Rice University’s James A. Baker III Institute for Public Policy recently hosted a conference, “Energy Market Globalization: Investment and Commodity Price Cycles and the Role of Geopolitics.” Much discussion focused on the relationships of oil prices to other economic indicators, and whether these relationships indicated that oil prices may tumble in the near future. The Federal Reserve’s quantitative easing programs were another hot topic, agreed to have seriously affected energy prices and the economy as a whole since the initiative began in 2008, but whether positively or negatively was a matter for debate.
The most dramatic subject of the day was a three-fold exploration of why oil prices may be headed for a downslide, presented in different parts by Ken Medlock III, Mahmoud El-Gamal and Amy Myers Jaffe, all of whom have ties to the Baker Institute. Should oil prices fall sharply, the unconventional oil production paying the bills for U.S. shale exploration and development would be under far more pressure, with the new network of pipeline infrastructure it requires along for the ride.
Medlock, James A. Baker, III, and Susan G. Baker Fellow in Energy and Resource Economics at Rice, examined what is driving oil prices and whether price cycles could be predicted using historical data. Comparing oil prices from 1973-97 to 1998 through the present, he analyzed prospects of a price collapse.
The cost to drill a well is correlated to the price of oil, he pointed out. “This is a pretty fundamental feature of what determines oil price. Frankly, it gets at the heart of the nature of cycles.” In short, when prices are high there is a large incentive to drill more oil and develop new ways to get it to market, whether via new technology, farther-flung locations or unprecedented methods. As prices stay high, consumers adjust their behavior to use less oil, and demand falls. Prices then fall with demand, and historically, “the barrel at the margin got kicked out.”
“During periods where prices are generally trending upward, you actually can relate that back to what’s happening in the upstream sector, in particular, investment opportunities. So supply begins to respond positively. But at some point the whole thing begins to trend the other way.”
In the United States before the shale boom, “the reason we stopped producing oil wasn’t that there wasn’t any oil, it was because there was a cheaper alternative—imported oil.”
Talking about the parallels between today’s expanded sources of oil and the situation before the oil bust in the ’80s, Medlock asked, “Are we setting ourselves up for another repeat?”
Mahmoud El-Gamal, professor of economics and chair in Islamic economics, finance and management at Rice, suggested that the price of oil is being kept artificially high by the quantitative easing program, with an additional boost from the threat of war in the Middle East. Therefore, unless something changes, oil prices should be expected to crash.
El-Gamal said the economic recovery in the U.S. is lackluster largely because oil prices, which should fall in a recession as economic activity decreases, have not come down enough to fuel further growth.
“The pattern, which has been studied econometrically very extensively by people like Jim Hamilton, Lutz Kilian and many others, is that high oil prices lead to recessions and low oil prices lead to recoveries,” El-Gamal said, referencing economists from the University of California, San Diego State and the University of Michigan, respectively.
“The Fed is inflating away asset prices, preventing them from coming back to the normal levels that they should have given, the current level of economic activity. What has happened is this recovery is stymied.”
He came to his judgment of current oil prices by mapping oil and gold prices and determining how much gold would be needed to buy a barrel of oil at a particular point in time. By this measure oil prices were at approximately their mean point versus historical data, at a value equivalent to about 3/50ths of an ounce of gold per barrel.
“Because we don’t have the recovery yet, demand destruction is going to continue, and other things being equal, we expect prices to collapse.”
Amy Myers Jaffe, executive director for Energy and Sustainability at University of California, Davis and El-Gamal’s coauthor on “Oil, Dollars, Debt and Crises: The Global Curse of Black Gold” (Cambridge University Press, January 2010) built on this thesis with an exploration of a “worst-case scenario” that could keep prices high or even raise them higher: a situation in which the civil war in Syria became a regional conflict, Saudi Arabia experienced an implosion of status quo such as those that have destabilized other Middle Eastern and North African nations in recent years, or another event caused supply blockage from a major oil-producing nation.
“There’s no replacement for Saudi exports,” Jaffe reminded the audience, and although Saudi Arabia could potentially make up the difference from other potential events, she outlined results to a scenario without a Saudi backfilling of supply that included an immediate reversal of the economic recovery and an impact on international banking reminiscent of the 2008 crisis.
A decline in oil supply would help some industries, though, including, possibly, natural gas. “I like natural gas in transportation if suddenly I can’t have oil from Saudi Arabia because it’s available and everybody can convert their car for $300. The second I would see something’s going down in Saudi Arabia I would buy clean energy stock.”
Jaffe also pointed out that lifestyle trends from the millennial generation, including enthusiasm for urban living and telecommuting, could coincide well with a decrease in oil supply, and that any interruption in the Middle East oil supply would make U.S. shale investment leap, intensifying changes in energy transportation needs that are already in process.
“We used to think the oil was going to be far away and we needed lots of distribution infrastructure, giant tankers, giant pipelines. Now the oil and gas is actually where the lights are on, it’s next to end-user demand.”
Noting that investment in the shale plays by 2015 is expected to be quadruple what it was in 2010 even without a disruption in other supplies, Jaffe discussed how the proximity of resources affected what got developed. “New pipelines, refinery tower upgrades, all of that is going to change transport patterns and export economics. I think after we see the Panama Canal expansion in 2015, again, there’s a lot of product that might not necessarily be 100% commercial to move out today that’s suddenly going to be really commercial, that may plug a hole in supply in Asia or compete against traditional naphtha or LPG.”
With more energy commercially recoverable in non-OPEC nations, Jaffe said OPEC must decide whether to defend price or market share. “If they pick price, they’re swimming upstream,” she said, referencing what she called the long-term structural decline of oil use. She said this was an argument for the U.S. to export energy commodities in order to exert downward price pressure and promote a transparent market economy for energy.
Not all the speakers held the same views of the market and its levers. Chevron’s chief economist Edgard Habib gave a thoroughly different interpretation of the future of energy in the twilight of the quantitative easing program, crediting the central banks with saving the economy from collapse when politicians could not act in concert quickly enough to avert the fallout of the financial crisis. The banks created “a floor below benchmark financial prices, eliminating uncertainty concerns and pushing investors into riskier assets.”
“In a credit-driven economy, stabilizing the financial system was a business imperative for the government. When fiscal policy was busy with austerity, the central bank had to act.”
New energy and the intervention of the central banks catalyzed growth, he said. “In the absence of these two factors in the world, the recovery would have been much more muted than it is today.”
Habib noted the diffusion of economic power worldwide and the potential for a reshuffling of the geography of energy markets. On whether unconventional tactics could be replicated elsewhere he acknowledged the U.S. has widely recognized advantages in technology, intellectual property, mineral rights and resources, but that did not mean unconventional methods could not be applied elsewhere.
“China is next, in my estimation. I was privy to a dialogue in Washington and I was saying to the departed president of the World Bank, ‘They have water issues in China. They can’t do that.’ He said, ‘They build pipelines and they build big ones. When they say they’re going to do something they end up doing it.’”
Habib explored the prospect of regional energy markets developing in place of global ones. Given that North America is producing, refining and consuming much of its own energy, with associated advantages in proximity and security, he suggested other markets might become regionalized similarly, Latin America and China in particular. “We could be entering the world of a race between OPEC and technology.”
Daniel Ahn, a visiting scholar at the International Monetary Fund, offered a correlation he had found between the dollar versus other currencies and the WTI price for crude beginning in 2004. Since then, he said, changes in the value of the dollar have coincided with those in the real price (non-dollar-denominated) of crude oil, so that when crude rises in price, the dollar becomes weaker. Likely contributing factors were that oil was being used as a hedge against inflation and a safe investment in times of uncertainty over the dollar’s strength.
“Crude oil seems to be coalescing as a benchmark for global economic activity, for confidence in the financial system, and as a proxy for what financial econometricians call risk-on assets,” commodities and currencies used when traders fear inflation.
Oil trading has become disconnected from the oil actually consumed, dating to when Ahn can see the relationship between dollar and oil developing. Commodity markets in general are becoming more sophisticated, Ahn said, in part because of China’s rapid growth.
“There was no way for financial investors to get direct access to China, a few small pockets aside, so commodities served as this indirect back-channel way of buying into the China story,” since investors could take positions in the raw materials China needed from the global market. Other indirect inputs, such as quantitative easing and the Eurozone crisis, also became important, as well as classical indicators such as inventories. “All these new factors started going in to what determines crude oil prices.”
Some questioned the situation which leaves the industry unable to take full advantage of the current price point. Charles McConnell, former Assistant Secretary for Fossil Energy at the Department of Energy who stepped down in January, said regulatory foot-dragging on the Keystone XL has wide-ranging effects.
“This inaction, this not deciding continues to keep investments in U.S. refineries on hold, and I could argue pipeline decisions from the Bakken to the East Coast for East Coast refineries are just as much in an unknown circumstance,” he said. “It’s domestic and North American-based energy, it’s all good and part of our long-term strategy, but still those investments remain locked up because of the uncertainty.”