How OPEC's Strategic Miscalculation Created Its Own Worst Enemy

Recently, Andreas de Vries posted an interesting article on Strategy Management: "Does Strategy Matter in a VUCA World?". The main points in it are:

1. An organization's strategy must be based on an expectation regarding the future, not on the reality of today;
2. While executing strategy organizations must remain aware of their environment, because things might not develop as foreseen;
3. Organizations must remain flexible, because if the future threatens to be different from what was assumed the strategy and the strategic plan must be updated.

Andreas used IBM from the 1970s as an example. At that time IBM's expectation regarding the future was that mainframes would remain the core of the computer industry. As we (now) all know, things developed differently and the Personal Computer become much more important. By the time IBM realized this, its market share had dropped by 50%. I could give another example of organization either not tracking their environments closely enough, or not responding fast enough, and getting into trouble because of that: OPEC

In 2012 I wrote an analysis entitled: “The US unconventional oil revolution: are we at the beginning of a new era for US oil?” My key message back in 2012 was “It could be in the interest of OPEC to already increase its production now and allow oil prices to decline to below $60 to discourage further development of shale oil”. This view was based on lessons from history: higher oil prices allow the industry to go into unexplored areas. In this particular case, the threat (from an OPEC perspective, at least) was that the high prices would allow companies to drill horizontal wells and carryout frac jobs on a massive scale, enabling this part of the industry to learn, grow and mature.

Since OPEC didn't implement this strategy, sustained higher oil prices of over $100/B from February 2011 to July 2014 allowed the US fracking industry to grow rapidly. For example, Bakken shale/tight oil production increased from 0.14 million barrels per day (MMBD) in 2007 to 1.12 MMBD in 2014. Likewise Eagle Ford increased from 0.05 MMBD to 1.46 MMBD and Permian from 0.85 MMBD to 1.64 MMBD. Overall, US total unconventional oil production increased from 1.14 MMBD in 2007 to 4.72 MMBD in 2014, helping the US to reduce its net oil import dependency from 60% in 2005 to below 27% in 2014.

But from OPEC’s perspective, however, that is not the most important consequence of its failure to address the strategic threat that fracking is for her. It could be argued that the US fracking experience from 2011 to 2014 has really taken fracking out of the unconventional oil & gas production category and moved it into conventional production (just as deepwater was once unconventional but is now more or less conventional). The techniques used have now been developed to such an extent that for some of the basins they can be used profitably even at an oil price in the range of $50/B - $60/B. Drilling and fracking thousands of wells between 2011 and 2014 has allowed the oil companies involved to better understand the geology, use less water in the fracturing process and optimize the distance between frac-jobs, to maximize production rates while lowering production cost (Recently, the CEO of ConocoPhillips Ryan Lance said operators were seeing 20%-30% reductions in their well costs compared with 2014 peaks). Consequently, fracking can no longer be defeated by OPEC. Even in today's low price environment the tight reservoirs in the US are not being abandoned. Production is merely being postponed. The number of wells waiting to be hydraulically fractured - known as the fracklog - has tripled in the past year as companies delay work in order to avoid pumping more oil while prices are low. Bloomberg Intelligence analysis shows that drillers in oil and gas fields from Texas to Pennsylvania have yet to turn on the spigots at 4,731 wells they’ve drilled. These wells could easily add 0.32 MMBD to current shale oil production of 4.68 MMBD (in 2014 data).

In other words, OPEC's strategic miscalculation has created its own worst enemy. If OPEC had properly scanned the trends in its environment during the period of 2008 - 2012, such as the trends in technology, economic development and demand, and had based its strategy on the future (2012 - 2022) rather than on the past, it could have (substantially) delayed or even prevented swift advancement of fracking success. Unfortunately for OPEC, it was the content with its situation in 2012 and thereby facilitated the rise of fracking with which, in my view, a new era in oil has begun. Due to fracking, namely, OPEC may have lost the swing producer role that made it powerful and influential in the past. To regain its power OPEC need to formulate another strategy keeping in view of current and future expected challenges not only from unconventional but also from renewables.

Dr Salman Ghouri is Oil & Gas industry advisor.

for full referred article please click the following link:

http://europeanenergyreview.com/site/pagina.php?id=3759

 

Aftermath of US Shale Gas - Oil index or Decoupling?

Dr. Salman Ghouri[1] and Umama Ghouri[2],

Liquafication of natural gas requires huge capital upfront investment; therefore LNG producers in an effort to protect investment and to satisfy their bankers enter into long term sale purchase agreement. In the absence of developed natural gas market, the pricing mechanism more or less directly linked with agreed crude oil prices. Therefore, LNG prices in various markets tend to directly or indirectly correlate with the oil prices with some lags. Figure-1 demonstrates this historical relationship between oil and natural gas prices in various markets.  Up until 2007, LNG prices in all the markets were closely associated though with different magnitude and lags. This situation changed after oil price shock of 2008 when oil prices peaked to a record level of $147/bbl in July and then collapsed in December to below $40/bbl. Since around the middle of 2009 oil prices recovered strongly (on an average remained above$70/bbl during June 2009/Feb 2011, thereafter above $100/bbl). The prolonged period of higher oil prices finally dwindled in late 2014 and down to below $50/bbl in January 2015.  In contrast, LNG prices other than US and Canada continue to correlate with oil prices but the historical relationship has surely weakened and vary from market to market.

In North America for example, the historical relationship not only weakened but de-coupled with the crude oil prices due to significant increase in US shale gas. In Canada, prices were also tracking a similar weaker link as US reduced its gas imports from Canada that resulted in surplus gas. In contrast to North America, the oil based relationship in Europe remained intact though somewhat weakened[3]. Historically, Europe LNG prices remained between Asian and North American markets for the reason of multiple options at their disposal. Excellent pipeline infrastructure, regional gas production, flexibility of importing natural gas - pipe gas from Russia and Algeria and greater flexibility of LNG imports. However, unlike North America, UK and Europe LNG price differentials widened as the new LNG supplies meant for US market found its new home in Europe, but the oil relationship remains intact.  Europe and UK were absorbing bulk of new LNG supplies but economic slowed down has waned natural gas demand. The weaker demand in Europe, also allowed some European countries to re-export to Asian markets - cargo diversion from West of Suez to East of Suez became a norm.  

In contrast, Asian markets remained tight due to the increase of demand for LNG in India and China in addition to traditional markets of Japan, South Korea and Taiwan. The Asian LNG market further tightened as a result of 2011 tragic Fukushima disaster in Japan. Historically, 30% of Japanese electricity generation was associated with nuclear and 27% accounted by LNG. In 2011, all the 54 nuclear plants were shut down. This 30% nuclear shortfall was met by 50% increase in LNG imports; the rest with oil and energy conservation measures. This tragic incidence created additional demand for LNG in Japan and attracted cargos from all over the world, and in particular from Europe. The incidence combined with higher oil prices has really affected the Asian buyers – as they were locked in long-term contracts.  Spot market was in infancy and therefore prices were at about $1-3/MMBTU premium. This situation could have been worse if economic and financial crisis in Europe had not caused sluggish natural gas demand in Europe. The situation was not pleasing for the sellers as European buyers were able to take advantage of their sluggish domestic demand (Europe LNG imports down by about 30% due to recession) and diverting or re-exporting most of it to the Asian market at premium[4]. 

Figure-1: Historical relationship of natural gas and crude oil prices. Source: BP Statistical Review of World Energy June 2014.

From the buyer’s perspectives, the pricing issue is dependent on individual country’s energy policies – as to what energy mix they like to have, which depends on country’s endowment and economic situation. For example, if Japan decides to reopen all its nuclear plants then it may ease their LNG import requirements and to some extent ease its import bills. Since disaster of 2011 until recently Japanese buyers are paying higher LNG prices to substitute shortfall of nuclear energy. To counter this high import dependency and avail some flexibility in supplies, Asian major players are investing in the US, Canada, Australia, and other resource rich countries to enhance flexibility in supplies and prices. Our assessment is that with the expiration of existing contracts, the quantity will be substituted with new supplies coming from Australia, USA, Canada and other new LNG suppliers. Though the recent collapsing of oil prices provided some relief to LNG importers, the LNG prices did not dwindle in a ratio of one-to-one as protected by S-Curve pricing mechanism and further some benefits were lost due to stronger US dollar.  As a result, contracted prices did not decline substantially, however, spot prices were down and in some cases were traded around $10/MMBTU as compared to $22/MMBTU during period of tight market. This is due to softer LNG demand and availability of more uncontracted quantity in the market[1].  

 

Global LNG capacity and Outlook 

Figure-2 illustrates LNG capacities as of Feb 2015. During the last forty-five odd years global LNG capacity has gradually increased, however, acceleration was witnessed during the last decade. As a result, global LNG capacity increased to 314 MTPA. Presently twenty countries are LNG producers compared to 22 LNG importers[2].

Figure-2: LNG existing capacities – by countries (MTPA) Feb 2015. Source LNG Journal Feb 2015.

At the end of 2013, out of total global natural gas consumption of 3347 BCM, about 69% is domestically consumed while 31% is traded as pipe gas (21.2%) and LNG (9.7%). Japan the largest LNG consumer accounting for about 37%, South Korea 17% and China 8% are the dominant LNG consumers. As far as regional LNG import is concerned, Asia accounted for 73%, Europe 16%, C&S America 6%, North America 4% and Middle East remaining 1%. Natural gas consumption in the Middle East is expected to increase rapidly in the years to come due to rapid regional economic growth and environmental related issues. Regional pipeline from Qatar to other GCC and other neighboring countries probably allows them to substitute oil based power generation with more benign natural gas.

The last forty-five years saw the global LNG capacity increase to 314 MTPA, however, in the next just 10 years or so additional LNG capacity of 450 MTPA is expected to be added.  (see Table-1). How this new LNG supplies coming from multiple sources, particularly from US, Australia and Canada will affect the oil-indexed relationship? Well, US and Canadian LNG is expected to penetrate global market, however, British Colombia LNG shall end up in Asia taking advantage of shorter distance. Australia and East African countries on the other hand expected to target Asia market.  The question is how new LNG supplies from these countries likely to influence the LNG pricing mechanism? Does it mean that LNG prices will significantly soften and decouple from crude oil? In our personal view the answer is no. The reason is that most of the Australian and East African LNG projects are quite expensive, and especially Final Investment Decision (FID) for Australian supplies already are locked-in based on oil-index basis. A similar pricing mechanism is expected to be followed by new East African LNG producers. In contrast, US and Canadian LNG pricing mechanisms will be based on Henry-Hub plus. The bulk of cheaper shale gas definitely provides a leading edge to US to effectively compete in any market in the world. At the same time more LNG supplies will promote the development of much needed spot market and allows the buyers/sellers to enter into new sort of flexible partnership. Due to only few sellers in the past, contracts were signed on long-term basis bounded by clauses of take or pay in order to lock higher percent of Annual Contracted Quantity (ACQ) 80% (it could vary from contract to contract). The future contract may call for reducing this binding ACQ. That will allow more LNG to be available for trading in spot market providing some room of flexibility to both buyers/sellers. The combination of oil-indexed supplies, Henry Hub linked supplies from USA, or from other sources will allow the buyers to address security of supply related issues and reduce Asian buyer’s average imported prices.

In all fairness, despite expected significant increase in LNG and natural gas supplies, our opinion is that historical relationship between crude oil and LNG prices will remain intact though on a weaker mode and with some modifications of sliding scale for mutual benefits. The reason being that new LNG projects are expensive; banks and sponsors ensure long-term contracts with some linkage to crude oil prices in order to protect their financing. However, we expect some rationalization of price ranges and respective discounts (sliding scale bounded by various price ranges) to avoid paying exaggerated prices by the buyers and also protect the interest of sellers. In addition, new long-term contracts may also look for reduction in minimum ACQ. This will provide some flexibility to both the parties to maneuver their balance quantity to buy/sell to their advantage. This may help both the sellers and buyers to maintain long-term mutually beneficial relationship should the oil prices collapse or further increase to over $120/bbl. We think the supplies from USA, Canada and Africa will facilitate the speedy process of price rationalization without breaking the historical oil-index relationship. In addition, the major LNG consumers in Asia are already in the process of supplies diversification. Investment in supply chains in the USA, Canada, and Australia will allow them to lower their security of supplies premium to avoid repeat of the past. 

Table-1: New LNG Export Projects

Countries	Expected Time	Capacity (MTPA)
Australia	2015-2018+	70*
Canada	2017-2020+	108
Indonesia	2015-2016	6.5
Malaysia	2015-2016	6.3
Mozambique	2018-2020+	22.5
Nigeria	2016+	38.4
Russia	2017-2019+	46.5
USA	2016-2020+	152
Total	2013-2018	450.6

Source: LNG Journal February 2015

*Including A

 

 

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[1] Despite oil price down below $60/bbl Japanese buyers are still paying around $15/MMBTU based on long-term contract.

[2] Libya’s LNG is out while Egypt’s LNG plants are operating at less than 50% capacity due to feedstock issues.

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[1] Dr Salman Ghouri is Oil & Gas advisor with over 30 years of experience in global /regional long-term forecasting, macroeconomic analysis and market assessments.
  [2] MBA Student at University of Texas, Arlington.

[3] Natural gas pricing formulas in Europe are generally based on industrial buyer markets, where natural gas competes with heavy fuel oil, gas oil, and low/high sulphur oil.  

[4] GDF-Suez, the French utility and liquefied natural gas and energy player, earnings before tax and depreciation for 2014 from its global gas and LNG business rose almost 11 percent last year to 2.2 billion euros ($2.5Bln) because of strong LNG activity in Europe and Asia, partially offset by the fall in prices in the exploration-production division because of oil price falls (as reported in LNG Journal).

 

This article was published in European Energy Review April 2, 2015
http://europeanenergyreview.com/site/pagina.php?id=4356

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Petroleum Linkages and Socio-Economic Up-Liftment

 

DR. Salman Saif Ghouri  

Apr 17 - 23, 2000

A balanced Petroleum Policy is the key to attract sizable foreign investment, that in turn, facilitate in elevating social up-liftment

Pakistan literacy rate of 40% during 1998 is one of the lowest in the Southeast Asia. Efforts have continued to design proper policies and program to raise literacy level and to improve the quality of living for the common man. Apart from education facilities, health and safe drinking water also remained inadequate especially in rural areas where over 70% of the population reside. For example, in 1997, there was only one doctor for 1724 people; one dentist for 42823; one nurse for 5460 and one hospital bed for 1545 persons. Only 43% of the rural population had access to safe drinking water during 1997.

Inadequate social services and large unemployment in the rural areas forced masses to migrate towards cities. Immense influx of people added multiple problems to the already crowded cities and limited infrastructure. With the limited resources and high population growth, it is difficult to take care of all social dimensions by the government alone especially in the developing countries.

A balanced Petroleum Policy is the key to attract sizable foreign investment that in turn, facilitate in elevating social up-liftment, generate employment, transfer of technology, and generate revenues through its various direct and indirect linkages. However, pre-requisite to attract sizable local/foreign petro dollars is to offer attractive incentives, provide conducive risk free environment (especially political risk). It is often observed that despite attractive incentives, country failed to attract foreign investment on account of slow or non implementation of laid down policies. The policy should be balanced to allow oil companies to derive normal profit, but at the same time host country must also reap appropriate economic rent and other direct and indirect benefits from its exhaustible natural resources. Petroleum industry has a variety of impacts on country’s development process. Some of these arise internally within the petroleum industry, while others consist of external economies. Following are some of the different ways through which growth in petroleum industry could contribute to the country’s development process.

·         Promotion of regional development in isolated or lagging regions of the economy

·         Expanded employment for labor and locals boosting their income through increased direct employment in petroleum sector

·         Expanded labor and capital income for local firms directly or indirectly linked to the petroleum sector as suppliers of input

·         Expanded access to technological knowledge, managerial know-how and markets

·         Saving of foreign exchange (in case discovery is made)

·         Increased fiscal revenues from local and foreign companies in the form of royalties, taxes, duties etc.

Direct Benefits

The direct contribution to development of petroleum sector consists of value generated by the petroleum ventures, earnings from which could be spent to compensate labor, capital and the entrepreneurial effect or to satisfy fiscal agents. A major contribution that petroleum could make in the improvement of domestic economic welfare is that of fiscal revenues to the government in the form of economic rent and saving of foreign exchange. Increase in the production of oil and gas in the country would raise government revenues in the form of royalties, taxes, duties etc. Such increased production will also reduce oil import dependency (reduced oil import bill), that in turn improve balance of payments, thereby improving upon other macroeconomic variables.

Forward Linkages

The forward linkages facilitate the setting up of forward processing of crude oil. The crude oil has to pass a number of transformations before final consumption in the form of gasoline, diesel, kerosene, and other by-products. Hence, the forward linkages can have a very large impact on development as they give rise to the establishment of downstream industrial activities. For example, increase in indigenous oil production will result in the establishment of new/expansion of existing refineries that in turn gives rise to the development of petrochemicals industries. Further down the chain, the petrochemical industry produces (plastics, synthetic fibers and rubber), detergents, fertilizers and fine chemicals, as well as alternate fuels. This enormous range of products and the degree of domestic comfort that they offer could never have been achieved with natural products alone. The investment in petrochemicals is significantly higher than in the refining industry, yet it creates more jobs.

From the refineries to the end-users, petroleum products pass through distributor circuits that differ considerably according to product type and use. Mass distribution products, for which unit consumption is small, are distributed by retailers supplied by the refining companies or wholesalers buying direct from the refineries. However, specialties and products delivered by mass means are generally sold directly by the refining companies or major independent distributors/importers.

The distribution sector employs more manpower than other sectors of the oil industry. In addition to the employees of the oil companies, of whom about 20 to 50% work in this sector, transportation, retailers, service station operations and their personnel also make a living from the industry without being oil employees. Thus the forward linkage is very important as it give rise to transfer of technology, generation of employment, saving of foreign exchange, etc and development of other associated industries that is so essential for the sustainable economic development of any economy.

Backward Linkages

In addition to direct and forward linkage benefits, petroleum venture will also give rise to various backward linkages through its requirement of inputs. The prospects for establishment of industries producing goods and services will be enhanced through the venture’s demand for such inputs. The expanded demand for food, local raw material and the need for new housing requirement (arising out of additional employment and enhanced wage bill) will constitute an incentive to increased economic activity (agriculture, industry, construction, services etc.).

Infrastructure Linkages

Yet a third type of linkage, which is neither backward nor forward, is related to the infrastructural facilities which form part of petroleum venture. Unless the project site is situated in an economically and industrially well-established area, a large part of overall investments has to be expended on indispensable infrastructural installations. Only seldom can these facilities be reserved for the exclusive use of petroleum enterprises. Companies other than petroleum industry as well as common man could benefit from such infrastructure. Thus industrial or agricultural activities although quite unrelated to the petroleum industry, can become economically viable as a result of the infrastructural development.

It is generally expected that investments in petroleum, whether by state-owned or foreign companies, can play a major role in promoting the development of lagging or backward regions of the country. Investment in infrastructure by the petroleum companies could possibly play a pivotal role in providing the basis for sustainable regional development. Such infrastructure investment would interalia lead to construction of schools, roads, hospitals, electric power, water and other community services. In case a commercial discovery of oil/gas, a lagging region could turn into a small town where small scale industries might flourished along with increased agriculture produce. The share of royalty and other surcharge to the provincial government will further facilitates regional development and welfare of local population. For example, to transport heavy equipment to the location of drilling sites, oil companies construct roads that are linked to major road network. The road network would facilitate communication, promote trade and exchange of culture between depressed and develop areas. With the road network, the agriculture sector can also be encouraged as the farmers would have access to bring their agriculture produce to the market, especially perishable produce which otherwise could not reached the market in time.

The success of petroleum venture will improve the quality of life and help in elevating regional development through its various linkages. Once the commercial discovery is made and production commence, the remote area subsequently turned into small town where small scale industry and agriculture sector is flourished through its various linkages.

The Pakistan’s petroleum policy 1997, on the one hand, provides adequate incentives to local and foreign oil companies to increase exploration activities, on the other; it also includes certain pre-requisites to ensure regional development on a large scale and provides basic social facilities to the locals in their operating areas. For example, companies will contribute towards the:

·         Development of roads, water supply, health and education facilities in the areas of operation,

·         Eradication of illiteracy in the country,

·         Rehabilitation of mentally retarded and handicapped children,

·         Promotion of sports and

·         Fight against drugs and narcotics.

The road network in remote areas of Pakistan as a result of petroleum industry operation has greatly improved the quality of life in Baden, Hyderabad, Tando Alam, Sanghar, Gohtki, Dadu, etc (Sindh), Bawalpur, Bawalnagar, Chakwal, Fateh Jang, Kohat etc (Punjab), and Kalat, Kachhi, Sibi, Quetta, Dera Murad Jamali, Dadhar, Pasni etc (Balochistan).

In many developing countries thousands of people die in remote areas for want of medical facilities. Establishment of petroleum operation in remote or lagging areas has taken care of these important issues. To meet any accidental or other related emergencies, a dispensary is usually established in all of operating fields and drilling sites. People of surrounding areas have free access to these facilities. In case of emergency, a free ambulance service is used to bring the patient to the city hospitals. Most of the oil companies, Like Union Texas Pakistan, LASMO Oil Pakistan Limited, Pakistan Petroleum Ltd (PPL), Pakistan Oilfield Ltd (POL), Oil and Gas development Company Ltd. (OGDCL) and other operating companies have established dispensaries at their producing fields and drilling sites. These companies provide free medical treatment and medicines to the local population. In an effort to eradicate Tuberculosis (TB), OGDCL has established a TB Center at its Tando Alam Complex. So far a large number of patient sof the surrounding areas as well as far-flung areas have been treated to this disease.

The companies operating in remote areas require plenty of water for its operational need as well as for drinking, washing and cooking. For this purpose they usually drill tube wells or lay water pipeline if the source is nearby or even transport water through bousers (tankers). The people of adjoining area have also free access to this water.

On the educational front, oil companies operating in Pakistan have devised laudable schemes that will benefit the people of the areas for a long time to come. To promote the level of education in the less developed areas of their operations and for higher education, each foreign and local exploration and production company require to keep a minimum budget of US $ 10,000 per license/lease per year at the pre-commercial production stage and US $25,000 during post commercial production stage. Similarly, all local and foreign oil companies are required to place social welfare funds in their respective agreements that must be utilized to give lasting benefits to the communities. Social welfare projects must be agreed with the local community and Government. In this head, each company is required to place US $ 10,000 per Licence per year for Zone-1 and 20,000 for Zone-2&3 during pre-commercial production. This amount will vary progressively with the production level during post-commercial production.

Like other oil companies, OGDCL has constructed primary schools in remote areas of its operations (e.g., Pirkoh, Loti, and Kali Talu), provide furniture and award scholarships to the outstanding students. It has also established Oil and Gas Training Institute (OGTI) with the Canadian assistance and offers two months internship to 30 outstanding students from various universities throughout the country to impart training in all disciplines of petroleum industry. By this scheme, OGDCL is delivering various technical courses and also providing on jobs technical training at its fields. In this way, OGDCL is serving and preparing our young generation to meet the challenges of next millennium.

In summary, Pakistan’s balanced, attractive and integrated petroleum policy had successfully able to attract sizable foreign and local investment. Such investment in oil and gas exploration and production has generated a large number of direct and indirect benefits to the masses through its various integrated linkages and handsome revenues to the government in the form of royalties, taxes, surcharge and other levies. In an effort to continue to attract more foreign investment in oil and gas sector, the government should earn foreign investor’s confidence provide conducive environment and positive signal towards implementation of its policies.

The views express in this paper are those of the author and not necessarily those of his organization.

http://www.pakistaneconomist.com/issue2000/issue16/i&e3.htm