Sanity Zone March 3, 2022 Misunderstanding Oil

Hi all, it's been a LONG time since I posted to my blog. Lot's of factors, but that's in the past. Hopefully some of you will participate in a discussion in the comments section.


At this writing, US consumption of petroleum based products for energy purposes (as opposed to some of the non-energy chemicals like plastics and fertilizers) is roughly 97% of total output. That means that all other sources make up 3%. Solar, wind, nukular (hah) and geothermal are a growing, but minor part of our country's dynamics. Even by 2050 with incentives and subsidies, that rises to only 21% according the the EIA. What this means is that petroleum based energy is a national security risk for the country.



While the US is the world's largest producer and exporter of natural gas, and a net exporter of oil products, we do not have enough market clout to affect the global supply or demand to meet whatever administration is leading's policy goals. The current situation with Ukraine/Russia is providing a cruel spotlight on these facts. The US oil and gas industry is almost (99%) of its pre-pandemic production. We are a net exporter. But we cannot control prices. I'd like to get into the mechanics a bit, so bear with me.



Let's say that I'm an exploration company with a lease in West Texas with a large proven reserve. I want to monetize that reserve. First, I need to contract with a drilling company to determine how much it will cost to drill, pipe and manage the extraction. A typical well pad may have 6 spuds (holes) over its lifespan, that will be drilled in rapid succession to minimize total costs. With setup, permits and other associated costs, figure around $50 million if the reserve is sweet, $75 million if the reserve is sour. The bank will finance this 80% as long as I have a contract to sell with either a midstream company or refiner. It has to go somewhere and the bank requires a repayment! It will take about 18 months to first barrel out.



Here's the catch. I'm selling a future on the oil I will produce 18 months from now. First, who in their right mind would commit to pay $110/barrel based on spot today? Right, no one. Second, what bank is going to lend without a fixed price contract - take or pay? So what happens? Nothing.


There are currently 9000+ issued leases to exploration companies to extract oil and gas that are currently not producing. The Federal government has no say in these leases as to when or how (as long as they operate within the acceptable laws). Most states don't have a reason to interfere either. And, preemptively, the current administration is only discouraging certain types of drilling in remote protected lands that have not been permitted (leased), not on leases currently issued.


The US also processes oil from other oil producing countries. Our refining capabilities are very large. There's one refinery in Texas that has more throughput than the entire Brazilian infrastructure, which is why some of their oil shows up in our refineries. The US petroleum industry is remarkably complex, made even more so by its integration into world markets. It is so complex that it is a fatuous statement to assert that the US should be "energy independent."



Does oil from countries like Russia get imported to the US? Duh, yeah. On long term contracts, usually to process for export customers. Who is buying? It depends. Sometimes, Russian crude oil is owned by an airline who contract processes it at a refinery in the US that produces jet fuel. Sometimes it's owned by another country who doesn't have enough refining capability. Sometimes, Russian crude my make a stop in another country, and other crude is laded. The key here is that the US government is not buying Russian crude. Private companies and other countries have long term contracts for which they have already paid money to Russia for that crude.


OK. So let's talk about banning Russian crude (or anyone's for that matter). First, you crush the company that has bough the crude already (hiya Delta, love me yet?). Alright, let's say they haven't paid for it yet. Gotta get it now! Spot prices are increasing because nobody wants to be caught short on inventory, so whatever surplus (and there's always a little....) gets bid. Additionally, some buyers play the hedging game. Let's say Delta figures that higher prices will cause airfares to go up, and demand for air travel will fall. Delta will offload some of their excess contracts to the arbs for a profit, and the arbs try to place the contract before the oil reaches the port (key point here that we can delve into in another blog or in the comments). The arbs are not interested in holding oil, just driving spread. The reason you see such high spot prices today is because no one is selling their excess contracts. And arbs have to bid up to entice.



Back to the banks. Just before the pandemic, the spot price of oil went from $73/barrel down to $40. Remember those guys with the 9000 leases? Those guys' cost of acquisition of a barrel of oil in West Texas is about $43/barrel. Guess what. Banks wouldn't lend to them. It got worse during the pandemic, when the price went down to the low $20's. Some drillers failed, taking some of those banks' stability with them. The financial system would like to make profits, too, but the volatility is a bit daunting for most. Lending is only just returning now. The EIA has estimated that the average barrel of oil price should be between 70-85/barrel, and that makes people of all production stripes happy. However, one can imagine that once this geopolitical episode is over, it would be difficult to estimate where prices might stabilize and where long term contracts will iron out. All it takes is production to surge and the bottom will fall out on price. This likely possibility has banks reticent to lend just yet.


Returning to the original proposition that the oil and gas industry is a security issue, energy accounts for a large portion of factor costs in a 1st world country's GDP. Stable energy prices are a cornerstone to energy policy. A country that cannot mitigate price fluctuations or supply fluctuations will be hostage to international events. Most recessions since the 1940's have been a result of energy insecurity. In the 1970's we initiated a plan to be able to produce the entirety of US domestic oil and gas requirements - energy independence of a sort. While we have essentially accomplished this, the US is still subject to world prices due to the fact that multinational firms control the system here, and they are profit driven. If they can sell for a higher price outside the US, then that's the direction of oil and gas flow.



The conclusion to make at this juncture is that "energy independence" is not a linear achievement - making enough for ourselves in this one product alone, particularly in the most sophisticated market. Any engineer will tell you that in a Critical Point analysis, things that will fail, are inevitable. The job of the policymaker is to avoid or lessen the impact that critical point failure by all means possible. All ideas, not just the politically (read partisan here) popular should be on the table.