Financial Planning For An Uncertain Energy Future

Financial Planning for an Uncertain Energy Future

December 16, 2014

by Richard E. Vodra

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Advisors hearing optimistic forecasts of plentiful new supplies of oil that may last for decades may be encouraged to make aggressive projections for their clients. It is critical to understand the role oil plays in the economy and the factors that will affect future supplies. Advisors should “drill down” beneath the slogans to see both risks and opportunities upon which to base their recommendations.

This article reviews the state of global oil supplies. World crude oil extraction¹ outside the US and Canada has actually declined since 2005 from 67 to 64 million barrels per day, despite much higher prices until recently. The U.S. fracking boom faces many challenges. Net energy from oil declines faster than gross production, and it is the net number that determines the strength of the economy.

It is very likely that the U.S. will never again be a net oil exporter or even “energy independent” in terms of oil.

The recent decline in oil prices to levels first seen in 2007 has reshaped the conversation about oil. For advisors helping clients, here is what you need to know.

The long-term oil picture has not changed, but this oil-price shock – the second in less than 10 years – challenges the conventional wisdom. Americans have assumed that we could produce all the oil we could and someone else (OPEC, or more precisely, Saudi Arabia) would manage oil prices, keeping them high and stable. This was important because oil from fracking in the U.S. and tar sands in Canada is some of the most expensive to produce in the world. High stable prices allowed the debt-based financing of new production to expand through bank loans and junk bonds.

We have now been reminded that oil prices are volatile and fragile when nobody is willing to assume the role of gatekeeper. It is hard to persuade others to cut their production, so any rise in fear or fall in demand lowers prices quickly. This is common to most commodities, but no other commodity is so crucial to the world economy. Last March the head of Chevron said that they expected prices to continue to rise from a base of $100, but now few expect prices to return to that level for five years. The truth is, nobody knows.

Unless there is a deal to raise prices again – and don’t rule that out – many new projects will be deferred and some companies will cease operations. The current short-term supply surplus will last for a year or two as existing wells continue to produce and new wells that have been started or funded will be completed. Since shale wells have a rapid decline rate and yield nearly all of their oil within their first three years of operation, expect a significant decline in US oil extraction rates as early as 2016.

Even before the recent price drop, major oil companies had announced cuts to their exploration budgets, reflecting rising costs and disappointing results. These companies focus on massive projects that take years to complete but create decades of productions. Additional price-related cancellations will result in further reductions in production before the end of this decade.

Remember that the quoted price of oil is for “spot” purchases and can be quite volatile when no one is trying to control the price. Much of the current production is pre-sold at fixed prices, so the immediate impact of a price drop is hard to determine – whether it boosts oil consumers or burdens the oil companies, banks and other lenders who financed them. Over time, prices tend to fall to the cost level of the marginal producer unless there is (as there usually is) a controlling force like OPEC that can regulate extraction amounts and thus support prices. On the upside, prices are limited by what consumers can afford and by the marginal cost of new sources of oil (like U.S. shale) or alternative-energy processes.

If prices stay low, within a year the flow of new money to new high-cost wells will fall. Expect a cutback in current investments and fewer opportunities for new investments. Longer term, for those with deep pockets and patience, there may be an opportunity to acquire assets at fire-sale prices that could recover by the end of the decade.

A climate-change agreement over the next year could change the energy picture in other ways. Because of the growing urgency of controlling CO2, methane and other climate-altering compounds, a global agreement to limit fossil fuel use could emerge soon. If that happens, the future value of reserves of oil, coal and natural gas will decline, and new ways of doing almost everything will be developed. That outcome faces major obstacles and is by no means assured (or even likely), but it would certainly lead to updating all of our long-term plans and expectations.

People commonly discuss oil production, but oil is not “produced” by nations or oil companies; it is “extracted.” The actual creation of oil takes millions of years, starting with algae trapped underwater and subjected to massive pressure and just the right geology. We extract oil from the ground, and that phrase reminds us that we are draining a fixed and limited resource.

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