on Middle East oil.
The high prices of the 1970s displaced crude oil from power generation and industrial uses in favour of coal, natural gas, nuclear, and other alternatives.
But crude oil managed to maintain its monopoly over the transportation sector. Gasoline, diesel, and jet fuel are all derived from crude oil and have so far faced limited competition from other fuels such as natural gas and electric cars.
Consumers have tried to find cheaper and more reliable alternatives, but until recently they have not been available on a large and commercial scale. But things are changing, and quickly.
In the meantime, geopolitics has remained a major source of volatility and uncertainty, giving consumers an incentive to find alternative solutions.
In 2011, around the same time as the Fukushima disaster was changing the nuclear and natural gas markets, North Africa was involved in a geopolitical tsunami that would become known as “the Arab Spring”.
The events that started in Tunisia quickly spread across the region – Egypt, Libya, Syria, Bahrain, Algeria – in what seemed like an unstoppable geopolitical domino that would eventually reach the core of the Middle East.
I was supposed to fly to Riyadh in Saudi Arabia around those dates. During my career in the oil industry I have travelled to many live conflict areas – Sierra Leone, Nigeria, Colombia, Venezuela, and Jordan – and from the airport to the hotel to the meeting to the hotel and back to the airport,I have always been accompanied by bodyguards and a convoy of armoured cars. Sometimes it felt a bit excessive, but time would prove them right. During those trips I had numerous scares. Perhaps the worst one happened 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.
