Flat White

The story of oil

6 April 2022

9:00 AM

6 April 2022

9:00 AM

Don’t look to experts for predictions. ‘Experts’ are just as surprised by everyone else at what actually transpires each day – a fact for which the last two years have afforded us countless examples. What we can look to experts for is an understanding of the present and the past.

In the Oil and Gas (O&G) industry, the last few years – and particularly the last few months – tell a fascinating story that explains much of what is currently happening in the world.

The shale revolution:

I start by going back to 2008. If you read the International Energy Agency’s outlook from 2008, you will find the following sentence:

Oil shales are not projected to make a significant contribution to world oil supply before 2030, but technological breakthroughs could change this outlook.’

None of the experts at the time knew that this sentence held the key to the next shift in global energy.

It is common to consider the oil market in terms of OPEC and non-OPEC. The Organisation of Petroleum Exporting Countries (OPEC) is a group of Middle-Eastern countries that each have an abundant supply of low-production-cost oil and are engaged in a non-competition agreement. This gives them sufficient market share to ‘balance the market’ (i.e. price-fixing).

Over several years after 2008, however, technological breakthroughs did occur, and led to development of non-conventional oil resources, the most significant of which was shale oil. Soon the USA was emerging as the largest global exporter of oil and natural gas.

OPEC’s market share was reduced due to the new supplies, which compromised their ability to control the price and ensure they walked away with most of the profits. Hence, in November 2014, OPEC decided to maintain their levels of production, instead of decreasing production to balance the market.

This resulted in the oil price plummeting, and throughout the world the share price of many oil and gas companies also plummeted. By this stage I had begun working in Oil and Gas at a design consultancy in Adelaide, and it was intense – capital expenditure was cut overnight, multi-million dollar projects were shelved. There were multiple rounds of layoffs, reduced working weeks, pay-freezes, pay-reductions, and finally office closures. Only the strong survived! 

And I kept my job too.

It wasn’t just the West that suffered. Although OPEC’s oil supplies generally have low production costs, the high revenues from oil were propping up their economies significantly. In just a few months, OPEC countries turned surpluses into deficits, or turned small deficits into big deficits that continued to grow at a consistent rate. Nevertheless, OPEC felt threatened by the USA emerging as a global producer.

Enter the OPEC+:

The staring contest between the Middle East and the West was hurting everyone, and yet no one wanted to blink first. Eventually, in 2016, a solution was formed. OPEC made another non-competition deal, this time with Russia.

Russia had also been suffering from the low prices, but also felt strategically threatened by the USA emerging as such a major producer. Russia is a large nation but not a strong one by most measures. They are the eleventh largest economy globally (not that big a fish), and in terms of GDP per capita they are embarrassingly low for a developed nation. Only one year earlier Russia had annexed Crimea and they got away with this without consequences; one reason for which may have been that the rest of the world needed their oil and Europe, in particular, needed their gas.

The new deal was called OPEC+ (and was renewed again just this week, on March 31). The combined market share of OPEC+ was high enough to balance the market.

Over the next several years, the USA’s oil and gas output continued to grow. The Trump administration came into power and viewed the boost in production as a change in geopolitics that ought to be favourable to America’s interests. A shift in attitude towards both Russia and the Middle East was evident during this period for those who knew to look. For example, when tensions rose in the Strait of Hormuz, America showed a reduced inclination to interfere. They didn’t need the oil as much as they previously would have.

America also reimposed sanctions on Iran and imposed sanctions on Venezuela during this period, which they could now afford to do; global trade did not suffer from this curtailing of supply. Yet they also negotiated the Abraham accords for Israel, and encouraged security cooperation with Saudi Arabia and UAE on equitable terms, which showed perhaps a more positive vision for future relations in the region.


Europe’s foolhardy energy policy:

President Donald Trump also urged Europe, repeatedly, to pivot towards USA’s gas to supply their energy needs. This was not merely because USA needed a customer, but was also in Europe’s interests. As the USA gained energy security and independence, Europe was careening in the opposite direction. Europe is heavily dependent on Russia and northern Africa for their natural gas and oil, with significant pipelines going through Ukraine. 

At times in the past, the notoriously corrupt government of Ukraine has (allegedly) skimmed off the top of the pipelines going through their land. Russia has responded by shutting off the gas supply to the pipelines, and Europe has borne the brunt with gas shortages (this happened in 2005-6). The EU and particularly Germany have responded to that situation over the last two decades by building pipelines that bypass Ukraine; firstly with the Nordstream pipeline, then the Turkstream pipeline, and most recently with Nordstream 2, which is only partially built.

Another German energy policy for the last few years has been to turn off all their coal and nuclear power on an aggressive timetable. Their ultimate hope is to replace it with renewables, combined with hydrogen storage to iron out the gap between supply and demand fluctuations.

This policy of actively phasing out reliable existing sources of energy in favour of a new source that is infrastructure intensive, has never been tried, and hasn’t yet been built, seemed (to me) to be scarcely less than self-sabotage. The reality is that Germany turned away from Coal and Nuclear – two fuel supplies that they can purchase in the global market from multiple countries (e.g. Australia) – and left the only viable alternative being natural gas, for which they relied on purchases from a local market controlled by Russia.

Covid causes upheaval:

When the pandemic hit in 2020, all aspects of every economy were affected, including oil and gas markets. You may recall that early in 2020, demand dropped so low that there was a glut of supply and the oil price actually went negative. Yes, producers were paying people to take their oil!

Unsurprisingly, as the pandemic waned, the opposite then happened. The oil price skyrocketed as demand increased and supply increases couldn’t keep up. This situation wouldn’t be expected to last forever. While the price is high, there is plenty of money for producers to recover and to bring more production online. OPEC+ were happy with the high prices, and continue to maintain a gradual increase policy for their production planning (though I have heard some speculation about whether they could increase rapidly, even if they tried).

Nevertheless, the high prices due to lack of excess supply worried a number of developed countries, in part because it came on top of supply chain issues and high inflation. No one wanted high fuel prices to slow down that ‘V-shaped recovery’ we were promised, and so around the end of last year a number of countries, including China, discussed dipping into their strategic petroleum reserves to provide some short-term supply relief.

At this point, if you thought petrol prices were getting high, however, that was nothing compared to what was happening to local natural gas prices in Europe. Usually the price hovers around 25 euros per Megawatt-hour. That increased to sit above 100 during most of Europe’s winter, a level at which it currently remains. This was not just a result of Covid recovery. Europe had a cold winter, and also gas stocks were low.

Putin picks his timing:

Then Russia invaded Ukraine. It is fairly obvious that Putin considered Russia’s role as an essential energy supplier would be a buffer against serious opposition from the rest of the world. As mentioned already, the EU has simply tried to bypass Ukraine in the past, not particularly showing any love for the notoriously corrupt country. When they annexed Crimea, Russia faced no serious opposition from the world at large. Surely Europe would not risk Putin turning off gas while the price is currently five times usual?

In part, Putin was correct. Governments in the rest of the world did not react by sanctioning his energy, but they happily sanctioned everything they felt they safely could. There has also been ‘self-sanctioning’ of energy, which is a silly term; Russia hasn’t been sanctioning themselves. Really it should be called ‘private’ or ‘independent’ sanctioning, because many private companies, ports, purchasers, refineries etc. have refused to take Russian product, and several of the O&G ‘supermajors’ have pulled out of Russian operations. Due to the impacts of this on a market that was already tight, the oil price jumped to a record high. I’d never seen it over $2 at the pump, and suddenly it was at $2.20!

The efforts to secure additional oil supply became more frenzied overnight. More hope was placed on talks with Iran, so that sanctions might be lifted from them. A delegation was sent to Venezuela for the same purpose. Several OECD countries dipped into their strategic oil reserves (though it should be noted that in the end China did not join them, but appears instead to be increasing their stocks). Canada redoubled efforts to get product out of their country by any means possible; for several years Canada has had plenty of supply, but inadequate export pathways (the Keystone XL pipeline was intended to help fix that, but Joe Biden cancelled it on his first day in office).

At the time I write this, we are experiencing a reprieve from high oil prices. This is being credited to low demand from China, because they are putting some cities into Covid shutdown again. It is unclear how long this will last.

Though Putin was partially correct, the current consensus is that on the whole he miscalculated, and on two fronts. His first error was underestimating the resolve of Ukraine and its ability to ensure that this war is, at least, a protracted one.

His second miscalculation is that, while it will be painful, the West has found sufficient resolve to wean itself off Russian energy. We may never have had the guts to take Russia on, but we can certainly cut Russia off. The Nordstream 2 pipeline has been abandoned and will likely never be finished; Europe is looking to secure new gas supplies. Most likely, Russia can’t curtail oil output without breaking their OPEC+ agreement. Putin is trying to make the most of the situation he is now in by demanding that ‘unfriendly’ nations pay for Russian gas using Russian currency, Roubles, or risk having their gas turned off. 

While resolve is currently high, it remains true at the moment that Europe is heavily dependent on Russia for energy and will take time to disconnect and secure alternate supplies.

What about Australia?

Aw… Australia is at most a footnote in this tale, though we’ve had our own cute little saga. For a decade now we have been a net importer of oil, and our refining capacity has been decreasing consistently. The side-effect of this was that, a few years ago Australia’s in-country oil stocks reduced, such that we had enough for about three weeks (when discounting oil ‘in transit’).

After repeated warnings on the issue (and because this actually amounted to a breach of an international agreement we are party to), Australia responded by purchasing some of USA’s strategic petroleum reserves while the price was very low. Although that petroleum reserve would take more than three weeks to get here by ship, nevertheless it gives us trading options in an emergency. Australia also subsidised remaining refineries so that they wouldn’t close, and commissioned building of new oil tanks. Which haven’t yet been built.

It remains true that Australia’s liquid fuel security is very much tied to the global market (Incidentally, China has also become a net importer and has also been building massive strategic reserves, currently estimated sufficient to supply the whole world for about 17 days.)

Lessons to learn:

This story has now caught up to the present time, which brings me back to my first point. I dare not predict the future, but there are lessons to be learned by understanding the present and the past.

One lesson comes from Germany’s wilfully waltzing into increased dependency on Russia. There’s a myth that trade has a civilising influence on other nations. The same myth invited China to join the World Trade Organisation – the belief that they would naturally democratise if only they were admitted into the global community. Hoping for this is one thing, relying on it is quite another.

A second lesson is simple realism. Western nations, including Australia and the USA harbour openly hostile attitudes to the fossil fuels industries, despite the fact that these industries keep us alive every day. At the same time, green advocates are flagrantly lying about the current ability to displace fossil fuels with renewables.

What has this looked like? The Biden administration has banned exploration in the arctic, oil leases were delayed due to issues measuring the ‘social cost of carbon’, the Keystone XL pipeline was cancelled… In Australia we have had fracking moratoria, exploration moratoria, increasing requirements to offset emissions, a merry-go-round for the Adani mine approvals and similar.

And that is only government action – in recent times, private action has been more impactful. Banks, investors, and most notably superannuation companies don’t want to finance oil projects, divesting profitable fuel-related infrastructure and pacing activists on the boards of production companies. It’s even difficult to recruit university graduates, because no one wants to work for ‘evil’ fossil fuel companies. Nevertheless, everyone wants to drive cars, fly overseas, and charge their i-phones. Talk about cognitive dissonance!

Some are optimistically speculating that the high oil prices and the uncertainty caused by it will serve to accelerate the ‘energy transition’. That is, the apparently inevitable transition away from fossil fuels and toward renewables. Their worldview is shaped by Paris promises, UN ‘sustainable development goals’, Davos talk-fests, and fairy dust. It neglects the harsh reality that renewables are not ready to fill the gap. Across the whole world, we consume 100 million barrels of oil a day, the equivalent again in coal, and only a bit less in natural gas. In contrast, the total energy generation from all wind and solar combined averages the equivalent of about 3.8 million barrels a day and only in the form of electricity that must be used the moment it is generated.

In addition to the unrealism, I am frustrated by the false dichotomy. It is actually possible to develop renewables and to adopt renewables for energy consumption to the maximum extent afforded by current technology, and at the same time to supply still-necessary fossil fuels to the world.

Energy is a staple for the developed world – it is essential for life. Fossil fuels remain a necessary form of delivering it. Rather than green sabotage, we need to acknowledge the present reality of the world we live in. We need oil and it’s not a great idea if we can only buy it from a long list of nations who don’t like us very much.

We should be very thankful for the shale revolution, but we should also learn its lesson.

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