The former Saudi oil minister Zaki Yamani famously said that the Stone Age did not end because of a shortage of stones, and the Oil Age will not end because of a shortage of oil.
Peak Debt and Peak Demand
Global markets are now at the second of two major inflection points. The first of these – the point of Peak Debt - was the collapse of Lehman Brothers in October 2008 at which point the burden of debt on the US economy outstripped the capacity of the US people to repay it. Since then, the US economy has been, and will remain, after the approaching global recession hits home, a Japanese-style ‘zombie’ economy.
The second is the point of Peak Demand, leading to the ongoing deflation of China’s massive production boom. What I mean by Peak Demand is that resource costs – and specifically the energy costs of producing the fuel and other commodities needed by China and its Asian Tiger competitors – have now reached a level which the shrinking purchasing power of the developed world can no longer sustain.
Current Oil Market
Readers of ‘Trend’ may recall in October 2014 my accurate forecast of a further collapse in the oil price. I had in fact predicted a fall to $45 to $55/barrel in March 2012 when the price was $110/barrel, but misjudged how long US Federal Reserve Quantitative Easing (QE) would last.
In my analysis, the US successfully engineered for reasons of energy security a five year oil market bubble. They inflated and supported the oil price above $80/barrel using as capital a combination of passive (‘inflation hedging’) private fund investment and Saudi/Gulf Cooperation Council (GCC) reserve assets. The necessary liquidity came from QE dollars printed by the Fed.
Why on Earth would the greatest global energy user support high energy prices? The reason – as in 1973 after the Oil Shock – is that the US is able to pay for oil in dollars manufactured out of thin air by their deficit-based $ banking system. The combination of inflated $ oil prices and Saudi/GCC $ oil proceeds invested in the US (which became known as Petrodollars) enabled the US between 2009 and 2014 to fund the development of an additional 5m barrels per day of high cost shale oil.
This essentially repeated the method by which, after the 1973 Oil Shock, the US and UK had been able to use the original wave of Petrodollars to finance development of relatively high cost Alaskan, US Gulf and North Sea crude oil and hence re-establish a measure of energy security.
However, the US also found, as an unintended consequence, that these inflated $ price levels also led to massive investment in renewable energy – which substitutes for carbon fuel – and to the cheapest carbon fuel of all (Nega Barrels of carbon fuel savings) where the US reduced fuel demand by some 2m barrels per day over the period.
This largely Saudi/GCC funded US oil market manipulation on a heroic scale was made possible by the completely dysfunctional nature – which I have documented for half a decade – of the global benchmark Brent crude oil market price and the Intercontinental Exchange (ICE) market platform on which the Brent Complex of contracts is traded. The outcome is that the US has at last freed themselves of reliance on the Saudis who have increasingly become an embarrassment. So the 70 year relationship between the US and the Saudis has now changed drastically, beginning with a switch by the Saudis from Petrodollars to Petroeuros.
In January 2015 the Saudis/GCC used precisely the same techniques as in the previous US $ financed oil bubble to successfully and rapidly (within six weeks) re-inflate the oil market price to over $60 per barrel. This time, the Saudis/GCC achieved market price support by swapping Bunds (ie € denominated German sovereign debt) instead of US Treasury Bills for leased oil inventory, The necessary € liquidity came from Quantitative Easing by the European Central Bank.
The result was that the private sector received the funding needed for what has been termed a ‘Dark Inventory’ of leased or borrowed oil. The continuing market oversupply of oil has gradually filled global oil storage, and in my analysis this has been funded by Saudi/GCC Petroeuros and ECB € liquidity.
Unfortunately for this Saudi/GCC market support strategy, global oil demand for refining and consumption has been either relatively flat or possibly even falling. This oil market reality has been clouded by demand from China and other oil consumer nations for oil to store in strategic reserves. This demand is not only for physical energy security reasons, but also because these nations calculate that it is economically preferable – at zero interest rates – to hold oil reserves rather than Dollar or Euro reserves.
Meanwhile, on the supply side, producers are competing to produce oil as fast as they can in a race to the bottom. This brings me to the question of OPEC’s strategy as promulgated by the dominant Saudi/GCC OPEC faction. It is said that there are always two reasons for an action: the reason given, and the real reason. The rationale given by Saudi Arabia to OPEC and to the world for pumping oil flat out is that they aim to preserve market share and to destroy competition from US shale oil.
In my analysis, this rationale is spurious, and the real reason for pumping oil flat out is that Saudi/GCC are repaying – in oil – the leased oil inventory for which they exchanged US Treasury Bills (petrodollars) in order to support the global oil price. So the true oil market position in my view is that in the absence of drastic production cuts there will be – within months if not weeks – a fall in oil prices into the $30s at least, and possibly even a market discontinuity to much lower levels.
After this imminent short term decline and fall in the oil price, then in the medium and long term the market will in my view never rise – other than perhaps briefly – above $60/barrel again. The reason for this oil market ‘cap’ or upper boundary price is firstly because the US now has a massive strategic petroleum reserve of shale oil viable at that price level; secondly because of substitution by renewable energy, the costs of which are declining rapidly; and finally because as this price level approaches, investment in energy efficiency – Nega Barrels – becomes increasingly profitable.
So to cut a long story short we are, I believe, seeing the death throes of the existing oil market paradigm of oil bought and sold as a commodity for $ profit.
If so, what may replace it?
Transition through Gas
The dominant International Oil Companies (IOCs) such as Exxon and BP are now caught between the Irresistible Force of rising costs (since cheap to produce oil has almost all – apart from Iraq and Iran – been extracted) and the Immovable Object of a $60/barrel cap on prices.
While some IOCs pursue the chimera of Iranian and Iraqi oil, others such as Shell have made a strategic switch to gas development instead. In the gas market, extraction of excess profit is taking place through unnecessarily over-complex and costly mega-projects, particularly in increasingly baroque LNG projects.
In my view, the transition through gas now under way will involve a change in both business objectives and business structure towards a less capital intensive model. Firstly, there was a significant but little reported intervention in Ashgabat by Azizollah Ramazani – CEO of the National Iranian Gas Exporting Company (NIGEC) and a board member of National Iranian Gas Company (NIGC) – at a conference in December 2014 convened by the UN and Energy Charter Treaty organisations.
Iran was expected to join Russia in opposing the proposal for Turkmen gas to be piped via the Caspian and the Southern Corridor to Europe. But Ramazani observed that rather than wasting energy in such long distance export it makes more sense to use the finite resource of natural gas as locally as possible, and with as little waste as possible through creating new Caspian Energy Grid infrastructure . The energy market operating principle, Ramazani suggested, must in future be to minimise the use of carbon fuel for a given output of electricity, heat/cooling and power. He pointed out that such a Least Carbon Fuel Cost operating principle has been applied by Denmark since 1973 for reasons of energy security and national resilience.
This policy principle is gaining traction among the astute Iranian officials at the Energy Ministry who are working hard to upgrade – post-Sanctions – Iran’s disastrously inefficient and wasteful legacy energy infrastructure. They observe that this has to some extent been forced upon Iran by the need for self sufficiency and a resilient economy in the face of market exclusion.
The key to implementing this principle, as my colleagues and I have pointed out to an increasingly receptive audience in Iran’s corridors of power, is to utilise a new approach to financing and funding energy infrastructure. This consists, in our view, of a combination of energy swaps – ie flows of energy such as Iran’s swap of natural gas for Armenian power – with a new class of direct investment in energy infrastructure. This transparently uses the very same prepay mechanism which Saudi/GCC has been opaquely using, with US facilitation, to fund the recently ended oil price bubble.
The global gas market of the future which I envisage will not consist of gas sale agreements (gas as a commodity) but will consist of gas swap supply agreements, such as gas for power; gas for petrochemicals and even gas (CNG) for transport swaps. Physical spot gas supply and demand will constitute the necessary regional ‘Balancing Point’ spot price for optimising physical gas supply and demand.
The key gas market financial instrument based upon this new spot gas market will no longer be a derivative (forward) instrument, debt instrument or even an equity share instrument, but will be a generic natural gas prepay credit instrument. Simply put, gas producers & exporters will issue in exchange for value received promissory instruments which they will then accept from their physical gas customers in payment for gas instead of (or as well as) $ and €.
Gas producers collectively may then come to an agreement – a Gas Clearing Union – within which they would mutually accept, account for and settle gas credit issuance. Since 2011, I have advocated a regional Caspian gas/power market as a starting point for such a new gas market architecture.
In relation to oil I think we will see a new generation of oil swaps. Firstly we will see more geographic swaps such as the Caspian oil swap pioneered by Iran which exchanges a flow of oil into Northern Iran for a flow of oil exported from the Persian Gulf: the US and Mexico have recently begun to use this method.
Secondly we will see oil for product swaps, so that instead of selling oil as a commodity, producers will increasingly enter into long term supply agreements, with potential for swaps of oil for oil products, or rights to oil products (product credits).
The outcome of the combination of energy swaps and prepay credits will therefore be a transition away from an energy-as-a-commodity competitive market paradigm of energy bought and sold by middlemen for $ transaction profit. Instead we will see a collaborative market paradigm of energy-as-a-service where market participants co-operate to share in cost reductions through the use of the least carbon fuel cost principle.
A New Market Paradigm
I believe that if natural gas is valued correctly, and then monetised through the use of gas prepay credits then any resulting surplus over production costs may be shared within a new settlement between gas producers and consumers. New and efficient energy infrastructure could then be funded by investors via Gas Loans of gas credits and operated by gas market service providers with very low needs for conventional finance capital. In this way, it will be possible for a neutral global gas market platform and gas credit instruments to facilitate the financing and funding of a Transition through Gas to a low carbon economy.
This also provides a more rational market mechanism for the fundamentally misconceived Kyotomarket architecture which will in all probability receive the last rites at the upcoming COP21 conference.. As has been said, if you wish to keep a cow healthy you regulate what goes into the cow, not what comes out. So instead of monetising intrinsically worthless CO2, which is carbon after the energy has been combusted, it makes sense to monetise – and value correctly – the intrinsic energy value of natural gas (and other carbon fuels based upon it as a benchmark) and thereby fund the transition to a low carbon economy.
Finally, we are seeing the EU, led by an increasingly desperate Germany, attempting to combine its top down Energy Union project (essentially creating an EU Energy Ministry) with the EU-centred Energy Charter Treaty, in order to finance new energy infrastructure using European technology and services to energy producers outside the EU with € denominated debt.
In this way, the ECB would not only give energy backing to the € but would also achieve energy security through accessing regional energy using € denominated loans. In my view, this ‘least € cost’ combination of € bank debt finance and the Western paradigm of absolute property rights is incompatible with the resource sovereignty of producer nations and is therefore doomed to failure.
The first element of an optimal geopolitical solution is, I believe for the EU to join a Eurasian Energy Clearing Union based upon the ‘least carbon fuel cost’ principle first publicised by Ramazani in Ashgabat a year ago. The second element is a new Energy Accord public/private market framework agreement which is complementary or additional to the Energy Charter Treaty and shares risk and reward more equitably.
While some observers believe that Iran should be invited at next weekend’s G20 meeting to join the G20 post-Sanctions this seems an unlikely outcome. So perhaps when Russian President Vladimir Putin attends the upcoming Gas Exporters Countries Forum meeting in Tehran the following week, the idea of the formation of a gas-specific Russia/Iran G2 might instead be on their Agenda?
* Chris Cook is a former director of the International Petroleum Exchange. He is now a strategic market consultant, entrepreneur and a commentator