Volume 15 Issue 1 This is an excerpt from the Spring 2015 issue of The Linneman Letter. Oil Economics By Dr. Peter Linneman, PhD Chief Economist, NAI Global Principal, Linneman Associates The big questions on everyone’s mind are, “What do low oil prices mean?” and “Will they remain low?” The volatility of crude prices has increased since 1994. From 1964-1993, the standard deviation of real crude prices was $24 per barrel. In contrast, the standard deviation of prices for the most recent 20 years was $31 per barrel. In the first quarter of 2008, immediately before the Great Recession, real oil prices increased 41%, from $104 per barrel to $146 per barrel, a 50year high. Since 2008, real oil prices have been volatile, with crude plummeting to $43 per barrel in the first quarter of 2009 before rising to $116 by the second quarter of 2011, and subsequently declining to current pricing. $140 Historical Crude Oil Price Per Barrel (Real 2014 $) $120 $100 $80 $60 $40 $20 $0 1969 1973 1977 1981 1985 1989 1993 1997 2001 2005 2009 2013 The real price of West Texas Intermediate crude oil in February 2015 averaged about $51 per barrel, which is 51% below its $105 peak in June 2014, but 2% above the 50-year average of $50 per barrel. At $43 per barrel in mid-March 2015, real crude prices are 2.7 times their 50-year low of $16 per barrel, reached in 1998. This compares to a real price of $103 per barrel in 1981; real prices today are 58% below this mark. Table of Contents Over the past 50 years, real oil prices have generally been $20-50 (in 2014 dollars), while the ratio of oil to natural gas prices has a norm of 6.8x. As fracking over the last 7 years massively increased natural gas production, natural gas prices fell dramatically. At natural gas prices of $3-5 per MMBtu (million British thermal units), the price of oil should be $20-45 today. Yet just 6 months ago, to our utter confusion, oil prices were well in excess of $100. Thus while we do not claim to understand the timing of the collapse of oil prices, nor its “emperor has no clothes” speed, we understand today’s oil price far better than we did when it was above $100. Comparing Renewable Energy Resources Several years ago we conducted a very simple exercise to calculate oil prices based on economic growth and elasticities of supply and demand. Repeating this analysis indicates that since 2004, global real GDP has risen by about 31%. If the elasticity of demand with respect to real GDP is (a very high) 4, while the price elasticity of oil The Sun Is Shining And Canaries Are Still Chirping Canary Watch Box Tax Inversion Is Not A Crime – In Fact, It Is Good Oil Economics The Linneman Letter Look-back: Oil Prices Central Bank Interventions Must End Linneman Perspectives The Impact Of Immigration On Citizen Welfare Ten Facts You Should Know About U.S. Immigration The Survey Of Household Economics And Decision Making Real Estate Capital Markets The Linneman Letter Look-back: China: From Net Importer to Exporter Housing Market Update Market Close-up: Minneapolis Office Market Close-up: Phoenix Industrial Market Close-up: Chicago Multifamily Market Close-up: Atlanta Hotel Office Market Outlook Industrial Market Outlook Multifamily Market Outlook Retail Market Outlook Hotel Market Outlook Seniors Housing And Care Market Outlook Vacancy/Occupancy And Absorption Projections ® For more information about a subscription to The Linneman Letter, contact Doug Linneman at [email protected]. Volume 15 Issue 1 demand is zero and there is no increased supply due to higher oil prices, the price today should be 2.24 times the $36 price in 2004, or about $80. But if the elasticity with respect to real GDP is a more realistic 2, the price today should be about $49. Add to this a 2% increase in global supply (all due to increased U.S. output), some degree of demand elasticity with respect to price, and the collapse of the OPEC cartel, making oil prices in the range of $30-60 feel “about right”. Perhaps we will finally be proven right about oil! Better late than never. ® 10 5 0 1987 1991 1995 1999 2003 2007 Average 1983-2009 Historical Energy Prices 140 $ per Barrel 2011 Ratio (Real 2014 $) 16 120 14 100 12 10 80 8 60 6 40 4 20 2 0 1983 0 1987 1991 1995 1999 2003 Crude Oil 2007 $ Per Thousand Cubic Feet 1983 2011 Natural Gas U.S. Oil Imports 400 350 300 250 200 150 100 1990 1993 1996 1999 2002 2005 Barrels 2008 2011 U.S. Net Import of Gas and Oil 12 2014 Average LTM 4.0 3.5 10 3.0 8 2.5 6 2.0 4 1.5 1.0 2 0.5 0 1973 0.0 1978 1983 1988 Crude Oil 1993 1998 2003 Natural Gas 2008 2013 Trillion Cubic Feet (Gas) Fracking and deep sea production have not only pushed down prices by increasing oil supplies, but it has also made it far more difficult for OPEC to maintain an effective cartel. While Saudi Arabia could reduce its production to a point that would offset U.S. fracking and deep sea production, this would impose a staggering cost on its domestic economy. The largest beneficiaries of any Saudi production curtailment would be Iran and Russia, but the Saudis are unwilling to subsidize their Iranian enemy (or their Russian ally), with whom they are waging proxy wars in Syria, Iraq and Libya. One does not subsi- 20 15 Millions of Barrels It is important to appreciate the scale of U.S. oil production expansion and the scale of output reduction required by Saudi Arabia in order to maintain oil prices. In 2010, the U.S. produced roughly 2 billion barrels of oil annually, representing 7.4% of global output. And at that time, many said we had reached “peak oil”, both in the U.S. and globally. We have always written that “peak oil” is a tragically flawed concept, as it ignores the power to innovate in terms of both supply and demand. In 2014, thanks to fracking and deep sea production, the U.S. produced 3 billion barrels, achieving a 10.8% market share. This 50% increase in output in just 4 years is due to innovation. In fact, U.S. production is up by 1 billion barrels while the output of the rest of the world (which refuses to embrace fracking) is down by 500 million barrels. (Real 2014 $) 25 Million Barrels Per Day (Oil) The U.S. has net imports of 5.2 million barrels of oil daily. At a price decline of $60 per barrel, this amounts to a net gain of $114 billion for U.S. consumer wallets, or about 0.7% of GDP. This is an enormous gain to the U.S. economy, even though oil producers and related services have both suffered severe capital losses. But these capital losses are more than offset by the gains to U.S. consumers of oil products. This will prove particularly beneficial to those in the lowest 20th percentile of the income distribution, who spend roughly 3% of their income on gasoline. These consumers have de facto received an enormous subsidy thanks to U.S. fracking, which has disrupted the pricing dynamics of OPEC. Ratio of Crude Oil to Natural Gas Prices vs. Historical Average 30 Volume 15 Issue 1 Of course, not everyone wins, as oil producing areas will notably suffer. For example, at oil prices below about $65 per barrel, the Bakken region is generally not a viable extraction area. Houston and Dallas will also see notable slowing in their oil focused economies. Large capital losses have also been suffered by the owners of oil extraction and servicing companies, while their lenders will likely incur loan losses. In the near term, the biggest problem for U.S. oil producers is the lack of growth capital. Much as real estate owners lever up in times of peak property values, oil producers have taken on staggering amounts of debt over the past two years. At today’s oil prices, not only will additional debt flows be shut down, but many producers will struggle to service their debt burdens. Over the next year or two, many U.S. oil producers will struggle under the weight of huge debt burdens incurred during the heady days of $100 oil. This debt burden will challenge the growth capacity of many oil and natural gas producers, even if on a project basis, IRRs support further drilling. Given their debt burdens, these ® 27.2 Total 27.7 Total 25 20 15 10 25.2 ROW 24.7 ROW 2 USA 3 USA 5 0 2014 2010 USA Rest of World Crude Oil Production 12 Million Barrels Per Day In a classic example of Adam Smith’s Invisible Hand theory, U.S. oil consumers have gained from the efforts of fracking innovators and entrepreneurs who were simply seeking profits. It did not result from the endless “energy” and “self sufficiency” policies created by the U.S. Energy Department (under 40 years of different administrations). The answer to economic progress is self-interest driven innovation, not edicts by mandarins. This is equally true for job growth. In short, fewer political photo opportunities and more private enterprises are the surest routes to economic progress for the poor, the rich and everyone in between. (Billion Barrels Annually) 10 8 6 4 2 0 1950 1958 U.S. 40 1966 1974 Russia 1982 Iran 1990 1998 Qatar 2006 2014 Saudi Arabia U.S. Share of Gas and Oil Production 35 30 Percent In order to offset increased U.S. production, Saudi Arabia would need to reduce their oil production by about 40%, or a billion barrels a year, costing them $50-60 billion, or nearly 10% of Saudi Arabia’s GDP. Thus, absent U.S. innovation (which continues), global production would have fallen, meaning oil prices would be rising rather than falling. And in spite of producing massively more oil than in 2010, U.S. proven oil reserves far exceed their 2010 levels. Yet again, so much for claims of “peak oil”. Believe in “markets”, not “peaks”. This output increase has not only enriched the U.S., but it has also provided the marginal capacity that broke OPEC. Oil Production Summary 30 25 20 15 10 5 0 1980 1984 1988 1992 1996 Crude Oil 2000 2004 2008 2012 Natural Gas Production Cost Curve Transformed Breakeven oil price, $/bbl dize countries with whom you are at war! Thus, the breaking of the OPEC cartel was inevitable, as large marginal supplies in the U.S. make Saudi curtailment too painful both economically and politically. 120 110 100 90 80 70 60 50 40 30 20 2009 2010 2011 2012 2013 2014 Shale has flattened the oil supply curve 0 10,000 20,000 30,000 Cumulative peak production, kbd 40,000 50,000 Volume 15 Issue 1 producers will lack the free cash flow and borrowing capacity to undertake profitable new drilling. This means that drilling will fall farther, even for natural gas, and faster than the economics of drilling profitability suggest. This is especially true of fracking for natural gas, for which drilling economics remain largely unchanged. As happens with real estate development, periods of high prices fuel inordinate production, which sows the seeds for future excess supply. During that time, little new exploration occurs, which in turn drives the next cyclical price increase. Eventually the debt of over-levered companies will be restructured, or defaulting or at-risk borrowers will be absorbed into firms with strong balance sheets. As that occurs, drilling will cautiously resume in the face of attractive project level IRRs. These dynamics, which will play out in the oil and gas sector over the next few years, are all too familiar to real estate developers. Oil Breakeven Price ($/Bbl) Kuwait 54 Qatar UAE 60 77 Iraq 101 Saudi Arabia 106 Oman 107 Venezuela 118 Nigeria 123 Bahrain 125 Algeria 131 Iran 131 WTI Oil Breakeven Price ($/Bbl) 24.2 25.6 32.4 Marcellus Shale - SW Liquids Rich Marcellus Shale - Super Rich Utica - Wet Gas Mississippian Horizontal - East Utica - Liquids Rich Eagle Ford - Liquids Rich Niobrara - Wattenberg Wolfcamp - N. Midland Bone Spring (1st / 2nd) - NM Eagle Ford - Oil Window Yeso Cana Woodford Shale - Oi Wolfcamp - S. Midland Cana Woodford Shale Mississippian Horizontal - West Wolfberry Bakken Shale Three Forks Bone Spring (3rd) - W TX Wolfcamp - N. Delaware Uinta - Green River Uinta - Wasatch (H) Granite Wash - Liquids Rich Horiz. Uinta - Wasatch (V) Barnett Shale - Southern Cotton Valley Horizontal 42.2 44.0 46.1 46.1 53.9 55.0 55.3 58.5 59.9 61.6 61.6 64.1 64.6 64.7 66.9 68.5 68.5 68.8 72.2 73.1 75.0 84.5 90.0 NYMEX Natural Gas Breakeven Price ($/MMBtu) Marcellus Shale - Super Rich Utica - Liquids Rich Eagle Ford - Liquids Rich Mississippian Horizontal - West Marcellus Shale - SW Liquids Utica - Wet Gas Granite Wash - Liquids Rich Cana Woodford Shale Cotton Valley Horizontal Marcellus Shale - NE Marcellus Shale - SW Fayetteville Shale Barnett Shale - Core Horn River Basin Barnett Shale Barnett Shale - Southern Pinedale Piceance Basin Valley Haynesville Shale - Core LA / TX Eagle Ford Shale - Dry Gas Woodford Shale - Arkoma Haynesville/Bossier Shale - NE ® 0.25 0.25 0.25 0.29 0.62 1.35 2.47 2.50 2.94 3.02 3.26 3.27 3.34 3.65 3.66 3.70 3.75 3.81 4.13 4.25 5.05 5.37