Oil and the Global Economy

How important is oil to the future of the global economy?  The remarkable economic expansion of in the United States and other industrial nations over the past century or more has been fueled by a steadily growing supply of low-cost energy—mostly from fossil fuels—oil in particular which accounts for more global energy consumption than any other source.

But there is growing uncertainty whether this trend will continue as it has in the past.   How will shifting trends regarding the cost, demand, and supply for oil affect the global economy and the outlook for investment and economic growth?

Guests:

• Stephen P.A. Brown – professor of economics and director, Center for Business and Economic Research, Lee Business School, University of Nevada, Las Vegas; visiting fellow, Resources for the Future; associate editor, Energy Policy
• Mark Lewis – senior analyst for energy, climate, and sustainability research, Kepler Cheuvreux ; former head of energy commodities research, Deutsche Bank
• Jim Hansen – president, Ravenna Capital Management

Key Questions:

• Cost: What are the key trends regarding costs of oil production and what are the implications for the global economy and investment in the energy sector.

• Price: How are recent trends regarding oil prices affecting the global economy? Is there a tension between sagging prices and rising costs and if so, what are the implications for the global economy and investment in the energy sector?

• Demand: How are trends regarding oil demand —rising sharply in some countries, flattening in others—affecting the global economy?

• Supply: How does uncertainty regarding energy supply factor into the outlook for the global economy and investment in the near-term and further down the road?

 

Takeaways:

Bullets below summarize remarks by featured guests; they are not definitive statements by The Energy Xchange. In the spirit of discourse, this information may be revised through continued discussion.

• Measuring the importance of oil to the global economy is an inexact science. By itself, oil accounts for less than 10 percent of world GDP, but much of the world’s capital stock is designed to use oil; when oil becomes more expensive, that capital becomes less productive. Moreover, transportation is critical to the function of the global economy, and transportation is extremely dependent on oil. Adequate alternative technologies have not yet been developed.

• The crux for reducing oil dependence and greenhouse gas emissions in transportation is to either find alternative liquid fuels or develop better batteries (or otherwise electrify the transportations sector). Alternative liquid fuels are currently estimated to cost roughly 4-5 times more than current prices for petroleum.

• The upstream part of the oil and gas industry has become much more capital intensive over the past decade or more—for both conventional and especially unconventional sources of petroleum—mostly owing to the depletion of cheaper conventional resources. From 2000-2013, capital expenditures increased almost three-fold in real terms—from $250 billion to nearly $700 billion (2013 US dollars), roughly 2/3 for oil and 1/3 for natural gas. Meanwhile, the global supply of crude oil increased only 11 percent over that period–mostly due to increased production from tight oil (shale oil) in the United States and oil sands in Canada. Global conventional crude oil production peaked in 2005, and is about 2 million barrels lower today than in 2005.

• The new reality in the oil industry represents a fundamental change for the global economy, requiring more and more capital to maintain oil supply, and higher prices to sustain investment. Energy has accounted for more than 40 percent of growth in global non-financial corporate capital expenditures—compared to only 7 percent for telecommunications, for example.

• Adapting the global economy to a future of more expensive liquid fuels will require dramatic improvements in energy efficiency and the energy productivity (dollars of GDP generated per unit of energy). Projections by the International Energy Agency (IEA) for liquid fuel production/consumption, oil prices, and economic growth are predicated on reducing the energy intensity of the global economy by half by 2035. This would require improvements in energy efficiency and energy productivity at a rate that is 1.5 times faster than the past two decades (1995-2015).

• Adaptation to new economic realities of oil will be disruptive—faster than oil companies would like, but slower than others might like. But there will be a plethora of investment opportunities. One does not need to find the next superstar, just understand the general trend.

 

Other Key Points

• There is a lack of consensus among economic researchers about the role of oil and oil prices on the global economy. Many studies indicate that oil price shocks have played a major role in creating global recessions; other research disputes that work. An oft-heard saying: if you lined up all economists end to end, you still wouldn’t reach a conclusion.

• Rising capital expenditures in the oil industry were already a concern for investors before a sharp decline in world oil prices, but price drop has triggered rapid reductions in capital expenditures—with corresponding production declines observed in many cases. Current oil prices are unsustainably low, and if prices don’t recover back to $100 territory, a constriction in global supply will be evident within two to three years.

• Increasing price volatility has consequences—there are limits to how quickly industry can respond. For example, after price collapse of the 1980s, had there been a jump in prices, the industry would have had no capacity to respond. Even during more recent deployment of hydraulic fracturing (fracking) and other technology, industry was scrambling to find engineers. It takes time for capacity to be built. Shale can come on more quickly—because of rapid decline rates and more intensive drilling—but it still subject to disinvestment if prices are depressed for too long.

• Uneconomic drilling can continue for a while—despite declining value of rigs and lower returns on investment—as firms think it better to get something rather than nothing—but eventually infrastructure supporting industry will start to disappear.

• Pressure to maintain dividend payments and the interest of investors who view oil as an income investment also constrains capital expenditures. If it becomes questionable whether dividend payments can be maintained at previous levels, oil companies would have to seriously rethink how they face the future.

• The oil industry will have a hard time growing global supply at prices under $100, but can the economy and consumers endure high oil prices? Research on long-term impacts of climate policy suggest that the economy would gradually adapt, mostly by becoming more efficient and holding down total expenditures on energy, but recent experience in advanced industrial nations suggests the transition may be rather bumpy. China and other developing economies continued to grow despite high oil prices.

• The experience of many European countries shows that strong economic performance and a high standard of living is possible while consuming much less oil per capita. Acknowledging the many differences among European and other economies, the United States and other resource-based economies like Canada and Australia have enormous potential to thrive on much less oil.

• The United States cut oil consumption dramatically following oil shocks of the 1970’s—most of it came from non-transportation uses. In 1978, three million barrels per day (mbd) of oil was used for electricity versus 0.2 mbd today; heating oil, 6 mbd then versus 1 mbd or less today. New nuclear electric plants and cheap coal helped. Total reductions of 8 mbd are almost equal to total current U.S. oil production.

• The challenge is that remaining uses of oil in the economy—primarily transportation—is a tougher nut to crack. Previously, substitutions occurred where they could. If available in transportation they would have happened there too. Thus far, natural gas, electricity, and other fuels haven’t pushed oil out of the transportation sector, but if viable substitutes are available and timeframe is long enough, it is still possible.

• The transition to electric transport is likely to be gradual—the rate will depend on whether electric vehicles can come at a price point that consumers will cycle through auto fleet of 250 million vehicles in the United States and are affordable to booming markets like China (which sold roughly 20 million cars in 2014). Cycling rate for U.S. passenger fleet is projected to be in the single digits according to some studies—perhaps slower for commercial trucks. For full electrification, not just hybrids, battery technology needs to improve dramatically, but we are starting to see large amounts of PRIVATE sector capital moving into battery research and development—e.g. Tesla’s giga-factory in Nevada.

• Pace of adoption of electric vehicles may be most limited by consumer ability to financially handle conversion–not just vehicles, but charging infrastructure etc. Creative financing may help, but there is only so much debt that consumers and the economy can handle. Seven-year car loans are already becoming more common—buying more car with lower payments akin to developments in housing. Moreover, developing countries without sufficient electric infrastructure need either distributed electricity generation or else they will use liquid fuels.

• International Energy Agency projects global demand for liquid fuels will continue to rise, from 90 mbd to 105 mbd (all liquids) by 2035. Prices will rise in real terms to $135/barrel in 2013 dollars (to ensure sufficient investment) and world economy will grow by three or more percent per year on average year. To square their model, IEA assumes global oil intensity (energy per unit GDP) will fall by half—i.e. efficiency will double. This is ambitious—the rate of improvement would be 1.5 times the speed of oil efficiency improvements over the last two decades. The challenge is that each successive efficiency gain and oil reduction becomes more difficult. Absent a change in climate policy, IEA scenario seems unrealistic as oil would now have to be squeezed out of transportation—whereas before there were ready substitutes—and it will be more costly than previous improvements.

• Carbon pricing may be an increasingly important shaper of investment in the oil and gas industry, but it is uncertain how much it will influence demand; effects will likely fall more heavily on oil and natural gas (even though natural gas is less carbon intensive than oil, there are easier ways to cut carbon). Pressures on all fossil fuels from carbon pricing may be easier for economy to handle given they would be relatively predictable, but pressures from renewables and electrification are likely to be less so.

The Energy Xchange