Energy Academic Group Seminar February 20, 2015 The Causes and Consequences of The Oil Price Decline Dr. Robert Looney, NSA Federal Reserve Bank of Chicago, Strong Dollar Weak Dollar

Future Oil Prices Many analysts feel movements in future oil prices are likely to be influenced by several key factors: Future supply/demand conditions OPEC strength/objectives Geopolitical factors Movements in demand As a general rule, lower oil prices today, by reducing investment, result in higher prices in the future Key question – how has shale modified this relationship?

Future Supply Conditions I How persistent is the supply shift likely to be? Depends on two factors First is whether OPEC and in particular Saudi Arabia will be willing to cut production in the future This depends in part on the motives behind the change in its strategy and the relative importance of geopolitical and economic factors in that decision. One hypothesis is that Saudi Arabia has found it too costly, in the face of steady increases in non-OPEC supply, to be the swing producer and maintain a high price – other countries free ride at Saudi expense If so, and unless the pain of lower revenues leads other OPEC producers and Russia to agree to share cuts in the future – strategy unlikely to change in the near term.

Future Supply Conditions II A related hypothesis is that it may be an attempt by the Saudis to reduce profits, investment, and eventually supply by non-OPEC suppliers, and even OPEC suppliers Some of whom face much higher costs of extraction than the Saudis The Second Factor is how investment and in turn oil production will respond to low oil prices. Exploration and production budgets for 2015 face significant curtailment Major projects in high-cost oil basins will be cancelled or postponed However the time lag between investment and production means that additions to supply will continue to come on stream for some time Many projects are simply too far ahead to be stopped

Future Supply Conditions IV For unconventional oil such as shale (which now accounts for 4 million out of a world supply of 93 million barrels a day): The break even prices – the price at which it becomes worthwhile to extract in the U.S. are typically around $60 per barrel However a new analysis based on individual well data finds that 80% of new tight-oil production in 2015 would be economical between $50 and $69 a barrel Companies will continue to improve technology and drive costs down. Still with prices near or below $60 a barrel, U.S. companies are looking hard at their investment plans – where and how much to cut or postpone. But it will take time for these decisions to affect supply U.S. output will continue to rise in 2015

Future Supply Conditions V Break-Even Prices for U.S. Shale basins Lower Oil Prices Are Putting the Freeze on Fracking Projects Around the World Business Insider December 8, 2014

OPEC I An effective cartel requires three things: OPEC lacks all three Discipline A dominant market position, and Barriers to entry OPEC lacks all three Its members cheat on quotas, It supplies only 30% of the world’s oil – too little to exercise control and New producers abound OPEC more follows the a dominant firm model than a cartel Saudi Arabia its most influential member could have sent the price up simply by deciding to pump less The Kingdom has savings of $900 billion Economist

OPEC II But Saudi Arabia can also weather a low price Its production costs are $5-$6 a barrel – the lowest in the world History suggests most of the gains from any cut in its output would go to other producers who would sell their oil for more while increasing their market share Saudi Arabia did try this tactic in the early 1980s cutting its output drastically Result -- higher prices but also a boom in investment and then production in places like Britain and Norway Trying to save OPEC with such tactics could be even more dangerous now Cheap oil has its consolations for Saudi Arabia Russia and Iran two countries which the Saudis have differences are hurt much more

Likely Future Prices I Likely developments regarding future supplies, and OPEC strength impacting on future prices suggest little upwards pressure. This is also the market interpretation -- futures markets now show an expected recovery of prices into 2016 However, uncertainty comes not only from supply, but also geopolitical and demand factors Geopolitical Factors geopolitical tensions in Libya, Iraq, Ukraine and Russia should not be underestimated Demand Factors High uncertainty about global economic activity, especially in the Eurozone and China, and thus the derived demand for oil Not much optimism now for rapid global expansion.

Likely Future Prices II Short Run Oil Price Movements Currently the oil market is massively oversupplied Unless OPEC acts as a swing supplier a glutted market is highly unlikely to be avoided given the lags involved in curbing production. Some supply curtailment is already evident in early 2015 especially in U.S. shale However there will be a substantial inventory overhang through most of 2015 Demand for oil should increase somewhat given lower prices and by early 2018 demand and supply should once again be in balance.

Future Prices V Several factors might modify this outlook Key downside risk instability in Eurozone results in many countries falling into recession Key upside risks are an acceleration in demand particularly with China topping up its strategic reserves, or A supply disruption sparked by geopolitical frictions, Baring these, oil prices should reach approximately $65-70 in 2018.

U.S. Energy Security I Implications for U.S. energy security We define energy security as the ability of households, businesses and government/military to effectively manage disruptions in energy supply. Traditionally low prices have been looked on as reducing energy security because they Undermine incentives for investments in energy expansion and efficiency May remove sources of revenue that deter investors from upgrading or expanding energy infrastructure that that could enhance the reliability of the energy system. Countering these two tendencies are The prospect of rising prices beginning in the first part of 2017 and, Developments in global markets that may have fundamentally altered the economics of oil

Energy Security II How will U.S. energy security be affected? With the good prospect of markets firming up again in 2017, whatever loss in energy security has occurred because of the oil price decline, should be quickly reversed. In addition the period of low prices are unlikely to have an adverse effect on alternative renewable energy supplies The period of low oil prices has demonstrated the weakness of OPEC. That organization unlikely to play a major role in the future in constraining energy supplies

U.S. Energy Security III Most importantly the oil price drop demonstrated that there is a new economics of oil In the past, new supplies of oil had come from large expensive fields with a long lag between price increases and subsequent follow on investment Today, a shale-oil well can be drilled in as little as a week and at a fraction of the cost of conventional oil Process is a little like manufacturing drinks – whenever the world is thirsty, you crank up the bottling plant. Shale development should reduce volatility in oil markets while providing the world and the U.S. with diversified sources of oil – both enhancing energy security

U.S. Energy Security IV In addition there appears to be underway a shift in conventional oil production away from unstable higher cost sources --- Venezuela, Russia, Nigeria, and Iran toward more secure lower cost locations -- specifically the GCC The GCC is determined to maintain market share and to do this they are expanding productive capacity and will likely hold the price lower than in the past to accomplish this – in effect replacing OPEC Their output will come at the expense of higher cost countries Saudi Arabia has sustainable oil production capacity of 12 million b/d Kuwait is investing in sustainable capacity of 4 million b/d and Abu Dhabi going for 3.5 mill b/d Shift to opec from o’ Sullivan

U.S. Energy Security V By 2020 the six GCC states could be in the position to produce 21 million b/d Why Should the GCC countries change their strategy? Markets since 1973/74 have allowed the GCC OPEC states to meet global demand at times of supply interruptions elsewhere and to adjust exports to meet OPEC price targets Supply risks remain but they are much lower. Consuming countries have Increased strategic reserves Diversified away from potentially unreliable oil and gas sources Boosted domestic energy production and Promoted renewables

U.S. Energy Security VI There are good reasons for the GCC to radically raise production and exports We are entering an era where production efficiency rather than control of reserves will be decisive Neither Saudi Arabia nor OPEC will be able to prevent a secular and structural decline in energy prices If the GCC wants to maintain its oil and gas income, it will have to increase hydrocarbon exports Lower prices in turn will weaken three U.S. adversaries Russia, Iran and Venezuela

U.S. Energy Security VII If Saudi Arabia and the GCC lift production as much as possible US-GCC combined production will exceed 30 million b/d by 2020. This is a figure higher than OPEC’s 2014 production and would be equivalent to about 30% of forecast world demand for that year. It would be enough to ensure the GCC working with the US for a generation and more will be able to shape the structure and direction of global energy These oil price trends and associated developments should considerably enhance U.S. energy security.