ROGER HIRST: From this month forward, we're going to use our Tuesday slot to feature a recurring theme or topic. These are going to be themes or topics that we think are really key in the market. Ones that might be dominating the news or ones that we just think are underappreciated, and we're going to look at them in more detail using that Tuesday slot to look at these topics from different angles. It could be volatility, it could be gold, it could be liquidity.
In May, we're going to start this series with oil. It's a topic we've not probably covered enough in recent months. So, we thought we'd look at that as our first startup. The first episode that we're going to look at is going to be an expert view with an old favorite Diego Parrilla, who's going to look at the oil market from a very top-down view, looking at the major proponents of this market and some of the offshoots. Then in the rest of the month, we'll look at things like the stocks within the oil sector and maybe some of the other details within this market.
So, hopefully, you'll enjoy this series that we're putting out, these angles that we'll look at, and following us on every Tuesday, as we use these recurring themes and topics to tackle what really matters in the market.
DIEGO PARRILLA: My name is Diego Parrilla, I'm a mining and petroleum engineer from Spain. I did my masters in Mineral Economics in the Colorado School of Mines and the French Institute of Petroleum in Paris. I spent pretty much half of my career on the investment banking side with some of the leading global investment banks, such as J.P. Morgan, Goldman Sachs and Merrill Lynch, where I held senior roles across London, New York and Singapore. The second half of my career was on the buy side, initially with my own fund, and then I've been privileged to work for some of the largest macro players before I move back to Madrid about two years ago, where I'm the managing partner for Quadriga Asset Managers.
My first book, The Energy World is Flat, I was lucky to come and present to you, in the early days of Real Vision, became a bestseller published in Spanish, English, Chinese, and led to a number of contributions with selected media such as two inside columns with the Financial Times. My second book, The Anti-Bubbles, I've also have the opportunity to discuss here on Real Vision, which deals more with macro events.
Outline 'The Flattening of the Energy World'
So, to refresh the framework of The Flattening of the Energy World, this is a contrarian investment thesis. It argued- remember, it was first put forward in 2014. It was a pretty different world, $120 oil. The perspective of $200 peak oil, and also we have a very different world across other energies such as natural gas with LNG at $20 with $2 prices in the US.
It was a very different world. And the thesis was highly contrarian. You had mainly two parts. First of all, what I would describe as- or the process has two components. The convergence across energies, this is effectively crude oil versus natural gas versus coal versus other pieces, that convergence across energies. The second one is the convergence across regions. So, even for the same commodity, such as natural gas, we would argue for the convergence towards the lower end, but the convergence globally.
The two together- the convergence across energies, the convergence across regions- lead to effectively a world with more abundant, cleaner, cheaper and reliable energy. So, it is a good news for the world in general. But there are obviously major winners and losers in the process.
The thesis was reinforced and not only proven but reinforced with the passage of time and events. And it was structured with what we call flatteners. Flatteners are forces at play that contribute to these flatteners. They're obviously also inhibitors. But it's a very comprehensive framework that understands and analyzes all the pieces. Within that, perhaps very importantly, we challenge along with my coauthor, Daniel Lacalle- we challenged a number of beliefs that were held very strongly in the market, which can lead to gross mistakes. So, major winners and losers in the process.
Within the framework, and I think it's timely to review, I think there are two main pieces. We've sliced the problem and opportunity slightly different. The first one is what I would call the battle for demand, which is well understood. The second is the battle for supply.
The battles for supply and demand.
So, let's look into both of them in slightly more detail. Let's start with a battle for supply. This is effectively some kind of civil war between, let's say the energy producers and is generally being a very siloed dynamic. So, we look at crude oil, for example. And we have this kind of civil war between the different technologies, regions and processes. So, we've seen how conventional crude oil extraction has been competing with more unconventional and newer technologies, whether it's Canadian oil sands, or shale, or others and how the different countries whether Saudi or Russia or the US and the exporter dynamic.
So, this battle for supply and obviously, the long-term impact of the survival of the cheapest and most reliable one has been very acute and has been driven primarily in the last few years with the entrance of a new technology being shale with horizontal drilling and fracking. So, these dynamics, there's been a number of game changers, which have dramatically shifted the regime of the oil market, and I think is worth discussing shale in some degree of detail and how it's changed the old regime.
In the olden days, we were pre-shale, we were looking at processes, where if someone gave us green light for developing oil in Alaska, it would take 10, or probably closer to 15 years, since the green light 'til the first drop of oil is actually in our cars. These are incredibly long periods. But this is the reality in the dynamic that we faced for decades, which forced us to go into technologies, such as Ultra Deep Oil where we were looking for oil 15 kilometers deep with one mile of salt in the coast of Brazil, for example. Incredibly expensive technologies that effectively were economic on a marginal basis in that old regime. The
entrance of shale was a game changer in a number of ways. First, it's large, it's significant. There's been tremendous debate in whether shale is a bluff or not. But those resources are there. They're huge. The US is by no means the largest in these reserves that are reasons why the US has been leading, but the volume is very large, and the technology works. And it's there. And it works at marginal prices that are substantially lower as we will discuss in more detail, closer perhaps or definitely lower than $60 a barrel.
But perhaps beyond the quantity and the marginal cost, which are obviously game changers, the key thing is the time to market. So, we've been seeing a response in two ways. First of all, from the green light to get in those drops of oil is three to six months, which is dramatically shorter than the 10 to 15 years we were used to. And second, you can also open and close the top, literally, without hurting the fields. This is something that didn't happen before where producers where if you stopped producing in a low-price environment, you could dramatically hurt the pressure on the field and therefore, impact the resources negatively.
So, these dynamics have made shale in my view, a real contender, a game changer. And it has changed in the dynamics in multiple ways. So, the battle for supply is better understood on the price section and on how it impacts.
The second part of the discussion in the thesis, which is less understood is what I would call the battle for demand. And this is something that again, we're looking at effectively different sources of energy- be it crude or natural gas or coal or others competing for demand. And historically imposed, the 1970s, what we saw is the energy world really divided into two- the transportation, which has been heavily dominated by crude oil, and by OPEC and the other, i.e. mainly industrial and power generation and others.
In that sense, what we've seen, and very often when we talk about energy, we're talking about transportation, we're talking about crude oil. That's been, let's say King Oil's turf, pretty much undisturbed. And what we've seen through the development of other resources, in particular, the globalization of natural gas and the development of the energy broadband, as I call it. The impact of the technology, which brought natural gas in the US through shale to literally $2/MMBTU which is about 12 to $15 per barrel of oil equivalent and the fact that we had Fukushima sending prices 10 times higher $20/MMBTU, $120 with LNG.
This sharp difference, this sustained price difference was a very strong price signal that led to major investment in LNG. It broke this duality of contracts that were take-or- pay. It created singles where we have liquefaction that would find its way and it contributed to the globalization of natural gas. This is truly major, because natural gas went from being an unreliable regional source of energy to a more reliable, cheaper, of course, environmentally friendly, but abundant source. And that led this globalization of gas- it has been- or it was in our view a key challenger in a number of ways for crude oil's dominance in the transportation.
So, in that sense, the dynamics on the battle for supply and this civil war across producers for a given silo, and the dynamics on the battle for demand, which are in a way breaking these silos and interconnecting them, not only in the power generation, which has always been there, that dynamic of competition between nuclear and coal and natural gas, and now, renewables, but also in the transportation space, which was pretty much oil's kingdom, which is being challenged in a number of ways.
Where does OPEC now stand?
OPEC, it's been a major driver of oil prices, pretty much since its creation in the '60s. It was obviously behind the lot of the dynamics that we saw in the '70s and as I just described, this dynamic where the energy world broke between transportation and others. One of the key things that we- the concepts or the beliefs or misconceptions that we challenged in the book at the time, and that I think is still not well enough understood is it's this perception that OPEC's success has been driven by an oligopoly of supply, meaning I have the oil, therefore I control the price.
And it makes sense. I would argue that the fact that there are over 45% of let's say production, over 80% of the proven reserves current that creates this obvious control. But I would argue that this is a necessary but not sufficient condition for the success. In that sense, we've seen also other markets with very large dominance, which haven't had the success of OPEC. And the real reason is that it is not just about an oligopoly of success. It's not about I control oil, I control the price. What OPEC's success has been about is a monopoly of demand.
So, when you have a situation where transportation has been pretty much oil and oil products whether it's- we talk a lot about oil, by the way. But what we're really using day today is gasoline, is diesel, is jet fuel, is fuel oil. So, in that sense, this dynamic where we have the combination of strong demand growth and the fact that crude had really no challengers- for the reasons we discussed- means that the actual real reason why OPEC has been successful is the monopoly of demand. And this can lead us to major mistakes and so, I hear on a regular basis how people talk indistinctively about the transportation demand and oil demand.
Now, one of the arguments used for peak oil was look, China and India are going to come in with so many cars, that of course, oil demand is going to continue to grow up forever. And this is a basic mistake or misunderstanding, because effectively, we're confusing transportation demand, which indeed may or may not continue to grow with oil demand. Because it is perfectly possible that this incremental demand might be met by other sources. We've seen, obviously electric, but we'll talk I guess in more detail about other drivers such as natural gas and how it's played out in LNG into heavy industries such as being long- term transportation, and rail and buses and many others.
So, I would start my- the first thought I would leave with OPEC is yes, it's been incredibly successful, but not just for the reasons that you might think- which is the idea that they control the supply, therefore they control the price- but more because of their effectively monopoly de facto over demand- which I would question on a medium to long- term basis. And in that sense, remember, this is really a marginal barrel game. So, it's not about- the averages is really about the marginal barrel.
Now beyond that, and with this very big picture, let's obviously, in the short to medium-term OPEC is being and remains hugely influential for the energy markets. In particular, we are currently in a process where OPEC and its current 15 members have reached an agreement with a number of allies, which brings them over to 24, including critically people like Russia- which effectively have agreed to cut about 1.2 million barrels since January 2019. Now, these 1.2 million barrels comes approximately 800,000, from OPEC. 400,000, from non-OPEC, where the big part comes from Saudi- about 320, and Russia- 230. So, together Russia and Saudi represent roughly half of the cut of these 1.2 million barrels a day with a number of other contributors.
These cuts are meaningful back to my point on marginal economics, relatively small changes in the supply can lead to significant changes in prices due to the low elasticity of demand on the consumption side- which is last time I looked, it was about 2%, meaning 100% move up in prices can actually adjust a 2% reduction. So, you can see what major impact it could have. People talk about this new OPEC Plus de facto expanding- I call it ROPEC, because I do think that it's really about Russia and Saudi, like the meaningful players. And this is something that has the rationale here, this comes from post let's say 2014- 2015, when they led the market forces play. Oil goes from 120 to sub-30.
But it broke another of the strong beliefs in the market, which is the OPEC put, this idea that Mommy Saudi and Daddy OPEC were always going to be there able to control the price. But we saw that this dynamic effectively broke, and as the price sold off, producers, who at the end of the day, care about the fiscal side- how much money they earn, were actually producing more- not less- in a low-price environment, which effectively accelerated the process. So, this conception, and this belief, this misconception of the OPEC put proved to be weak and something I presented before it happened as the BTU that broke OPEC's back and something that remains like a big challenge in the market.
So, I would argue that OPEC for the short to medium-term will remain very powerful. But the real rationale following this move was inventories. At the end of the day, a scenario where production exceeds demand or consumption leads to an increase in inventories. And this increase in inventories, once it reaches certain critical levels, and you approach full storage effectively leads to the collapse in spot prices- which creates these negative dynamics.
Now, it was the high level of inventories that really drove all the OPEC members to get there and allies to get their act together. And what we've seen is a normalization of it's been a big success, is a normalization of inventory levels closer to five-year averages, which is the target that OPEC has. They don't really want to be in either extreme. Of course, by no means, you always want to avoid the scenario with full inventories, that is an absolute disaster for them. But a market that is too tight, it can also create problems because effectively, unlike what common sense might tell you, these spikes whether are geopolitically driven or other can actually lead to strong supply responses. And that's something that I think a lesson learned by OPEC.
What are the current drivers of crude oil prices?
So, how does this translate into the crude oil markets? And let's start with Brent, which is a global, more reliable benchmark, as most of WTI, West Texas Intermediate, is subject to bottlenecks. So, it may not be a fair reflection of the actual dynamics on a global basis. Brent is widely accepted as a more reliable.
What we've seen is a true roller coaster in prices. Over the past five years, we saw $120 oil going all the way to sub-30. But even in the last year, we've seen crude going from closer to $85 to $50. This, there are a number of drivers that we'll discuss in more detail, not only micro supply and demand driven, but also macro. But beyond the price action in the front end, I think I'd like to highlight a couple of things which may not be on the radar for most of the viewers. The first one is long-term prices.
So, what we've seen is