Energy Sector Developments:

The Energy Crisis Has Not Been Solved

by Joseph Dancy, LSGI Advisors, Inc. | January 9, 2009

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Global energy demand correlates very closely with economic growth. As the global economy came to a sudden standstill in the last quarter energy use was impacted. Supplies quickly exceeded demand for both crude oil and natural gas.

Dow Chemical closed 20 facilities and temporary idled 180 plants in December amid a deepening global recession – and other chemical manufacturers did likewise on a global basis – putting a dent in demand as crude oil and natural gas serve as both a feedstock and fuel source.

The decline in U.S. manufacturing deepened in December as demand for such products as cars, appliances and furniture reached the lowest level since at least 1948 according to the Institute of Supply Management’s Manufacturing index, signaling future cutbacks which will lower total energy demand.

Exports and imports from China declined by roughly 20% last month, a figure that surprised many. European manufacturing activity also continues to shrink at an alarming rate. As the global economy slows both crude oil and natural gas prices have been adversely impacted.

That said, several developments are worth noting and are bullish longer term:

  · Crude Oil Prices Remain in ‘Super Contango’  The crude oil futures markets are in a rare condition some have called  ‘super contango’ - a condition where prices twelve or twenty-four months in the future are much higher than the current spot price for crude oil (charts courtesy of Financial Times).

A contango condition is not the normal situation in the futures markets. Normally prices in the future are lower than the current price (a condition known as ‘backwardization’ and is illustrated by the ‘one year ago’ line on the chart). And a ‘super contango’ (illustrated by the ‘yesterday’ line on the chart) where the spot market price is substantially lower than the price 12 months in the future is a very unusual event.

The super contango is most likely being fueled by the credit crisis and the need of companies to produce as much product as they physically can to generate cash. The contango situation would normally create an incentive to delay production to a future date, and generally supports upward pressure on short term prices as such production is delayed.

This condition has lead some larger companies to charter large crude oil carriers to use as storage facilities. Buying oil at spot ($42 a barrel roughly) while selling 12 month futures simultaneously (at $60 a barrel) yields a profit even after the cost of the charter and storage.

What the super contango condition telegraphs, according to some analysts like Donald Coxe, is the fact that market participants realize that crude oil will not be in excess supply for long. As the global economy regains its footing demand will increase, and so will prices, all as reflected in the crude oil futures curve.

  · Russian Production Declines  Over the last eight years global supplies of crude oil have benefited  from strong increases in exports from Russian fields. Russia is the number two exporter of crude oil globally behind Saudi Arabia. The importance of this country to the global crude oil markets cannot be understated (see export and production chart from the Wall Street Journal).

In 2008, instead of another gain in production, analysts were surprised as production fell year over year. Worse, with the price decline in crude oil Russian finances and the economy are in a state of shock. Production is expect to decline further in 2009.

The ruble has fallen in value as the crisis has progressed, and some Russian cities experienced protests over tax policy and employment issues as the economy slowed.  Several Russian energy firms are in serious financial difficulties due to debt burdens and have applied to the state for assistance.

Meanwhile, as noted last month, without significant capital expenditures and maintenance in existing oil fields the average production decline rate was estimated at roughly 9% - and some major fields are declining much faster (Mexico’s massive Cantarell field for one, declining in excess of 12%).

  · Global Demand Declines Are Temporary  Recent estimates of global crude oil demand for 2009 have all been adjusted downward. With the global recession the forecasters all expect a decline in consumption next year (with the exception of the International Energy Agency (IEA), chart courtesy of the Financial Times).

While crude oil demand may have declined suddenly with the economic slowdown, supplies will also be impacted as depletion continues to take a toll. Companies and countries put off maintenance and exploration activities due to the current weak pricing, and the ongoing global financial crisis will restrict capital expenditures.

Short term, over the next year, assuming no geopolitical unrest or internal disruptions in major exporting countries (including Russia, Iran, Iraq, Venezuela, Nigeria and Mexico) energy prices may remain below what we have seen the last few years.

International Energy Agency Chief Economist Fatih Birol predicted downward pressure on oil prices to remain in place for 2009 due to the drop in demand, but he expected prices to move up sharply again in 2010. "The projects aimed to develop oil fields are being postponed. This poses a great risk. Demand will pick up when the world economy starts recovering," he said. "Because oil supply will be limited due to today's postponed investments, a serious supply-demand problem will emerge in 2010."
Birol forecast that oil prices may rebound to around $100 per barrel with a recovery in the world economy, and he expects to see a transition from an energy market dominated by multinational oil companies to a market ruled by national energy companies.

  · Rig Counts Are Falling Quickly  One of the characteristics of both natural gas and crude oil production is the fact that both deplete over time. The rate of depletion for both has increased over the last several decades, somewhat significantly, in part due to technology and in part due to the age and nature of some of the major fields.

Production from unconventional natural gas wells in shale reservoirs can decline over 40% in the first year of operation, so drilling activity is needed to keep deliverability in place.

The number of active natural gas rigs in the U.S. has taken a tumble over the last few months – and we expect the decline to continue into the first quarter of 2009. Less rigs drilling mean fewer wells completed, and as existing wells decline the supply and demand for natural gas will come more into balance (chart courtesy of Credit Suisse).

With the massive and abrupt slow-down of the economy natural gas demand for industrial and generation uses has fallen quite quickly and quite far – so even the cold winter and heating demand has not kept natural gas prices elevated. Dow Chemical and other chemical manufacturing facilities have idled or scaled back operating capacity at dozens of their plants due to plummeting global demand – and these plants use hydrocarbons for both a feedstock and for energy needs.

Over the last few years the increase in natural gas deliverability in the U.S., mainly from shale wells, has been stunning. That said, many producers have indicated that most of these unconventional wells will not be anywhere near profitable at the current spot prices now being offered.

While demand has fallen off a cliff for natural gas, we expect the supply side of the equation will begin to exhibit a much lower rate of growth – which will be clearly evident by the fall of 2009.

Long term supply and demand trends are very powerful – for both crude oil and natural gas – and we expect the market for both commodities to self correct relatively quickly. We think the worst case has been priced into the stock of many of the producers – it is clear we are in a severe recession, and energy usage does not generally expand during recessionary periods.

 

Copyright © 2009 Joseph Dancy
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Joseph Dancy Adjunct Professor, SMU School of Law | Oil & Gas Law, SMU School of Law
Advisor, LSGI Market Letter | Email | Website

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