US to Declare Energy Independence by 2017?

To the surprise of most investors, oil prices have been caught in the downward plunge of a treacherous roller-coaster ride recently.

West Texas Intermediate (WTI) dropped from over $105 per barrel in June 2014 to roughly $45 today and Brent Crude moved from nearly $115 to about $50 over the same period. To help investors make sense of the current oil market volatility, the 2015 Financial Analysts Seminar (FAS) featured two experts on the topic. Peter Zeihan, author of The Accidental Superpower, used geography to explain the changing dynamics of the world energy sector; and Adam Sieminski, CFA, formerly a senior energy analyst at Deutsche Bank and now the top administrator for the US Energy Information Administration (EIA), highlighted data collected and analyzed by the EIA to present the international energy outlook through the year 2040.

Supply, Demand, and the Influence of New Technology

Zeihan set the stage well. “The shale boom in the United States we’ve seen since 2009 is all about oil,” he said. “We haven’t even started the shale natural gas boom. That will begin about 20–30 years from now when we run out of oil.”

“Production always flows into demand,” said Sieminski. “And from 2004 to 2008, global demand was booming, particularly in China.” Then the Great Recession hit and industrial and consumer consumption worldwide collapsed and hasn’t recovered. Prices remained above $80 per barrel for the last five years which lead consumers to change their behaviors. “In the United States, they carpooled, bought Priuses, and put in solar panels,” Zeihan said. “These actions have essentially destroyed demand for the next 15 years.” In addition, he noted, demographics will continue to weaken demand as aging baby boomers cut back on their driving.

Estimated US, Russia, and Saudi Arabia Petroleum and Natural Gas Production

On the supply side, Sieminski showed that the United States is now the largest producer of petroleum and natural gas in the world and recently surpassed Saudi Arabia in oil production and Russia in natural gas. Zeihan described four (of about 12) new technologies that are rapidly reducing the break-even cost of production in the United States:

1. 3D and 4D seismic imaging
2. Sectional fracking and multi-level drilling
3. Subsurface water tapping
4. Refracking and waterflooding

All these innovations offer more efficient access to petrocarbons with greater drilling precision. As for the controversial hydraulic fracturing (fracking) technology, Zeihan said that the amount of water needed has been dramatically reduced and can be drawn from brackish, nondrinkable water deep in the earth. Sieminski said the Environmental Protection Agency (EPA) recently came out with a report stating that fracking is basically safe and does not pollute groundwater, though the process still needs to be regulated.

Putting all these technologies together, Zeihan expects the break-even cost for crude production in the United States to go from $45 per barrel today, to $40 per barrel at the end of 2015, to $30 per barrel by the end of 2016. “At this break-even price, US shale oil is competitive with every producer on the planet,” he  said. “We’re not just competitive, but we are on the verge of completely changing the global energy business. And the United States will easily reach energy independence by the end of 2016. We are there.”

Natural Gas Is Essentially Free

Turning to natural gas, Zeihan argued the production cost is basically zero. “Fifty percent of natural gas produced today in the Bakken, Permian Basin, and Eagle Ford shale fields is a waste product,” he said. “The Marcellus Field is the only one producing it on purpose. What happens when the most-used raw material on earth is free?” The dynamics of the energy and power sectors change dramatically.

A big positive for consumers is the effect on energy prices. Since 2008 electricity prices in the United States have flatlined, and in Texas they have dropped by a third. Zeihan expects further declines in electricity prices in the United State going forward. Because of cheap natural gas, there has also been a massive petrochemical expansion in the United States, and Texas is now the largest natural gas exporter to Mexico.

Energy Consumption Worldwide

Sieminski presented the EIA’s projections on world energy consumption for the next 25 years. “By 2040, China’s energy use will be double the US level, with India a little more than half the United States — despite its faster GDP growth,” he said. Production of shale gas has been limited in China due to access difficulties and lack of water. China’s major sources of power, now and for the foreseeable future, are coal and nuclear energy. Sieminski said China is expected to build more nuclear power plants than all the existing capacity in the United States over the next 20 years. The only development that would change this scenario is if China shifts from an industrial economy to a service economy more like the United States and Europe. For more on this topic, see the EIA’s annual International Energy Outlook.

Coal consumption in the United States is another matter entirely. Coal still fuels 30–40% of domestic US electricity (yes, even for Teslas), but Zeihan believes this dependence on coal will vanish by the end of the decade as power plants convert to natural gas. “It’s hard to compete with free (natural gas),” Zeihan noted. In addition, he said the turn of the regulatory screws is accelerating and the remaining coal users will be regulated out of the industry.

The US shale oil revolution and drop in oil prices has also had a severe negative effect on oil producers in Alberta, Canada. Western Canadian oil is costlier to extract, and because nearly all of it feeds into the US interior, it trades at a steep discount that will only increase as US refiners retool to produce shale oil. Zeihan predicts that if the Keystone Pipeline is not approved in the next 12 months, US refiners will convert to producing light sweet US shale oil and won’t be able (or need) to refine the thick heavy crude produced in Alberta. “The Alberta oil sands will close in about five years if it doesn’t get the infrastructure equivalent of four Keystones,” said Zeihan.

Supply Shocks

Both speakers are on the lookout for possible supply shocks that could change their predictions. “There’s only about 2% spare capacity in the world, mostly held in the Middle East and Saudi Arabia,” said Sieminski. As an example of how a small change in production can create a shock, he used the Arab Spring revolution in Libya, when 1.5mm barrels of capacity was lost and prices rose to $125 per barrel.

Zeihan predicted that Russia will attempt to re-anchor its western borders in the future, a move that could put about 6mm barrels a day in danger. “Half of Russia’s oil and natural gas exports to Europe are transported through Ukraine, making Ukraine an energy tool that’s valuable for its political leverage.” Zeihan is also closely watching the Middle East, particularly Saudi Arabia and Iran. “Middle East countries are not military leading lights, but they do have the capability to set each other’s backyards on fire,” he said.

Predicting Oil Prices

Supply shocks aside, Sieminski and the EIA have looked for ways to predict oil prices over the near term. One successful approach they’ve found is the familiar Black–Scholes options pricing model. The EIA uses Black–Scholes to “back out” the range of possible oil price outcomes using the WTI year and a half options contracts. “Everyone said no one saw the drop in oil prices coming this year,” said Sieminski. “Black–Scholes did!” In the summer of 2014, the Black Scholes model predicted that oil prices could fall as low as $60 per barrel in 2015 or go as high as $130 (at the 95% confidence level). Today, Black–Scholes is predicting a low of $30 per barrel to a high of $100 per barrel and, of course, the range of possible outcomes is widening given increased market volatility, a key input to Black–Scholes. For more information see the EIA’s Short-Term Energy Outlook report,

West Texas Intermediate (WTI)

Source: EIA, Short-Term Energy Outlook, July 2015.

For other recent reports from the US Energy Information Administration (EIA), see:

• “What Drives US Gasoline Prices?”
• “Effects of Removing Restrictions on U.S. Crude Oil Exports”
• “US States: State Profiles and Energy Estimates”
• Annual Energy Outlook 2015
• Short-Term Energy Outlook
• International Energy Outlook 2014
• Monthly Energy Review
• Today in Energy

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

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