale fields, had been known for decades, the high cost of extraction and the lack of technology to exploit these fields prevented them from being tapped. However, the creation of fracking—the use of water and abrasives to open up these formations—along with horizontal drilling and persistently high prices made these formations economically viable. The results have been dramatic. As the chart shows, current U.S. production is up nearly 85% from its recent low in 2008. On a yearly basis, the increase is 38%.

As U.S. production has increased, oil imports have declined as well. As the chart below shows, oil imports jumped in the 1970s as American production peaked. OPEC was supplying the majority of this oil, making the U.S. extremely vulnerable to disruptions from the Middle East. The drop in imports in the early 1980s mostly due to weaker demand caused by regulatory changes (e.g., higher automobile efficiency standards, the elimination of oil in electricity output) and two recessions reduced U.S. dependence on OPEC.

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However, as prices collapsed, OPEC regained some of its market share, supplying half of U.S. imports by the early 1990s. Note that imports peaked in early 2006 and have steadily declined. We have also included oil imports from Canada on this graph. Canadian imports now account for 30% of U.S. oil imports, the highest level in four decades. Oil imports from Canada are important because they represent perhaps the safest supply of oil outside the U.S. Tar sands oil is a major component of Canadian oil exports to the U.S. and an example of the impact of unconventional oil supply on the global energy market.

The increase in oil output is just part of the energy revolution. Fracking has also had a dramatic impact on natural gas production. As the 1990s came to a close, it was becoming evident that natural gas production was not keeping up with consumption. In the winter of 1999-2000, prices spiked to record levels and raised fears that the U.S. was “running out of natural gas.”

clip_image006_260.gif

This chart shows natural gas production levels for the U.S. on an annual basis. Note how production declined into 2006 then reversed rapidly. As fracking technology spread, production jumped. This production increase can not only (at least, potentially) offset oil consumption, it has lowered prices, which will offer the U.S. a comparative advantage in natural gas intensive industries (e.g., petrochemicals, fertilizer, steel and plate glass production).

The final piece of the puzzle is consumption.

clip_image008_231.gif

This chart shows U.S. oil consumption on a per annum, per capita basis. This shows how many barrels of oil the U.S. consumes per year, per person. Note that during the period of peaking U.S. production, consumption was rising rapidly. This was the period when Americans drove very large cars, fast, over longer distances. As demand rose and production peaked, imports (as noted earlier) soared.

Demand dropped as prices rose and consumers demanded smaller, fuel efficient vehicles. Of course, two recessions also dampened consumption. As growth returned and oil prices declined, consumption did not rise to previous levels (at least on a per annum, per capita basis) but ranged between 24 to 26 barrels per year. However, the 2007-09 recession, coupled with regulatory changes, has led to a massive decline in consumption. The U.S. is now consuming at levels not seen in nearly 50 years.

The combination of rising production and falling consumption has led to a sharp drop in energy dependence. In fact, if one includes North America as a whole, the U.S. is rapidly becoming energy independent.

The Geopolitics of Energy Independence

The geopolitical impact of energy independence cannot be overstated. If the U.S. is reaching the point where it can rely on domestic and North American energy to supply its military in case of a major global war, then relations with the Middle East change dramatically. Energy dependence on the Middle East required the U.S. to fulfill two goals. First, it had to prevent any potential enemy from gaining control over Middle Eastern oil. Second, it had to ensure that the U.S. had access to the same oil. The Carter Doctrine codified these points, making external threats to the region a casus belli. Regional energy independence means that only the first goal is required. In fact, the U.S. may be better off in a global war to purposely disrupt Middle Eastern production which would likely prevent any enemy from maintaining hostilities against the U.S. for very long.

If access to Middle Eastern oil isn’t a high goal any longer, our exercise of hegemony in the region changes as well. The U.S. has generally operated to ensure stability in the region, which has forced it to support authoritarian regimes and maintain the colonial borders in the region. If access isn’t as necessary, the U.S. can support indigenous movements in the region, such as the “Arab Spring,” which may overthrow previously reliable rulers and may even redraw the maps of the region. Other relationships change as well. The U.S. does not have to be as sensitive to Israel. If the Kurds want to carve out a nation from Turkey, Iraq, Iran and Syria, the U.S. can support this effort. Placating the Saudis becomes less critical.

The world has become accustomed to the U.S. ensuring the Middle East would be politically stable and that oil would continue to flow. The U.S. had a vested interest in this outcome since we needed the oil supplies ourselves. If this is changing, the rest of the world may need to make its own military and diplomatic arrangements. Simply put, Asia and Europe may no longer be able to “free ride” on American security. This could force foreign defense spending to rise rapidly.

If the U.S. manages to keep consumption restrained, American energy exports could rise. The jump in natural gas production has changed U.S. plans for that fuel; in the previous decade, the U.S. was expecting to import liquefied natural gas (LNG) from other countries, including Qatar. Now those plans have been reversed, with permits being approved for LNG export facilities. If a nation wants to purchase U.S. LNG, it needs a permit from the U.S. government. According to American trade law, any nation that has a free trade agreement with the U.S. automatically grants export permits. The U.S. is currently engaged in free trade discussions with Asia and Europe. Access to American LNG will give the U.S. leverage in these talks. American LNG can give U.S. allies access to reliable fuel and undermine leverage for other energy providers; this could be a major factor in weakening Russia’s hold over Europe.

Essentially, the energy revolution will give American policymakers a powerful tool in managing global relations. Still, it is quite possible that defeat could be snatched from the jaws of victory.

The Necessary Elements

For the energy revolution to have the results discussed above, there are some key elements policymakers will need to provide. Otherwise, the promise of energy independence could still disappoint.

Support for production: Although no one supports environmentally dangerous energy production, there are elements of the environmental movement that want to end all hydrocarbon production. The political class will need to ensure that such radical positions do not become policy.

Foster an “all of the above” energy policy: At the same time, skewing energy policy to only support hydrocarbons is a mistake. Every barrel of oil or cubic foot of gas that can be offset by renewable energy is a resource that enhances U.S. power. Continued support for wind and solar power is essential, especially the development of storage technologies that offset the intermittent nature of these energy sources. In addition, the Federal government will need to use its powers of persuasion to overcome the regional nature of the power grid to allow for a truly national energy grid that can more fully utilize Midwestern wind energy and coastal tidal resources.

Support North American energy: Simply put, it is necessary to build the Keystone pipeline and other pipelines to open up Canadian tar sands for export. The oil is environmentally controversial. However, from a geopolitical standpoint, if the U.S. does not relieve this bottleneck, the Canadians will eventually act to export this oil themselves. It appears that President Obama is leaning toward approving the XL pipeline; in return, he is severely restricting coal consumption as an environmental tradeoff. Although this trade does violate the previous point, coal is not as critical of a fuel geopolitically and this trade may be his best chance to sway the environmental movement to accept the pipeline.

Suppress domestic energy demand: Americans seem to be susceptible to various policy myths. For most Americans, health care reform seems to offer the promise of being able to “consume all the health care they want for free.” In reality, health care reform is, at some point, about changing how care is rationed. In energy, the idea of independence means “cheap gasoline and large cars.” Although the U.S. could certainly go that route (deeply subsidized oil product prices are common in the OPEC nations2) and it would be politically popular, allowing domestic demand to rise would doom the geopolitical promise of the energy revolution. Ideally, taxes should be levied on energy consumption; not only would it help reduce the deficit but it would keep consumption down and foster consumer choices for efficiency. It would also create demand for new efficient technologies and alternative fuels. Unfortunately, such taxes are politically unpopular; instead, policymakers tend to favor regulations that bring efficiency (e.g., outlawing incandescent light bulbs, mandating auto mileage minimums). No economist would prefer regulation to taxation, but few economists ever win public office either! If the U.S. suppresses demand, it means less dependence on foreign energy supplies and can free up domestic production for export. Although such actions are politically difficult, they are critically necessary for the geopolitical success of the energy revolution.

Ramifications

The ramifications of energy independence are potentially game changing. Freeing the U.S. from its attention on the Middle East and forcing other nations to bear more of the burden of global stability are probably necessary for the U.S. to transition its superpower status from the Cold War position to the present situation, something the U.S. has, thus far, failed to do effectively.

Clearly, energy companies, especially natural gas providers, should benefit from this revolution. The infrastructure firms should also benefit as the U.S. reorients its energy industry from an importing to an exporting nation.

Perhaps the most significant impact from the energy revolution could come from investor sentiment. Since 2000, U.S. equity markets have been mired in a secular bear market. Although there have been impressive cyclical bull markets (we are in one now), the change in sentiment that leads to a steady rise in long-term P/E ratios and rising, less volatile markets has not developed. In our opinion, secular bull markets are the product of a society that has addressed major issues and has given investors hope that the future will improve. What we are enjoying now is a cyclical bull market driven by unusually accommodative monetary policy. However, the energy revolution could be powerful enough to create conditions of renewed hope and end the current secular bear market.

Bill O’Grady

July 29, 2013

www.confluenceinvestment.com

About the author:

Canadian Value
http://valueinvestorcanada.blogspot.com/

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