The Petroleum Economics Monthly Philip K. Verleger, Jr. Volume XXX, No. 12 December 2013 The Success of Good Economic Policy Overcame the Failure of Terrible Energy Policy 140 Actual Dated Brent Prices vs. "But-For" Prices Had Oil Markets Believed in Energy Policy Officials' Competence, Jan 2005 to Nov 2013 Dollars per Barrel 120 Actual But-For 100 80 60 40 20 2005 2006 2007 2008 2009 2010 2011 2012 2013 Source: PKVerleger LLC. (Publication Date: 1/31/2014) 2014, PKVerleger LLC. All rights reserved. ISSN 1548-8098. Reproduction of The Petroleum Economics Monthly in any form (photostatically, electronically, or via facsimile), including via local- and wide-area networks, is strictly forbidden without direct licensed permission from PKVerleger LLC. Contact Dr. Verleger at 540 Fox Run Dr, Carbondale, CO 81623 or phil@pkverlegerllc.com.
The Success of Good Economic Policy Overcame the Failure of Terrible Energy Policy Philip K. Verleger, Jr. PKVerleger LLC Disclaimer: Although the statements of fact in this report have been obtained from and are based upon sources that PKVerleger LLC believes to be reliable, we do not guarantee their accuracy, and any such information may be incomplete or condensed. All opinions and estimates included in this report constitute the judgment of PKVerleger LLC as of the date of this report and are subject to change without notice.
Table of Contents Summary... 1 The Success of Good Economic Policy Overcame the Failure of Terrible Energy Policy... 3 Price Forecast... 22 Glossary... 24 Statistical Appendix... 26 List of Figures Figure 1. Actual Dated Brent Prices vs. Predicted Brent Price Based on Inverse Days of Supply, Jan 2005 to Nov 2013... 1 Figure 2. Monthly Dated Brent Prices, Jan 2005 to Nov 2013... 3 Figure 3. US Monthly Crude Oil Production, Jan 1995 to Oct 2013... 6 Figure 4. Net Long Position of Index Investors in WTI, Jan 2011 to Nov 2013... 8 Figure 5. Long-Term WTI Price Spread vs. Net Long Position of Index Investors in WTI, Jan 2011 to Nov 2013... 9 Figure 6. Monthly Global Commercial and Strategic Inventories of Crude Oil and Products, Jan 2003 to Nov 2013... 10 Figure 7. Inverse Days of Commercial Supply vs. Dated Brent Price, Monthly Data, Jan 2003 to Nov 2013... 11 Figure 8. Actual Dated Brent Prices vs. Predicted Brent Price Based on Inverse Days of Supply, Jan 2005 to Nov 2013... 12 Figure 9. Actual Dated Brent Prices vs. Prices Predicted by Model Using Strategic Stock Variable, Jan 2005 to Nov 2013... 13 Figure 10. Actual US Monthly Crude Oil Production vs. Levels that Would Likely Occur without Fracking, Jan 1995 to Nov 2013... 13 Figure 11. Global Monthly Crude Oil Supply with and without US Fracking Revolution, Jan 2007 to Nov 2013... 14 Figure 12. Estimated Unplanned OPEC Crude Oil and Non-OPEC Liquid Fuels Production Outages, Jan 2011 to Dec 2013... 14 Figure 13. Actual Dated Brent Prices vs. Crude Price Predicted in the Absence of US Fracking Revolution, Jan 2005 to Nov 2013... 15 Figure 14. Swap Dealer Long Position in WTI, Jan 2010 to Jan 2014... 16 Figure 15. End-January WTI Forward Price Curve in 2010, 2011, 2012, 2013, and 2014... 17 Figure 16. The Falling WTI Forward Price: Weekly Settle for the Forty-Second Futures Contract, Jan 2010 to Jan 2014... 17 Figure 17. Merchant Long Position in WTI vs. Backwardation or Contango in Twenty-Four-Month Futures Contract, Jan 2010 to Jan 2014... 18 Figure 18. Daily Dated Brent Prices, Jan 3 to Dec 31, 2011... 20 i
List of Tables Table 1. Estimated Parameters and Summary Statistics for But-For Price Model... 12 Table 2. Comparison of EIA s 2009 and 2014 Projections for Future US Crude Oil Production... 15 Table 3. Comparison of EIA s 2009 and 2014 Projections for Future US Natural Gas Production... 16 Table 4. Price Forecast... 23 ii
Summary The title of this Petroleum Economics Monthly is a mouthful: The Success of Good Economic Policy Overcame Terrible Energy Policy. Our view, which we illustrate in detail in this issue, is that consumers have benefited since 2009 from good economic policies that kept oil prices down. These benefits are coming to an end. As a consequence, the world will likely see much higher prices in the next two to three years. Our cover graph illustrates the effect of bad energy policy. The figure compares actual Brent crude oil prices with the Brent prices that would have prevailed had traders, refiners, and consumers believed in the ability of energy policymakers to manage oil market disruptions. As the graph reveals, the policymakers failure to do this has added $25 per barrel to the price, a significant amount. We arrived at this conclusion after developing a model to predict world crude prices as measured by Brent. The model s key determinant is the level of private global inventories. In the text that follows, we show how the model predicts Brent price changes based on inventory change. We simulate prices from 2005 to November 2013. The model s price predictions, which were not adjusted for errors, are quite accurate as long as one ignores strategic stocks, as Figure 1 here shows. The model s projections deviate from actual prices, though, when stategic stocks are included as a forecasting variable after October 2010. Figure 1 Actual Dated Brent Prices vs. Predicted Brent Price Based on Inverse Days of Supply, Jan 2005 to Nov 2013 Dollars per Barrel 140 120 100 80 60 40 20 2005 2006 2007 2008 2009 2010 2011 2012 2013 Source: PKVerleger LLC. Actual Price Predicted Price Before October 2010, the model does well. We explain the deviation after that date by pointing to two events in international markets. The first was the collapse of Libyan production. The second was the IEA s failed attempt to use a strategic stock release to moderate rising prices stemming from the Libyan crisis and other supply constraints such as the Iran sanctions. That failure prompted the market s vote of no confidence in energy policy going forward. Indeed, we conclude from our analysis that strategic stocks have no impact on market prices today. Those who buy and sell oil have realized that government organizations holding the reserves are inept. The consequence of that realization is crude prices are $25 per barrel higher than they might be otherwise. Fortunately, the negative effects of incompetent energy policies have been offset by good economic policies. One example of a positive government action is the Gramm-Leach-Bliley Act (GLBA, also called the Financial Services Modernization Act) passed in 1999 in the United 1
States. This legislation removed the impediments imposed by the Glass-Steagall Act of 1933, which separated normal banking activities from investment banking. GLBA allowed banks to participate in the commodities business and a number of other previously prohibited areas. As we show, the law contributed directly to the success of the independent operators who boosted US crude oil and gas production. Their achievements were particularly observable in 2012 and 2013. In 2013, for example, oil production was two million barrels per day higher than the Energy Information Administration predicted four years early. The output surprise, as we have noted often, occurred largely due to the efforts of independent firms. The surge would have been far smaller had these companies not had access to the hedging made possible by GLBA. As we show, a smaller surprise would have resulted in much higher global crude prices. In 2013 in particular, independent crude and natural gas producers, not the Exxons or Rosnefts, rode to the rescue of the global economy just like the posses in classic Western movies saved citizens in distress. Ironically, much of the economic relief came from the American West (North Dakota and Texas), where posses really did gallop to the rescue in days past. Regrettably, the current posse will be disbanded shortly. New regulations being pushed by the Federal Reserve and the Commodity Futures Trading Commission will constrain financial markets such that they can no longer support independent entrepreneurs. The effect of these regulatory efforts is already visible in the domestic oil and natural gas forward price curves. The government s actions will almost certainly limit the ability of independent firms to hedge, which will slow the growth rate of oil and gas production in 2014, 2015, and beyond if these policies are not reversed. The policy changes could not come at a worse time. Unplanned outages of crude production worldwide are at a peak right now and show little sign of declining. Slower expansion of US oil production will push prices higher absent a global economic downturn. We argue here that Brent prices will trend toward $120 per barrel in 2014. Natural gas will not escape the effects either. Of late, investment in international LNG facilities, particularly in Australia, has slackened as foreign buyers anticipate turning to the United States for lower-cost natural gas. They will likely be disappointed. As with crude oil, drilling for gas will slow and prices in 2014 will be pushed higher. Prices will also be forced up by the need to replenish stocks drawn during the severe US cold spell that lasted through January 2014. Our story, then, is that good economic policies have trumped bad energy policy for a decade or more. Their benefits were readily observable in 2013. These good economic policies are being tempered now, however, and in some cases will end. The balance is shifting and bad energy policy will drive energy prices in the future unless consuming governments and the IEA recognize the need and take the opportunity to deploy the currently sterilized strategic stocks. These gloomy observations do not, let us point out, imply that our previous predictions of the US economy s recovery need revision. To the contrary, the failure of energy policies regarding strategic stocks combined with the end of financial deregulation may work to our economic advantage. We discuss this anomalous impact at the end of the report. 2