Firstly though, I will summarise the arguments because it is quite long.
1. The US will now be able to produce cheap oil. Its not mentioned how, but I am guessing its something to do with shale and technological breakthrough with extraction (given that he contrasts it to natural gas, of which improvements in technology, eg fracking has allowed greater extraction) or the drilling around Alaska.
2. OPEC will have no choice but to produce more themselves, because eventually the increase supply will lead to decrease prices, and OPEC will have to adopt a more quantity approach to pay their bills. This is reliant on the assumption that OPEC (he includes Russia as well) can increase their supply easier than the US, presumably because their oil is the traditional and easier to extract variety.
3. Cheaper oil will benefit China more than the US even though the latter gains energy independence. Despite giving benefits to the US, its bad because it benefits China more. Note he uses an analogy with US gas shale production, claiming that China has benefited in the same manner by using increase global supply to bargain down the price of natural gas it buys.
4. With energy independence the US doesn’t need so many troops in the ME to maintain energy supply under official justifications. This is bad because the real reason the US troops are in the ME is “projecting pivotal U.S. power across Eurasia, the Middle East and into Asia.”
Also as a typical conservative, he makes no mention of climate change.
Now for the article in question.
Good. U.S. elections are out the way. It’s back to the serious business of government. In what’s long been billed as the inexorable rise of China and the relative fall of the U.S., energy gains in America are supposedly going redress the balance back in Washington’s favour. Conventional wisdom tells us that America can reinvent itself as an energy giant, vastly reduce its deficit, stimulate its economy, and pick and choose how far it underwrites global hydrocarbon security. Superpower status has been extended for another hundred years (or more) in what’s been coined the ‘New American Century’. Unfortunately, those writing this perfectly shaped script have missed a fatal subplot when it comes to cheap U.S. oil: Economic gains for America will only ever be marginal for a post-industrial country, whereas for China, it will be nothing short of an import miracle. If America forges ahead to become the world’s largest oil producer in the next five years, mirroring what’s already happened in natural gas, OPEC will have little option but give up on price, and go for enhanced volume instead. In a new world of cheap energy abundance, the only real winner is China, hands down. Far from being Washington’s global salvation, cheap energy will be its instrumental to its nadir. ‘Obama ground zero’, it starts here.
America As Number One?
The clock is already ticking for the U.S., precisely because it’s seeing liquid gains that have already played out in the gas world. After secular decline from 1986 to 2008 that left America importing over 60% of its oil, the turnaround has been staggering. Production growth has averaged 500,000b/d over the past four years, with liquids output set to hit a massive 11.4mb/d into 2013. What’s more, despite Mitt Romney’s ‘drill baby drill’ ticket, it was never really going to matter who won the White House on 6th November 2012, both candidates were always going to keep looking to energy as the main economic catalyst America has to hand. 60,000 wells have been drilled in the U.S. since President Obama first took office, and the numbers will keep going up towards 2016. This has fundamentally been driven by the private sector that went after dry gas first, and’s now moved to wets; hardly a party that the Federal government has any interest in wrecking. American liquids production stands at a 14 year high; imports are down to 41%, figures that could drop as low as 35% in the coming years – and significantly lower – if transport efficiency and switching measures kick in. Production is still fractionally below Saudi Arabia, but few doubt that under ‘business as usual’ American production will leap towards 13-15 million barrels a day over the next five years. Uncle Sam reclaims its mantle as the largest energy producer in the world. Balance of payments improve, the deficit is fixed, oil flows North to South across the Americas, never East to West across the Atlantic. America is back. And it’s big.
Sounds great, and even better when the message is relayed by the energy independence ‘coterie’ dangling the prospect of ‘1.6 million’ new energy jobs; but let’s stop there for a minute and ask what really happens if America goes headlong into become the world’s largest oil producer? Nobody wants to think about that side of the equation when the overriding aim is securing ‘energy independence’ – but think they must – precisely because America energy gains are going to come with a wealth of downside geopolitical baggage. The most fundamental of which is that it’s neither in Washington’s transitional interests to shift the energy pendulum West, let alone forging a new energy world where hydrocarbons are structurally cheap. This is a comparative game that America needs to play with China as its only rival to the global throne. Not a race to the ‘bottom of the barrel’ that delivers a pyrrhic ‘victory’ for the U.S. while handing over all the geo-economic and geopolitical keys to China.
Transitional Friction: Collateral Damage From U.S. Shocks
Transition issues first. While it’s true that America is already a net exporter of oil products, even if the U.S. surpasses Saudi Arabia to become the world’s largest single oil producer, it’s never going to be in a position to act as the ‘swing producer’, dictating how much everyone else should pay for a barrel of oil globally. U.S. volumes relative to domestic demand simply aren’t there to play that game. Rather, Washington’s ‘pricing power’ will be limited to the collateral damage it does to traditional producer states, not as a definitive geopolitical and geo-economic pricing tool that America can use at its instant disposal.
The fact that America can never be the ‘new OPEC’ isn’t all bad of course; it would be rather awkward dictating to Europe and Asia how much they’re supposed to pay at the pumps. But it doesn’t negate the ‘collateral problem’ America has here: U.S. oil gains aren’t just a ‘blunt instrument’ for Washington to play with, it’s a very dangerous one. Despite the current $25 spread between WTI and Brent, everyone knows that no single nation can insulate itself from global price pressures and shocks. But the ironic thing is that it’s America that’s going to be delivering the main ‘supply side shock’ for everyone else to cope with in the next couple of years. With (700,000b/d) production gains showing no signs of easing from Bakken, WTI will have to be fixed as a ‘broken benchmark’. Once Cushing gluts are drained, pipes are welded and oil companies selling oil to the highest bidders, WTI-Brent spreads won’t just narrow, America will start influencing global price bands elsewhere. The Seaway pipeline has been made reverse flow linking Southern American states to Cushing; the Keystone XL pipeline will be signed off into 2013 feeding Alberta tar sands to Texan refineries, alongside a raft of barges, lorries and trains all making their way to U.S. ports. Don’t worry about developments in the ‘Gulf of Aden’; it’s the ‘Gulf of Mexico’ that international producers need to worry about for oil markets.
That’s all going to be deeply problematic for ‘traditional’ producer states. The last thing they need is U.S. crude driving down international prices below $100/b thanks to rapid supply growth, acutely responsive to variable costs. OPEC states – just like FSU players – are all banking on three figure oil to balance their fiscal and budgetary books. Despite coining $1.026tr in 2011, and likely to net a record $1.16tr in 2012, OPEC states are desperately trying to cling onto power. Petrodollars have to be spent appeasing restive populations with houses, wages and subsidies, buying political support, paying off the military, bureaucracy and intelligence services. Quoting the geological cost of production is frankly irrelevant these days; it’s the geopolitical costs of survival that petro-states have to think about.
With the Arab Spring morphing into a ‘Salafist Séance’, that certainly applies to Saudi Arabia struggling with Shia unrest in its Eastern Province (not to mention Yemeni implosion to the South). It applies to daily crackdowns in Kuwait; it applies to an increasingly heavy handed UAE; it applies to a fractured Iraq; a splintered Libya; a nuclear bent Iran, and an explosive Nigeria. Not to mention corrupt Algeria and Angola – a politically divided Venezuela – and an increasingly nervous Russia. The IMF thinks that the Gulf Cooperation Council will be running fiscal deficits if prices slip below $100/b and government spending continues to rise. ‘Cash rich’ is relative term these days, even for Gulf monarchies. For those facing internal secession issues the political implications don’t bode well, especially if they’re working on the spurious assumption that power can still change hands behind ‘closed doors’ without the Arab street having a say. But it’s not just traditional producers that have a vested interest in three figure oil prices. The list goes far beyond into emerging energy players facing technical challenges to bring oil to the wellhead. Think Brazil, East Africa, Australasia and even Canada.
Now, at the expense of making the energy independence crowds’ case for them, many will indeed say, well, what’s the problem? This is exactly what we want. America can relax. Sit back, pick and choose what it decides to do to underpin global oil supplies and where, pretty much as it’s done in Libya and Iran (albeit in very different guises). America uses its energy growth to keep traditional producers on their toes and emerging markets firmly in their hydrocarbon place. All partially true – but there’s no free lunch here – not even a free entrée I’m afraid. Like it or not, American energy gains create three serious political problems for Washington. The first is that their own production growth will add far further volatility to international oil markets – volatility that American consumers will still have to pay for. Given America will have no ‘petro-friends’ left to speak of throwing its energy weight around, whether the Saudis will bother moderating markets on the road to U.S. energy serfdom, as they did for the 2012 Presidential elections, remains highly unlikely. U.S. supply growth is fast, but it’s never going to be as quick as control valves on OPEC pumps if they feel their market position is threatened.
The second – related fact – is that it makes a total mockery of American military posture in the Middle East. It doesn’t make sense for America to spend billions of dollars providing external security guarantees across the Gulf, only to watch them internally implode under the weight of lower oil prices, directly driven by U.S. energy output. That’s not great news for the State Department, who knows full well that its presence in the Middle East has nothing to do with securing energy supplies for American consumers, and everything to do with projecting pivotal U.S. power across Eurasia, the Middle East and into Asia. Stay planted in the Gulf, and Washington can exact ‘easy’ concessions elsewhere. But unfortunately for Mrs. Clinton, the ‘Carter Doctrine’ simply isn’t going to wash with the U.S. masses when it comes to maintaining Washington’s strategic role in the world. Why ‘waste’ America treasure and blood on OPEC states when the U.S. is swimming in oil? Trying to explain the complexities of global energy markets to American voters when things turn bad – and collateral costs spiral out of control – forget it.
But there’s a third, more serious problem for America. Despite the enormous upheaval that lower energy prices will create across producer states, many of whom will inevitably see regimes fall, once we’re out the ‘other end’, newly installed leaders could reach an inflexion point where they decide they’re no longer able to play the price game, but get forced towards sheer volumes instead. It’s not like they would have much to lose at that stage, particularly when you consider that domestic oil consumption has been damaging OPEC balance sheets. The Middle East saw consumption grow 56% from 2000-2010, four times the global growth rate, and double that of Asia. With populations and per capita energy use rising rapidly, OPEC needed an ‘energy revolution’ anyway – not just to pump more and more oil – but developing cheaper domestic alternatives as well. America’s cavalier approach to oil could provide the perfect excuse to do so: If the price game is up, reboot to a volume based system to cover receipts instead.
The numbers notionally stack up. As an Eni report suggested earlier this year, even under a run of the mill outlook, the world could increase its total production to around 110mb/d by 2020, up 17.6mb/d. The report also noted that ‘unrestricted’ additional production from international fields, unadjusted for ‘risk’, could yield up to 49mb/d extra production of liquids by 2020. Quite a hike by anyone’s standards; but what the report didn’t look into was the enormous conventional and unconventional potential still left in the Caspian, MENA and Russia. If America thinks it’s ‘big’ on the unconventional front, bet your bottom dollar, these guys are going to be absolutely massive. They’ve barely started looking at unconventional plays, precisely because they’ve been able to keep playing the conventional game till now, coining decent rents as they go. But start going down the volumes path, and expect unconventional numbers to explode alongside remaining ‘conventional’ lists. This basically gets us into a utilitarian game of who’s got what sitting under their soil, sand, salt or ice. In a race to the bottom, America doesn’t win that game, not even close: The EIA’s 482tcf of recoverable gas starts to look relatively modest, 25.2 billion barrels of oil, paltry.
Obviously, just as the Eni numbers will prove to be wildly inaccurate, nobody can put a credible figure on how large global reserves will be. The unconventional map needs to be fully chartered with realistic costs worked out before we get that far. But what politically matters here is the underlying point: Traditional producers have enormous potential to increase oil production. Whatever unconventional gains have been made in the Western hemisphere could be instantly reeled back in to reaffirm the original ‘8 to 10 rule’ of 80% of oil and gas sitting in OPEC & Russia, with around 10% left in OECD states and 10% in China. The status quo ante is basically restored.
But if the unconventional balance goes full circle, it will do so with a deadly twist; we’ll enter a brave new world where the aim of the game is volume, not one of price. For those confused, please don’t be. This is precisely why the U.S. needs to be very careful how it uses its energy gains in the next few years. If it opens Pandora’s Box of globally cheap energy, not only will it soon be surpassed by OPEC and Russia ramping up volumes on strategic grounds, it will have failed to grasp the biggest game of all: Washington will deliver exactly what China wants as its only contender to superpower status. The dream scenario of cheap and abundant energy supplies, handing the keys to the global economy directly over to China: Beijing gets its industrial revolution on the cheap, sourcing supplies from wherever they like in a perennial buyer’s market. It’s very simple question, cui bono from cheap energy? Not America, they’ve had their industrial highpoint in the mid twentieth century, but China, China, China. Far from being America’s salvation, cheap energy will be the biggest strategic own goal in history.
Structural Own Goal: Gas Lessons
And that’s America’s structural flaw here: In comparative terms, cheap energy doesn’t mean much to the American economy, but it means everything to China. Look at the numbers. America’s GDP was around $15trn last year, with the oil and gas sector accounting for little more than 1% of national GDP. America can pump all it likes – it’s never going to shift the needle for a post-industrial economy towards an energy based future. For all the talk of cheap gas giving America a competitive edge, manufacturing only employs 9% of the non-farm workforce in the U.S., and the chemicals sector a mere 0.6%. That’s pretty small beer when you consider America has a total labour force of 155m people. Even when you look at the trade deficit, most analysts think the U.S. will do will to clip it by $150bn towards 2020. Important, but not a ‘game changer’.
Compare that to China, and the contrast is stark. The Middle Kingdom is already the largest consumer of energy in the world thanks to ‘King Coal’. Irrespective of domestic reserves, its oil and gas import dependency rise towards 80% in the next decade. Considering China is going to account for over 40% of global hydrocarbon demand growth over the next decade with oil and gas still accounting over half the world’s energy mix out far beyond that date, that’s a serious amount of energy.
Understand that, and you understand why China is so keen to invest in North American energy production to keep the taps open. Beijing has placed around $17bn into American markets since 2010, not to mention making huge investments in Canada ($18bn), Brazil ($10bn) and Venezuela ($16bn) to hold a serious position in Americas production. China not only wants a physical stake in Western production, it’s well aware that this gives that it a virtual stake in commodity markets. As long as U.S. production growth continues apace, China’s knows they win hands down when it comes to sourcing larger volumes of energy on a global basis. America is an instrumental pawn in a far larger Chinese energy game.
Farfetched? Look at what’s happened in the gas world. Despite endless articles outlining American economic gains from 651bcm of gas, the real resonance has been in Asia. China has used U.S. shale to drive a far harder bargain across a wide range of gas exporters, all of whom have found it difficult to sell gas into Beijing, unless done so on Chinese pricing terms. But rather than just using America as a useful passive gas giant, China is going one step further to make sure that Washington becomes an active LNG player. That’s exactly why they’re still investing in U.S. dry shale plays despite the disastrous economics involved. Few U.S. companies can afford to say ‘no’ to Chinese money given the mess they’re in, just as those looking to play export angles see China as a smart option to offset poor credit ratings from collapsed Henry Hub prices.
Cheniere is the best example of this. China invested $1.5bn into its LNG export plants at Sabine Pass, the poster-boy of American LNG sitting on the Gulf Coast. With 125bcm/y of LNG export licenses awaiting FERC approval, expect China to keep pumping money specifically into these projects. Cove Point, Lake Charles and Jordan Cove will all be on the list, with the expectation that off-take agreements will follow the Cheniere model. That means using Henry Hub prices as a ‘tolling agreement’ plus mark ups. Translate that into plain English; China will import cheap U.S. gas into Asia, basing prices on spot market fundamentals rather than expensive oil indexed gas contracts. Beijing will have to pay little more than $8-10/MMBtu for its gas, compared to $18/MMBtu that’s been the going rate in Japan for most of 2012. Washington will literally do China’s pricing work for them.
Truth be told, it’s actually already happening. The mere expectation of U.S. LNG exports is creating huge problems for producer states trying to stick to the old oil pricing formulas in Asia. Given China consumes 155bcm/ of gas, with year of year 15% growth in pipeline gas – and 31% for LNG – everyone knows this is the one market they can’t miss. A 1% increase in Chinese gas consumption equates to 25bcm of the blue stuff. But thanks to U.S. shale developments, China has played the game very well. It’s refused to sign long term oil contracts with Russia, penned dirt cheap (65bcm) deals with Turkmenistan, Kazakhstan and Uzbekistan, sunk capital into Australian LNG plays as a regional hedge against liquid developments elsewhere, and kept Qatar on a tight leash. As far as China is concerned, gas will be spot based, and it will be cheap. A reality that unearths what most gas producers already know but don’t want to admit: The U.S. has totally destroyed the gas world as they knew it. No consumer state worth its salt is willing to pay oil indexed prices these days. That places gas producers – and especially Russia – at a crossroads.
If the price game is up for gas, they’ll have to shift to volumes. Look around the globe, and it’s almost inevitable this is going to happen. Up to 250mt/y of LNG is expected to hit the market over the next decade – Nigeria, Angola, Israel, PNG, Mozambique, Algeria, Equatorial Guinea, Canada, America, you name it. Not to mention 100bcm domestic shale targets being set in Beijing by 2020, figures that should be taken seriously given China sits on 1275tcf of gas. No doubt Russia will be the last heavyweight to fall on its pricing sword, but the bottom line is that American shale has smashed the pricing mould, and it’s American LNG that’s going to break oil indexations back. It couldn’t have worked out better for China if they’d tried. America is used as the lightening rod. They source all their external gas on a far cheaper basis between the Atlantic and Pacific Basins. Volumes win, prices lose. China’s laughing.
Structural Own Goal: Oil Futures
From there, it hardly takes a genius to work out that China is delighted by the prospect of American shale and tight oil repeating a similar experience for liquids. Beijing is well aware that it’s going to be importing at least 10mb/d of oil by 2020 and over 15mb/d by 2030 – not only does it want that oil to be cheap, they want to hedge their sources of supply. America is the perfect target. Why not replicate what’s happened in the gas world, and apply it to oil? Washington goes full steam ahead on liquids production, reshaping the oil world as they go – with China filling in financing gaps should they appear. The long term aim; use domestic U.S. production gains to turn the screw on OPEC, shifting them from a world based on price, towards volumes. China takes the economic plaudits.
Obviously America liquids production has a long way to go before it mirrors gas gains, but Beijing has wasted little time sinking serious capital into North American wet plays. The latest $15.1bn flagship Nexen deal in Canada is a telling example. CNOOC has offered a whopping 61% premium over share price, not just for some of the juicy assets spanning from Lake Long in Canada down the Gulf of Mexico and over to the North Sea in the UK, but because China is deliberately gaining physical assets in parts of the world that are instrumental to setting ‘virtual’ WTI and Brent prices. Even if the Nexen deal falls through, Beijing isn’t going to let North America out of its acquisition sights. If anything, the region will become one of its key suppliers. Not just for CNOOC, but Sinopec and PetroChina. ‘Seven Sisters’ becomes ‘Three Chinese Brothers’ as far as North America is concerned. Play to America’s worst energy independence dreams, all while working towards Chinese interests.
Sure, access to decent U.S. technology is useful for China to take back home, but the core motivation is making sure America fulfills its liquid potential. U.S. oil becomes a ‘public good’, helping China to apply market pressures across the globe. China has seen (largely at American expense) the difficulties of dependence on Middle East oil supplies. And while nobody’s fooled that OPEC supplies are the only credible way that Beijing can meet demand in the next few years, the unconventional genie is out of the international bottle. China is better placed than any other consumer in history to reshape the counters of the energy world – and North America is the instrumental key. Prolific Chinese investment in Washington’s backyard not only offers Beijing a tactical hydrocarbon hedge against traditional petro-states such as Russia, Central Asia and the Middle East as import dependency ratios increase, it’s likely to drag down oil prices internationally. Far from the Americas becoming a ‘self- contained’ unit, trading large amounts of oil between themselves (i.e. the defunct Citigroup vision), China will use the full weight of its investments and production base in the Western hemisphere against traditional producer states. The more prices ease, the more OPEC states will be staring down the barrel of popular unrest. Some regimes will fall from two digit oil prices, and for those who survive, shifting towards a volume based system might be only realistic way they can secure overseas receipts and meet rising domestic demand. Clearly that all remains to be seen, but if holds any validity whatsoever, China will have used America’s ‘oil egg’ to make an ‘OPEC omelet’. The final kicker is that Washington loses its trump ‘external security’ card along the way. As China likes to point out, they ultimately pay the bills for U.S. naval presence in the Middle East through treasury purchases. It wouldn’t seem worth the bother if we’re left with so much oil that we don’t know that to do with the stuff.
So, it’s a triple whammy. China uses America to forge a cheap energy world. OPEC and Russia duly respond by shifting towards volumes based strategies, the scale of which blows the U.S. out of the water as a supposed energy heavyweight of the world. With everyone going ‘unconventional’, we end up swimming in oil; Washington loses its external security role for oil in the process. It’s perhaps best left to economists what that means for the international status of the dollar, but I’m guessing it’s not good. America gets played all the way to the bottom of the barrel. China gets rich. China gets powerful.
Ground Zero: Tragic Ending?
To be fair, this was arguably where a doubling of the global resource base from unconventional finds was always going to get us. Inexorably shifting from an energy world based on price to one based on sheer volume. And it was probably always going to be a hyper capitalist America that paved the way to doing so – not least because what’s good for short term business and short term electoral politics – doesn’t much care for what’s in long term American strategic interests. Ultimately that’s the difference between President Obama being elected to office on 6th November and Xi Jinping being appointed on 15th November to oversee China. That aside, the real tragedy for America sitting at Obama ‘ground zero’ today, is even once Washington’s worked out that China wins most from a world of cheap energy, they’ll keep the drills going anyway. They just won’t be able to resist it. Well, why not? Cheap energy is the road to American nirvana don’t you know. The antonym of which, roughly translated, is ‘hell’ by the way…
Ok, the problems as I see it are
a. He needs to explain how the US increases its oil production
b. He needs to explain how OPEC and Russia can increase oil production so drastically since I thought the era of peak oil is near if not already upon us.