Breaking Good: The Outlook for Oil and Natural Gas

Tuesday, November 26, 2013

The U.S. energy future is breaking good. The projected energy future circa 2005 was one in which gasoline consumption was expected to grow continually over the long term and oil production was projected to steadily decline. Consequently, net petroleum imports were expected to rise from 60 percent of total petroleum consumption in 2005 to 77 percent in 2025. Over the same period, net natural gas imports (largely in the form of liquefied natural gas, or LNG) were expected to rise from 16 percent of consumption to 28 percent to accommodate increased use. In short, the U.S. was predicted to become ever more dependent on imports of oil and natural gas.

The surprising turnaround in the U.S. energy outlook is due in large part to the coupling of hydraulic fracturing with directional drilling as well as declined petroleum consumption resulting from increased energy and automobile fuel efficiency. Oil and natural gas production have risen dramatically since 2005 while U.S. consumption of petroleum products declined from 19.2 million barrels per day (mm b/d) in 2010 to an average of 18.7 mm b/d for the first nine months of 2013 despite the modest recovery from the Great Recession. Renewable energy in the form of wind, solar, and biofuels has also contributed to the improved energy outlook, although the importance of renewable energy will become more apparent over time.

The energy revolution has resulted in lower natural gas prices, an easing in the relentless upward pressure on the world price of crude oil, a reduced trade deficit, a competitive advantage for industries using natural gas, and increased demand for manufactured products.

The Oil and Natural Gas Revolution
In 1985, U.S. crude oil production stood at 8.97 million barrels per day (mm b/d). Thereafter it trended downward and by 2008, production totaled 5.00 mm b/d—a 44 percent decline. Oil production took off after 2008 and in the first nine months of 2013 averaged 7.35 mm b/d (Figure 1). The U.S. Energy Information Administration (EIA) projects that oil production will rise to 8.49 mm b/d in 2014, the highest level of production since 1986 and just 0.5 mm b/d below its 1985 level.1

The story is no less dramatic for natural gas. Production declined between 2001 and 2005 and virtually every energy analyst viewed imports of LNG as the future source for incremental gas supplies in the United States. Three large LNG terminals were built on the Gulf Coast and came on stream about the time hydraulic fracturing took off. Production of natural gas rose from 18.1 trillion cubic feet in 2005 to 24.1 trillion cubic feet in 2012, an increase of 33 percent.

Natural gas prices declined as a consequence. The average wellhead price of natural gas averaged $6.68 per thousand cubic feet (Mcf) between 2004 and 2008. Between 2009 and 2012, the wellhead price averaged $3.69 per Mcf.

Determinants of the Price of Oil
Unlike the price of natural gas, the price of oil is determined in the world market; global supply and demand conditions largely establish the long-term trend. The U.S. cannot insulate itself from the world market without imposing a substantial cost on the economy. Economic growth leads to growing demand since oil consumption rises with increased economic activity and higher incomes.

The volatility of oil prices on a day-to-day or month-to-month basis is affected by numerous factors such as swings in inventory, changes in the value of the dollar, new data on the economic outlook, and unexpected supply disruptions from hurricanes, terrorism, sanctions, etc. Many commodity market traders cite speculation as a key factor in the price of oil, but economists who have measured the impact using sophisticated econometric models find that speculation plays little if any role in determining the price of oil.

OPEC’s spare production capacity affects volatility and shorter-term trends in the price. As a general rule, when OPEC’s spare capacity is tight, the volatility increases in response to news of an unexpected supply disruption because OPEC has less ability to offset lost production. The opposite holds as well: when spare capacity increases, OPEC’s ability to maintain cohesion among its members is weakened.2 Virtually all spare production capacity currently resides in Saudi Arabia, and thus OPEC is a cartel only because Saudi Arabia chooses to be the swing producer.

The relationship between short-term trends in the price of oil and spare capacity is shown by looking at the price of oil (measured here by the Brent spot price) and the extent to which OPEC’s production capacity is being utilized (Figure 3). Although supply and demand govern the long-term pricing trend, Figure 3 shows that when the capacity utilization rate is high, there is often a tendency for the price of oil to increase. Conversely, when the capacity utilization rate is low, prices frequently begin to fall.

At 98.3 percent, OPEC’s production utilization rate in the third quarter of 2013 was at its highest level since the third quarter of 2008, when it stood at 99.0 percent. On a quarterly basis, the Brent spot price peaked in the second quarter of 2008 at $123 per barrel. In July 2008, it was $144 per barrel, a record high in nominal dollars, but receded shortly thereafter.

Despite the higher-than-average rate of capacity utilization over the past year, the price of oil has trended downward with the exception of brief rises following the outbreak of civil unrest in Egypt and when Syria’s civil war heated up in the third quarter of 2013. Not surprisingly, the price of oil reacted because capacity utilization was high, but as unrest and fighting abated, the downward trend in the price resumed despite the high rate of capacity utilization. The reason for this is the large increase in non-OPEC oil production, most of which has occurred in the United States and Canada. This rapid increase in production is not reflected in the measure of OPEC’s capacity utilization.

The Short-Term Outlook for Oil and Natural Gas Prices
The EIA updates its short-term energy outlook every month. The results of the November report are summarized in Table 1; the 2007 data provide a benchmark for gauging the extent to which the U.S. energy picture has changed in the past six years.

The outlook for 2014 is positive. Crude oil production is expected to increase by another 1 mm b/d while consumption of petroleum products will remain essentially flat. The price of oil is projected to decline moderately from 2013 levels, while world oil consumption is forecast to increase by 1.1 mm b/d in 2014.

The expected decline in the price of oil is due in large part to the surge in production (mainly in North America) and to a moderating rate of economic growth in countries such as China and India. In addition, OPEC’s capacity utilization rate is projected to decrease in 2014, thus allaying concerns about the impact of supply disruptions.

Natural gas production is forecast to increase by 1 percent while consumption is expected to decline by 0.76 percent. The decreased consumption is the result of electric utilities switching to coal to generate electricity in response to the rise in the price of natural gas above its very low level (by recent historical standards) of $2.66 per Mcf in 2012. The price of natural gas remains well below its average wellhead price of $6.38 per Mcf for the period of 2003-2008. The low price appears to be deterring development activity and thus explains why the surge in production that began in 2006 has slowed.

The Long-Term Outlook
The EIA also produces an annual comprehensive long-term outlook for energy that includes forecasts for U.S. oil and natural gas production, consumption, and reserves through 2040.3 The forecasts in the 2013 edition contrast sharply with those presented in the 2005 edition. In 2005, the potential of producing oil and natural gas using hydraulic fracturing and directional drilling was not recognized by most energy analysts. Crude oil production was forecast to decline at an average annual rate of 0.8 percent between 2003 and 2025 while petroleum consumption was expected to increase by 1.5 percent. U.S. imports of crude oil were expected to increase by 2.4 percent annually while petroleum product imports were projected to grow by 2.2 percent per year. U.S. crude oil reserves were forecast to decline from 21.2 mm b/d in 2010 to 16.5 mm b/d in 2025.

The 2005 report forecast that natural gas production would increase by 0.6 percent annually from 2003 through 2025 while consumption would grow by 0.8 percent per year. Consequently, natural gas imports were projected to increase by 4.6 percent annually (and by 12.9 percent annually for LNG imports). U.S. natural gas reserves were expected to fall from 204.2 trillion cubic feet (Tcf) in 2010 to 178.3 Tcf in 2025.

As shown in Table 2, the 2013 report calls for crude oil production to continue increasing over the next few years but then slowly decline. For the entire period of 2011 through 2040, however, production is expected to grow by an annualized average rate of 0.3 percent. Consumption of petroleum products is projected to be flat and imports of crude oil are expected to fall. Despite increased oil production, U.S. oil reserves in 2040 are projected to be 25 percent greater than they were in 2011.

The current outlook for natural gas is also very positive. Production is expected to grow by 1.3 percent annually between 2011 and 2040. Rather than importing increasing quantities of natural gas, the U.S. will become a significant exporter. Despite the forecast of increasing production, U.S. natural gas reserves are expected to increase by 20 percent, from 299 Tcf in 2011 to 360 Tcf in 2040.

The inflation-adjusted prices for oil and natural gas are projected to increase through 2040. EIA’s long-term forecast has world petroleum consumption growing by an annual average rate of 0.8 percent through 2040. In 2040, consumption is expected to be 21.7 mm b/d greater than its expected 2013 level. This represents a 24 percent increase in consumption and will put upward pressure on the price of oil over the long term. Given the expected growth in consumption, the extent to which the price increases will be determined by the ability of producers to bring new production on stream.

Other countries see what is taking place in the United States and many have significant reserves of shale that could be developed using hydraulic fracturing. These countries include Russia, China, Argentina, Australia, and some countries in Europe, including the United Kingdom. If hydraulic fracturing were more widely adopted, world oil production could grow at a faster rate, thereby putting downward pressure on the price of oil.

Natural gas markets are regional rather than worldwide owing to the cost of liquefying and transporting the gas. The price will increase over time as a consequence of increased demand by electric utilities, trucks, buses, and perhaps even automobiles, and because of growing export demand. Still, the cost of liquefying and shipping natural gas means that prices should remain lower here because domestic consumers can avoid these costs. Further constraining the price is the ability of electric utilities to switch to coal for generation. As the price of natural gas increases, drilling activity for additional supplies will expand, thereby limiting the extent of any increase.

The Price of Oil: How Low, How Long?
There is a chance that the price of oil could fall below $90, as it did as recently as January 2011 when the refiner acquisition cost averaged $88.04 per barrel.4 The general view among most energy analysts is that while the price could fall below $90 per barrel, any such drop is unlikely to be sustained. World economic growth is expected to pick up next year and this could lead to stronger growth in demand, especially in countries such as China.

While a sustained drop in the price of oil is unlikely, certain factors should contribute to continued moderation in the price over the next few years. At present, the amount of oil that has been removed from the market because of unplanned disruptions in OPEC countries (mainly Libya) averaged 2.2 mm b/d in October 2013.5 Separately, planned maintenance has reduced production in Iraq by 0.4 b/d; it is expected to be back on stream at the beginning of 2014. There is also 0.7 mm b/d in unplanned supply disruptions in non-OPEC countries. Eventually, resumed production will help offset the pressure from increased consumption.

Beyond Oil and Natural Gas
Beyond these dramatic changes in the U.S. oil and gas sectors, other positive trends are attributable to improvements in energy efficiency and continuing expansion of renewable forms of energy, especially wind and solar power. These topics will be the focus of future reports.

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  • 1. U.S. Energy Information Administration, Short-Term Energy and Winter Fuels Outlook (STEO), November 2013, www.eia.gov/forecasts/steo.
  • 2. In 1986, the price of oil collapsed as non-OPEC production grew in response to the high prices experienced in the wake of the two price shocks of the 1970s. As non-OPEC production grew, OPEC’s spare capacity swelled and member countries no longer found it in their interest to maintain production cutbacks. As they expanded production, prices fell rapidly. They began to recover somewhat starting in the middle of 1999.
  • 3. U.S. Energy Information Administration, Annual Energy Outlook 2013, April 2013, www.eia.gov/forecasts/aeo/pdf/0383(2013).pdf.
  • 4. As recently as December 2012, the WTI spot price averaged $87.48 per barrel. In January 2013, it was back up to $94.76 per barrel. The WTI spot price was not a good benchmark then because it was depressed by growing supplies of oil in the Midwest that could not be shipped through pipelines. The Brent spot price in December 2012 averaged $109.39 per barrel and the refiner acquisition cost of crude, which is based on prices paid by refiners for all oil, averaged $105.69 per barrel.
  • 5. U.S. Energy Information Administration, Short-Term Energy Outlook (STEO), November 2013, pp. 2-3.