Hearings and Business Meetings
September 6, 2005
SD-106 02:30 PM
Mr. John Dowd
Senior Research Analyst
Sanford C. Bernstein & Co., LLC
Tuesday, September 6, 2005
Testimony Before the
Senate Committee on Energy and Natural Resources
Good afternoon. I am John Dowd, Senior Research Analyst at Sanford Bernstein & Co., a firm that specializes in providing expert advice and research to Wall Street investors. I would first like to thank you for the opportunity to speak today about why gasoline prices are so high and how we might better protect ourselves in the future from the kinds of price shocks we have been seeing over the last few years and more recently, of course, in just the last few days.
This hearing was scheduled weeks before Hurricane Katrina barreled into the Gulf Coast, setting off a chain reaction in energy markets that has now raised the visibility and the urgency of the issues we are discussing to a whole new level. Once again we find ourselves wondering if an energy crisis is at hand and how long and how bad it might be. Once again, we find ourselves asking: Isn’t there some way to stop having these crises in the future?
My esteemed colleagues on this panel can speak with authority to the specifics of our current situation and to the pain it is causing the average American consumer and the larger economy. It is, of course, important that we address these specifics and that we take whatever steps we can to ameliorate the effects and minimize the duration of the present crisis. Hurricane Katrina has exposed the vulnerabilities created by a critical shortage of refinery capacity in our country and I agree with many of my fellow panelists that this must be addressed.
But I would also like to take the opportunity in my testimony to step back from the specifics of the pre- and post-Katrina situation to address some of the bigger-picture forces of oil supply and demand that have brought us here. For I believe that, unless we address some of these underlying dynamics now, we will be back in a few months or a few years, re-examining the same issues we are discussing today.
I would like to highlight five main points about our current oil predicament and what we can and can’t do about it.
1. The oil industry is inherently volatile in the sense that it is driven by a host of supply and demand factors which are largely beyond our control, at least in the short-run. That volatility becomes acute when, as now, spare production capacity is extremely tight. Under these circumstances, even a small disruption can produce large price spikes.
2. The primary reason that we find ourselves with such limited spare capacity is because the record investment by the energy industry aimed at expanding oil production has not resulted in the expected supply response. Conventional wisdom holds that more investment will lead to more supply. In the case of global oil production, the validity of conventional wisdom does not appear to be certain. This uncertainty emanates from several sources:
a. Global oil production growth rates outside of OPEC and the Former Soviet Union have slowed each decade over the past five, regardless of the level of investment.
b. Investment in U.S. hydrocarbon production has doubled over the past decade and production has not grown. The record investment undertaken by the industry over the past five years has not been sufficient to cause global oil reserves outside of OPEC and Russia to expand. Furthermore, exploration success rates in deepwater basins have been substantially below initial expectations.
c. Virtually every rig and every petroleum engineer in the world is already working. Materially increasing the level of activity beyond the current level is not feasible over the coming 3-5 years.
3. In the case of the refining industry, conventional wisdom regarding the effectiveness of additional investment does appear to be correct. We can and should build more refining capacity. Nonetheless, the industry today finds itself operating at a very high level of utilization due to the robust economic growth over the past decade, the slowdown in efficiency improvements in the auto fleet, more stringent environmental requirements, and the deteriorating quality of crude available to the industry.
4. This is not only a U.S. predicament. Gasoline prices this year have risen equally in Europe and the Far East. This is a global supply and demand issue. Important trends taking place overseas will likely exacerbate the situation. For instance, China has accounted for ¼ of the global increase in oil demand over the past decade. To date, this increase in demand from China has been entirely offset by accelerated production from the Former Soviet Union (FSU). What is alarming is that while Chinese demand continues to expand, Russian production stopped growing last September.
5. In the short run we have relatively few options for addressing a crisis beyond tapping the Strategic Petroleum Reserve. So even as we cope with today’s realities we must begin to think—and act—beyond the short run. In doing so it’s important to recognize that U.S. consumers and policymakers have far more control over long-term demand than they do over long-term supply. The demand side of the equation is where we have the most leverage and where we must focus our effort and resources.
High Utilization Is the Cause of Higher Prices
With spare production and refinery capacity at the lowest levels they have been in decades—not just in the United States, but globally—it was only a matter of time before some disruption, somewhere, would have the dramatic impact on oil markets and on our economy that we are seeing as a result of Katrina today. In fact, as you well know, gasoline prices have been rising for some time now, largely because rapidly growing global demand has outpaced the oil industry’s ability to bring new supplies to the market. This created a situation in which any disruption to existing supplies, even a relatively small one, would inevitably have an exaggerated impact on oil markets and on gasoline prices.
Just two months ago, in fact, my company provided expert analysis to support a simulation exercise called Oil ShockWave that attempted to examine how we might respond to a short to medium-term oil supply crisis of just the sort are experiencing now. The simulation brought together nine former high-level White House and Cabinet officials right here in Washington D.C. It was sponsored by two independent non-profit organizations—Securing America’s Future Energy or SAFE and the National Commission on Energy Policy—that see our nation’s oil dependence as constituting one of the preeminent public policy challenges of our time. In Oil ShockWave, the hypothetical events that trigger a crisis primarily involved terrorist attacks and political unrest in far-off lands. But the point of the exercise was that, due to the lack of spare capacity, it really doesn’t take much of a disruption to trigger a crisis in today’s market and it doesn’t really matter how that disruption comes about. Indeed, recent events may be proving, all too tragically, that Mother Nature can do just as well as Al Qaeda at sending a shockwave through the world’s advanced economies.
In addition, because there is so much overlap between these points and the findings that emerged not only from Oil ShockWave but also from the bi-partisan National Commission on Energy Policy, which issued a comprehensive set of policy recommendations last December, I am including with my testimony the two reports issued as a result of both those efforts.
As I have already mentioned, our growing susceptibility to a supply disruption like that caused by Katrina is rooted in a dramatic decline in spare production capacity as global demand for oil has grown more quickly than the ability to bring new supplies to market. The volatility and high prices we’ve been seeing since well before last week are a direct consequence of historically low spare production capacity, not only in the United States but in the world as a whole. When spare capacity is low, even a relatively small disruption in global supply can cause shortages and produce sharply higher prices. The market responds to the increased risk of future shortages by attaching a premium to the prices they would otherwise charge based on current inventories and current demand. This premium appears to be directly proportional to the amount of spare production capacity held in reserve.
For example: if there were 6 million barrels per day of idle capacity worldwide, no single terrorist act or natural catastrophe would be sufficient to cause a shortage. The risk premium would be low. At present, however, the world has only 1.4 million barrels per day of spare production capacity (assuming that all of the Gulf of Mexico capacity returns imminently), or less than 2 percent of current global demand. This is only enough spare capacity to meet a little more than one year of expected demand growth and it leaves world oil markets at the mercy of political conditions in Venezuela, Nigeria, and Iraq, not to mention natural disasters and potential terrorist acts. In fact, the price of oil over the last year has hovered somewhere between the cost of producing it and the $100-per-barrel price (in real terms) witnessed during past crises, indicating that the market was already factoring in some probability that a shortage would occur at some point in the future. In the weeks before Katrina, oil prices were fluctuating near $60 per barrel; last week, after the storm, they hit a high of $70 per barrel. Analysts have since speculated that at this point, any additional supply disruption—in the United States or elsewhere—could easily send prices into the triple-digits. In this context, the situation depicted in Oil Shockwave—where a global supply shortfall of less than 4 percent produces a world oil price of $160 per barrel—looks prescient.
Why has supply growth lagged expectations?
In theory, the policy response to this situation is straightforward. If we can increase spare capacity—either by increasing world oil supplies or by reducing world demand—we will reduce the risk premium and crude oil prices will fall. In practice, accomplishing either is anything but straightforward. On the supply-side, the primary concern stems from the apparent inability of non-OPEC producers to materially increase production in recent years despite increased investment and rising prices. The conventional wisdom within the energy industry for decades has been that the price of oil could not permanently move above $25 per barrel because if it did, this would invite a non-OPEC production response. High prices would attract more oil investment and production would rise.
Unfortunately, recent history suggests that the relationship between investment and output is not quite so simple, at least when it comes to this industry. The primary reason that capacity growth has been slower than expected is that the productivity of new basins has been substantially less than expected. A stark example can be seen in Exhibit 1. In the United States, capital investment by the oil and natural gas industry has doubled since 1994—yet natural gas production has not grown and oil production has actually fallen. This situation does not appear to be an aberration.
Source: IEA, Bernstein Analysis
A decade ago, the hope of the industry was that new reserves in the deepwater regions of the world would provide the next wave of global supply additions. The industry invested sizable sums in building new drilling equipment in order to tap the hoped-for reservoirs beyond the continental shelves in the Gulf of Mexico, Brazil, West Africa, and the North Sea. However, after an initial flurry of exploration success, discovery rates have been stable despite a jump in drilling activity (Exhibit 2).
Source: IHS Energy, ODS-Petrodata, and Bernstein Analysis
While the deepwater basins are a source of supply growth, it is important to keep the size of this production growth in context. For instance, roughly 1/3 of the deepwater drilling equipment in the world is operating offshore Brazil, and has been for a decade. Nonetheless, Brazil is still a net importer of crude oil. Viewed more broadly, even with the opening of the deepwater basins to exploration, reserve discoveries outside of OPEC producing countries and the Former Soviet Union have not kept pace with production from those regions. As seen in Exhibit 3, discovered oil reserves outside of OPEC and the Former Soviet Union peaked in 1997, despite the record investment by the oil industry since that time.
Source: BP Statistical Review, Bernstein Analysis
In fact, the same trend has occurred in all non-OPEC countries outside the former Soviet Union. Collectively, these countries have not only been unable to sustain production growth, they have witnessed a decline in production growth in each of the last five decades. During the 1970s, oil production in these countries grew by 3.1 percent annually. Over the past decade, production in these countries grew only 1.1 percent annually, despite considerably higher levels of investment, as seen in Exhibit 4.
Non-OPEC countries outside the former Soviet Union have experienced sub-par reserve discoveries despite an increase in exploratory drilling and the development of more sophisticated locating equipment. In fact, annual reserve discoveries in these countries have failed to substantially increase over the past 20 years. Worse, over the past four years the discovery of new reserves has fallen behind current production, resulting in a decline in total reserves for these countries.
Source: BP Statistical Review, Bernstein Analysis
To some extent, these recent trends are explained by simple geologic reality. As reservoirs are gradually depleted, the remaining oil becomes harder and more expensive to extract. New discoveries must constantly be made just to compensate for the depletion of existing basins, let alone to meet a substantial new increment of global demand growth each year. The world’s largest and most accessible reservoirs have already been tapped. As a result, we are now pursuing the less accessible and/or smaller reserves which typically cost more and experience more rapid production declines once they are developed (Exhibit 5). The U.S. experience with natural gas production provides a worrisome analog in this regard. Hence, I am including with this testimony a separate short paper that provides some additional detail about that experience.
Ultimate Recoverable Reserves per Well in the United States
(Excluding Deepwater Wells)
Source: IHS Energy
We are also pursuing development of crude oil reserves that in prior times, under lower pricing scenarios, were considered to be of unacceptably poor quality. The implications are significant not only for the oil producing industry, but also for the oil refining industry. When lower-quality crude oil enters the refining system, it must be refined more intensively in order to yield the same amount of gasoline. This is one of the factors that has contributed to the high utilization of the refining system. The performance of the U.S. refining industry in particular has been impressive. The industry has been able to increase gasoline production by 10 percent over the past decade, despite a reduction in the absolute number of refineries, more stringent environmental requirements, and a slow but persistent deterioration in the quality of crude oil available to the market (see Exhibit 6).
Exhibit 6: Quality of crude processed by the US refiners
Source: EIA, IEA, Wood MaKenzie, Bloomberg, Bernstein Estimates
To grossly oversimplify the energy sector, the exploration industry is essentially the business of finding gasoline, while the refining industry is the business of making gasoline. It is not possible to analyze one without the other. One of the major reasons that refining industry is tight today is because the lack of success of the E&P industry in finding new resources. Because we have not found substantial new deposits of light sweet crude oil, we have been forced to refine the barrels that we have found more intensively. Further deterioration in the quality of crude supplies will likely mitigate the benefits of future refining capacity additions.
One major concern is that the lack of necessary equipment and expertise may limit the future supply response. For example, there are today only four competitive offshore drilling rigs that are idle available to go to work tomorrow (by contrast, some 422 offshore rigs are already working). While demand for offshore drilling equipment has recently spiked, supply is expected to rise by only 3 percent annually through 2008 based on already signed construction contracts. One difficulty in quickly expanding offshore production capacity is that building a modern drilling rig requires 3-5 years and costs between $150 million and $500 million, depending on the type of equipment. Another difficulty is that qualified labor in the oil industry is limited, and we are already running into shortages of skilled workers.
These are International, Not Domestic, Issues
Meanwhile, a lively debate about whether we are, in fact, beginning to “run out” of oil has recently been picked up even by the mainstream press. My first response to that debate is to say that no one really knows. My second response is to say that I’m not sure it really matters. The question is not whether global oil production has begun to reach a peak. The question is whether the growth rate of supply can continue to keep pace with the growth rate of demand. Much attention has recently focused on the impacts of China’s growth on world oil markets. In fact, all of the increase in Chinese oil demand over the last decade has been offset by increased exports from the former Soviet Union (Exhibit 7). This does not, however, appear likely going forward. The fact that production in Russia stopped growing last September is potentially a game-changing development that will further exacerbate the risks of a major supply crisis. Unforeseen changes on the demand side could equally accentuate these risks. For instance, if global oil consumption were to grow at a pace of 3.1 percent next year rather than current expectations of 2.1 percent, the forecast surplus global production capacity would be cut in half.
Source: BP Statistical Review, Bernstein Analysis
Not only is the sensitivity of oil prices to supply disruptions heightened today because of the lack of spare capacity, the frequency of such disruptions is likely to increase because of where new oil producing facilities are being located. Throughout history, oil companies have taken a very rational approach to investment, weighing political risk against geologic risk when deciding where to explore and drill. As the world’s oil basins have matured and geologic risks have increased, the industry has demonstrated an increasing propensity to invest in politically risky areas. Today our attentions are understandably focused on the risks posed by nature, but any number of eminently plausible scenarios involving terrorism or political unrest could have similarly profound effects on world oil markets.
We may soon find out what our immediate options are for responding to a sustained supply crisis and how far those options will take us. At the moment it is still too soon to know whether recent events in the Gulf region constitute such a crisis. If they do I think we will find, as the Oil ShockWave participants discovered, that our near-term options are limited. The President has called for releasing some oil from the Strategic Reserve and for voluntary conservation efforts, while other countries have indicated that they too will tap emergency reserves. The relaxation of environmental constraints in the refining industry should be a small positive for supply. I would recommend a stronger call for conservation. If, as a country, we were to obey speed limits for the next two months, we would probably conserve more fuel than will be lost by the refinery outages. Reducing speeds from 70 mph to 60 mph, for example, improves fuel efficiency by 15 percent. If Americans want to know what they can do to limit gasoline price inflation, the answer is simple: slow down. I don’t think this is generally known, or believed, by the U.S. public, and it should be. That may be all we can do in the weeks and months ahead.
Longer-term of course, we must look for more fundamental ways to shift the current balance of supply and demand as a means of reducing our vulnerability to oil price shocks that we cannot control. Many will instinctively reach for supply-side solutions and for measures to increase U.S. oil output. For the reasons discussed above, however, it’s not clear that further incentives for expanded domestic production will do much good. And even if we succeeded in boosting domestic production for a time, our nation’s oil resources are simply too limited to make a lasting dent in the global market that determines the prices we all pay. Some of the provisions in the Energy Bill of 2005 will also help in the long run, especially those that seek to diversify the nation’s energy resources and promote efficiency, but most address the needs of the electricity industry, and not transportation fuels such as gasoline.
Our current predicament, simply put, is rooted in the near-total dependence of our transportation sector on petroleum fuels. Our nation possesses only 3 percent of the world’s estimated oil reserves but accounts for as much as 25 percent of global oil demand, the great bulk of it for use in our cars and trucks. When you look at these numbers it’s obvious that controlling our destiny in terms of oil security comes down to controlling the relentlessly growing demand of our transportation sector for gasoline and diesel fuel. Fortunately, the potential for efficiency improvements in this sector is also substantial if the political obstacles can be overcome. The National Commission on Energy Policy found, for example, that a concerted effort to increase fuel economy standards, and promoting hybrid and advanced diesel vehicles, could substantially reduce future petroleum consumption by the U.S. transportation sector. We estimate that improving the average fuel efficiency of the entire U.S. vehicle fleet by 2 miles per gallon—an objective that can be readily achieved using already available, conventional vehicle technologies—would reduce total U.S. gasoline demand by roughly 1 million barrels per day. This amount is equivalent to all of the growth in U.S. gasoline consumption over the past eight years.
Of course, to matter at a global level, demand reductions must be significant, especially given the growth pressures we face in other parts of the world. And significant demand reductions cannot be realized overnight any more than significant supply enhancements or refinery expansions can be. But it is reasonable to aim to achieve gradual yet steady progress that can yield substantial dividends over time. Gradually improving vehicle fuel economy through a combination of higher standards, manufacturer and consumer incentives, and other initiatives would essentially “buy us time” to develop the more advanced vehicle technologies and alternative fuels that will someday allow for a more decisive shift away from our current petroleum dependence. Even in the short run, moreover, the benefits of any efficiency improvements introduced in the U.S. vehicle market would likely be amplified as a result of their diffusion to markets in other countries, most of which have as keen an interest as we do in slowing demand growth and blunting their exposure to future oil shocks.
We are probably all familiar with the well-worn homily about having the serenity to accept what you cannot change, the courage to change what you can, and the wisdom to know the difference. I don’t know that anyone would counsel serenity under current circumstances, but courage and wisdom are certainly called for. We can’t control hurricanes, terrorists, or the investment climate in foreign countries. We can’t stop international oil markets from adding a sizable risk premium to oil prices as long as worldwide spare production capacity remains dangerously low. What we can do is limit our future dependence on oil and our exposure to these risks through thoughtful, long-term policies aimed at promoting a greater supply and diversity of fuel options while at the same time significantly improving the efficiency of our nation’s vehicle fleet. Something good will have come of the current crisis if it impels us to take the long view. We should try to control what we can control. And we should start doing that now.
Thank you again for the opportunity to testify.