The Energy World is Flat. Lacalle Daniel
at the Sheraton in Ikeja, Nigeria, when we were woken in the middle of the night by gunfire as a mob was trying to assault the premises. Luckily the situation was kept under control, yet, as scary as it was, we had our morning meetings at the hotel the day after as if nothing had happened. However, this time, for some reason, it felt different.
The developments in North Africa sent crude oil prices sky-rocketing in response to both actual and potential supply disruptions.
But the consumer world was better prepared this time and started to trigger its defence mechanisms. The US Energy Information Administration (EIA) coordinated the release of 60 million barrels from its global strategic petroleum reserves, helping to calm and stabilize the nervous markets.
Luckily the situation was contained, and the largest producers such as Saudi Arabia were not impacted, and despite the ongoing disruptions in North Africa, prices moved to what felt like an unstable equilibrium at high but moderate prices.
What is important to note is that events that perhaps create the perception that the energy world is not flat, such as geopolitics, supply concentration, and the dependence on oil, are actually strong flattening forces that destroy those imbalances.
How? Well, for every geopolitical event and every issue of security, consumers have always reacted by building buffers and making contingencies, from storage, to demand destruction, to new discoveries, to developing new technologies.
In 2014, despite the ongoing supply disruptions from Libya, oil sanctions in Iran, ongoing conflicts and disruptions from Sudan and Syria, and a drastic reduction in Iraq volumes, the price of crude oil had a very moderate response.
Yes, geopolitics can result in higher prices in the short term, but invariably result in lower prices in the longer term. The net result: a flatter energy world.
Expensive oil, cheap natural gas
In 2012, the price of crude oil in North America was almost 10 times more expensive than natural gas in energy equivalent terms. Never before had the ratio between crude oil and natural gas been so wide.
The reason for such extreme divergence is that there is no direct mechanism of short-term substitution between them. As discussed, crude oil is mostly used for transportation, and natural gas for power generation and residential and industrial uses.
But how about the longer term? Is there a mechanism for substitution? Why continue to rely on Middle East oil? Why continue to feed our cars with petrol? Or with corn-based ethanol? Why not use natural gas for transportation? Exactly!
In North America, the abundance of natural gas reserves, a surge in production, and a steep price discount are incentivizing consumers to develop and implement technologies that use less oil and more natural gas.
The substitution is starting to be evident and will have major implications for the crude oil market.
I am amused when I hear people say that crude oil is untouchable or that the shale revolution will only impact North America. The revolution is global and has deep implications across energy sectors with many winners and losers, OPEC among them.
The market does not attack, it defends itself
One of the first lessons I learnt when I got involved in the world of commodities is that prices are both signals and incentives.
Prices signal imbalances and incentivize economic behaviour, as the market “defends itself”. For example, Fukushima created a positive premium that incentivizes the transport of natural gas to Japan. On the other hand, shale gas has created a negative premium for US domestic producers, while incentivizing the demand via the substitution of coal for power generation, or attracting petrochemical businesses back to North America.
The large price differentials across crude oil and regional natural gas are incentivizing the development of new infrastructure capacity such as liquefaction plants, pipelines, and storage.
Energy infrastructure is very capital intensive, and can take many years to complete. A new LNG project can easily cost from $5 billion to $10 billion, and take 5 to 10 years to complete. But once the barriers to entry are removed and the investment decisions are triggered and completed, the capacity increases inexorably, perhaps slowly, but surely.
And the greater the barriers to entry, the greater the price signal and incentives needed, often creating “super-cycles” or multi-decade round trips from shortage to glut and back to shortage.
Winners and losers
We are currently living through an extraordinary phase in the energy world.
History books will look back at this period of transformation, which will ultimately transcend into a new world order.
Those who depend on commodity price inflation to survive or justify long-term returns are in trouble, but a flatter energy world is not a one-way “price inflation versus price deflation bet”. The dynamics are complex and reach beyond energy markets.
But before we dive into the energy revolution, the flattening of the energy world, and its winners and losers, I would like to review the recent history of the internet revolution and dotcom bubble and the important lessons and parallelisms it can show for the energy markets.
Chapter Two
Lessons from the Internet Revolution and the Dotcom Bubble
Of all the things I have lost, the one I miss the most is my memory.
He who knows how will always work for he who knows why.
I finished reading The World is Flat5 shortly after it was published. Four years had passed since the internet bubble had burst, and the word “dotcom” still carried very negative connotations. Many investors were left with a bitter taste.
It was easy to lose perspective of the bigger picture of what the internet revolution had done. It was easy to get lost in bubbles and valuations. But Thomas Friedman was an eye opener for me. His “post-mortem” analysis brought a new dimension.
The dotcom bubble had accelerated the impact of the internet revolution, and with it, the flattening of the world.
The internet has revolutionized the way we do business. But in the energy sector, not many things have changed. I suffered a few episodes of kidnap scares and terror threats when I was in the oil industry. We had to travel with an army of bodyguards and various vehicles and still, at least on three occasions, we were attacked by professional kidnappers aiming at the funds of the energy industry. One day, after a violent episode in Caracas, a colleague said “in a few years all will be done by video call and there will be no need for this”. Twenty years later, the energy business is still about meeting face to face …But technology and efficiency are gradually eroding peak pricing power.
The bubble path
This flattening, or equalization, of the world happened in two phases.
First was the “boom phase”, which took place during the 1990s, as a technological revolution led by internet, mobile, and broadband, had a major impact on productivity and growth expectations. Valuations were going up exponentially, based on growth expectations, not on profits. Traditional valuation methods, such as PE ratios, were largely ignored. A venture capital mentality had developed, where the potential winners would more than offset the losers in the portfolio. The cash piling in was used to acquire smaller promising businesses, feeding into the frenzy. Everyone wanted to participate and large amounts of capital flowed into the new industry. Pretty much overnight, the world was “wired” with fibre optics. High return expectations had attracted capital from other industries. A gradual build-up that might have taken decades, happened instead in a few years. The bubble had accelerated a process.
Second, and equally importantly, was the “bust phase”. Valuations had gone too far, supply had increased beyond realistic expectations. Bad news for profits. Valuations collapsed and many companies went bankrupt. The “paper
Thomas L. Friedman (2005).