Analysis 2009: Energy Sector Faces Volatile Year

By Kurt Cagle
January 6, 2009

Here in Victoria, my corner gas station has a liter of regular unleaded gas for CAN$0.80, about US$3.00 a gallon. Six months ago, a similar liter cost nearly $1.50, more than $6 a gallon when factoring in the dramatic change in exchange rates. While the driver in me is perfectly happy to see gas prices drop by 50%, the economist in me gets very, very jittery. It is very likely that this drop is an aberation brought about by uncertainty in the market, not just in the US but worldwide, rather than reflecting that significant a drop in real activity. Some shippers are parking oil tankers offshore, filled with oil, hoping to see higher prices, while others are trying to get out of the market now and are dumping oil at these prices rather than see prices drop further.

Oil producing countries are now faced with their own internal collapsing markets and are consequently shutting down production. Meanwhile, areas that were looking at developing fuels that are cost effective at price points about $90, such as extracting oil from shale in Alberta, are having to stop production and wait, in many cases with projections halfway to completion, while exploration efforts in search of new oil are similarly being mothballed.

This slowdown also applies to the push for alternative fuels and power sources. There is a certain specific price point at which alternative energy technologies become feasible - if oil stays below this point, investment and research into these technologies slow or stop altogether.

Ironically, however, it is very likely that all of this will end up causing serious disruptions in both oil and electrical power supply, especially by mid-summer. It's definitely worth understanding that the drop in prices of crude oil is not actually reflective of a drop in demand. In the fourth quarter, demand for oil dropped approximately 8%. Price, on the other hand, plummeted 75% from its high of $140 to a low reached around Christmas of $36. Most of this drop came as a result of investors selling off oil stocks that had been purchased as speculation because they were forced to cover their market positions. It's noteworthy that in the first few days of January, the price has climbed back to nearly $50 (a nearly 40% rise) as real demand begins to push the price back up. This means that the existing oil stock that's already been transformed into distillates should draw down very quickly, especially as consumers see the lower prices as an excuse to drive more.

The problem comes once those supplies are drawn down - it takes a certain period of time, proportional to the time that oil producing facilities are mothballed, to bring them back online, to ship the oil, to process the oil into fuels and other goods and to distribute it, and as countries have nationalized their oil supplies over the last several years, those countries will likely wish to hold onto their oil for as long as possible in the hopes of driving prices back up.

Additionally, if the prices remain relatively depressed, this will make critical infrastructure improvements (especially after 2008's fairly severe hurricane season) less attractive. This means that by late summer, the possibility of one or more refineries being forced offline becomes fairly high, and the likelihood of new exploration to augment nearly depleted oil fields drops beyond the ten year window.

Unfortunately, these may prove to be major problems. The Ghawar field in Saudi Arabia, one of the largest and most productive in the world, is showing signs of running dry, especially since pressurized ocean water has become increasingly used to push oil to the surface, reducing the quality of the oil and causing damage to the delicate spongelike lattice of chambers that hold the oil. It's very likely that, even with depressed demand world-wide, Saudi Arabia may be unable to meet its existing contracts by the end of 2011 if not sooner.

The Mexican Cantarell fields are facing many of the same problems, and Mexico was expected to become a net oil importer by this year, given 2008's consumption levels. As Mexico is the second largest provider of oil to the United States (Canada is first, Saudi Arabia third) this has already begun having serious policy implications for Washington and has been the root cause of a fair amount of the political instability in Mexico. It's likely that Canada will also likely be reducing supply beyond that already committed given that the oil sands are not profitable to liquify at prices below $85 a barrel.

Similar issues apply to natural gas, though there the US is probably better positioned than Europe. Most of Europe's natural gas comes from Russia. While the US has been hit hard by the financial collapse, it is in far better shape than Russia, which has watched the Ruble tumble in value compared to the Euro and has seen its primary export of oil essentially collapse to perhaps 30% of its value a year ago. This has made Putin considerably more belligerent (announcing earlier this week that after years of mothballing their nuclear arsenal that Russia will start producing nuclear weapons and ballistic missiles delivery systems for those weapons again).

This political instability will likely become increasingly common as standards of living decline precipitously throughout Europe, the Middle East and Southeast Asia (the violence in Greece over Christmas can be laid directly to economic conditions), which in turn is likely to further undermine oil development and exploration efforts.

There's a very real possibility that we are entering into a period of extreme oscillations in supply and demand, where oil prices go up dramatically due to spot political issues or infrastructure collapses, and then drop just as dramatically, making investment into oil based systems neither profitable nor even all that possible, at least for the near term future. This is a big part of the reason why reducing dependency upon foreign oil will be such a critical part of any administration's efforts - oil demand is one of the most significant factors in the current economic crisis (though that dependency is far from obvious), and by reducing the overal dependence upon oil, the administration also reduces the exposure of the US (and secondarily of Canada) to the coming oil shocks.

Overall, its likely that oil (and hence gas prices) will be all over the board, and it is conceivable that there may be spot shortages in certain areas as gas stocks run lower, pushing up prices and resulting in scenes similar to the rather agonizing time after Hurricane Ike significantly reduced refinery capability out of Texas.

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