Senate Energy & Natural Resources Committee hearing to Examine Challenges and Opportunities for Oil and Gas Development in Different Price Environments

In her opening statement, Sen. Lisa Murkowski (R-AK) said that oil and gas production is capital intensive with a long lead time before projects start production.

Because of low oil prices, tough decisions need to be made, she said.  People need to work together to ensure that the U.S. remains an attractive place for resource production.  Within the country’s mix of energy options, the U.S. needs to provide new access, establish reasonable systems for leasing and development, and reform the permitting process.

That system does not exist at the federal level currently, she added, but it can happen with policy improvements.  Sen. Murkowski is in the process of releasing a new series, Alaska: First in Energy, the first of which is The Alaskan Exception: Energy and the Frontier.  She said she will continue to unveil Alaska legislation in the coming weeks in order to construct the case that Alaska should be first in energy.

Jason Bordoff, Founding Director of the Center on Global Energy Policy, Columbia University School of International and Public Affairs, made three main points in his testimony:

1. The oil price collapse has hurt many workers, families and communities through job losses in oil-producing states. Though low oil prices are net a boost to the economy, the boost has been much more muted compared to past price declines.
2. It is far from clear that oil prices will remain low. Many factors could increase prices more quickly than anticipated.  Future oil prices may be more volatile.
3. The federal government has a diverse set of responsibilities regarding energy production, and the government should design smart and cost-effective regulations regardless of oil prices. This is particularly true because the commodity’s future supply, demand, trade, and price trends are notoriously difficult to forecast.

The unprecedented rise in U.S. oil production—driven by the shale revolution—was most significant factor contributing to the current oil price collapse, Bordoff said.

As prices started to slide in the summer of 2014, OPEC was confronted by a surging high-cost supply, including from the U.S., and an inability to forge agreement to curb production among its members and certain non-OPEC countries, particularly with post-sanction Iranian production slated to return market. Consequently, OPEC took no action at its November 2014 meeting, and oil prices fell off a cliff.  And, in 2015, OPEC countries sharply increased production, with Iraq and Saudi Arabia together placing and additional 1.2 million barrels per day on the market.

While many expected U.S. production to then fall sharply, it actually proved far more resilient.  Even with the price collapse, U.S. production rose in the first half of 2015, and then declined only gradually, even as the total rig count dropped 78 percent.

Eventually, the tight oil supply reality caught up with the rig count collapse and production declined.  In order to keep production growing, more wells need to be drilled, and that isn’t happening.  U.S. oil production fell 700,000 barrels per day in the past year, and is projected to drop another 1 million b/d by the middle of next year before a rebound occurs.

The oil price collapse may one day be seen in retrospect as an opportunity for the U.S. oil sector to make itself stronger and more resilient, Bordoff said.  Eventually, prices will recover, and U.S. output will rise again.  The rise may coincide with oil company efforts—under intense economic pressure—to improve efficiency, productivity, and cost-effectiveness through new and innovative methods.  While the U.S. may be a short-cycle supplier, it is most certainly not a high cost supplier (as some previously described it), and may be in a better position to weather future downturns.

Total employment impacts are greater than direct oil and gas sector lost jobs because of resulting reduced spending on other goods and services.  In percentage terms, the economic impact is greatest in oil-dependent states such as Wyoming, Oklahoma, North Dakota, and Alaska.

The U.S., however, is still the world’s largest net oil consumer and a major oil importer (even with the recent import decline).  The oil price fall, therefore, offers a macroeconomic boost by reducing consumer spending on fuel.  But, the macroeconomic boost was smaller than anticipated because:

1. The historical relationship between consumer spending and energy prices did not play out the same.
2. The U.S. is such a large producer that the U.S. net benefit is smaller.
3. The U.S. now imports less oil meaning consumer benefits come at the expense of domestic producers, which provides a smaller macroeconomic boost.

Changing demand also presents a challenge. Consumers have responded to lower prices by buying more SUVs and less electric vehicles.  U.S. gasoline consumption is rising and is projected to equal 2007 levels in 2016-2017.  With domestic production falling and consumer demand rising, U.S. net oil imports in January 2016 had increased 650,000 barrels per day from a year earlier.

Increased petroleum dependence reduces U.S. energy security, Bordoff said.  “We increase our energy security if we reduce oil consumption and concomitantly the exposure of the U.S. economy to inevitable oil price fluctuations in the future, not to mention the climate and environmental imperative to reduce oil consumption.  Policies to reduce oil demand and investments in alternative transportation fuel research and development not only increase our energy security, but also reduce greenhouse gas emissions that lead to potentially severe climate change impacts.”

Discussing natural gas, which has also been impacted by low oil prices, Bordoff said natural gas prices have been low for some time.  Despite the loss of “associated” gas production—gas produced as an oil production byproduct—gas output has continued to rise, and is expected to increase in 2016-2017.

The primary impact has been elsewhere in the world, especially Asia, where gas prices are often linked to oil prices.  The changing outlook has raised questions about the global market for LNG exports, including from the U.S.  In late February, a historic milestone was reached when the first ever large-scale LNG shipment was exported from the lower 48 to overseas, an event that may have significant geopolitical implications, Bordoff noted.

He said the futures market—now pricing oil below $50 through 2019—is a poor predictor of future prices, as the oil market is characterized historically by booms and busts.

“Currently the global market is oversupplied and inventories are at a very high level, which will weigh on prices for some time to come,” he said.  “At the same time, the best cure for low prices, the saying goes, is low prices.  U.S. production is falling sharply now.  Further production declines are expected this year from China, Mexico, and Colombia.  And roughly $400 billion in global capital investment cuts means that less supply will be available in the years to come.  Meanwhile, consumers are responding to low prices.  Global oil demand, which grew only 900,000 b/d in 2014, grew 1.8 million b/d last year, and is projected to rise another 1.2 million b/d this year.”

Beyond market fundamentals, prices may rise due to other causes.  Iran attempted to ramp up production after the sanctions were lifted, but apparently this won’t be as easy or quick as first thought.  Despite OPEC’s recent failed effort to freeze production, the members still may try to curtail output.

Additionally, geopolitical and economic risk still threatens world oil supplies.  Bordoff’s written testimony, page 7 provides details about Middle East and North Africa risks.

If a significant supply disruption occurred, the global oil market, with OPEC spare capacity at historical lows, has less of a cushion to handle it.  In a world with very narrow spare capacity, any disruption to global supply can have an outsized impact on price because there is little buffer in the event of supply disruptions, Bordoff said.  Once the market rebalances, likely later this year or next, and inventories draw down, prices could rise more quickly than expected.

A key question is whether the U.S. can act as a “swing supplier” and quickly ramp up production to stem the price rise.  Shale oil production, in theory, could rise quickly when companies start drilling again.

In truth, Bordoff said, we don’t know how quickly the U.S. can increase production and what price point would make that happen.  Shale oil is a new phenomenon.  Time is required for capital markets to reopen up, for companies to obtain rigs and equipment, and for laid-off workers to return.

Dominant producers have tried historically to curb boom and bust cycles by managing supply.  But the oil market today is functioning more like a free market, with OPEC’s hold diminished.  If OPEC continues to fail at market management, and U.S. lags in its market response, more price volatility may result.

Bordoff concluded with discussion about the policy implications of a low price environment.  As an example, the lack of public concern made the Congressional vote to repeal the crude oil export ban a relatively easy one.

As a general matter, energy and environment policies should be formulated without giving too much consideration fluctuating short-term oil prices, he said.  The government’s role is to correct market failures with, as an example, carbon emission reduction policies, which address a social cost not internalized in energy prices.

Government also determines which federal lands to open to energy development, based on potential environmental risks and impacts, as well as the potential benefits from increasing domestic energy supplies and reducing import dependence.  The government evaluates permit applications for new energy infrastructure projects to ensure potential environmental impacts are understood and mitigated.

The government’s role does not change in different price environments.  For instance, low gasoline prices have reduced demand for fuel-efficient vehicles, leading to arguments that the Obama Administration’s ambitious fuel economy standards should be weakened when they’re reviewed in 2018.  However, the reason for government fuel efficiency regulations—which reduce oil imports and pollution—is to push the automotive industry to achieve a fuel efficiency levels that it wouldn’t obtain on its own.

These policies are even more important when prices fall, because the market then would not achieve them on its own.  Even with today’s low oil prices, fuel economy standards still deliver net benefits to society and help protect consumers against future oil price volatility.

Oren Cass, Senior Fellow with the Manhattan Institute for Policy Research, gave a testimony that made the following points:

1. The primary impact of policy decisions will not be felt for years or even decades.
2. Market prices and predictions say little about what future prices will actually be.
3. Innovation and exploration will change the scale and economics of various resource bases.

Cass said the appropriate federal role is to establish a clear, stable framework within which the private sector can make long-term investments it chooses.  These same policies make sense in both low and high price environments.

This approach is most likely to produce:  The most efficient allocation of resources, maximum domestic energy production at minimal cost, lower energy costs for households and businesses, increased employment, reduced import dependence and price volatility, and increased U.S. geostrategic power at the expense of the worst actors on the global stage.

The exploration and extraction of natural resources occurs on decades-long timelines, Cass said.  Far offshore wells were first drilled in the Gulf of Mexico in the 1940s, but the technological advancements of the 1990s drove production costs down by 60 percent and made them economical.

When energy prices are high, the opponents of expanded domestic production argue the timelines are too long to justify the investment.  When energy prices are low, they ask “what’s the rush?”  But, in anticipating resources that won’t be available for a decade or more, today’s market price is not relevant.

The determinants of long-term demand include not only economic growth and total energy demand, but also the evolution of energy consumption technologies.

Supply projections are even less reliable.  The scale and location of recoverable resources changes constantly, as do the access costs for those resources.

When domestic oil and gas production exploded in 2010-2013, the level actually fell on federal lands.  Cass said that if private lands were subject to the same regulatory restrictions, permitting requirements and political infighting as the federal lands, the boom might never have happened.

Looking beyond the sale boom and excluding North Dakota entirely, proven reserves increased by 104 percent from 2008 to 2013 in the states where the federal government controls less than 10 percent of the land, while reserves declined by seven percent in the states where the federal government controls more than 50 percent of the land.

Off-limits federal resources, however, may be far richer than those driving the shale boom.  The closed Outer Continental Shelf (OCS) areas are estimated to contain more than 40 billion bbl of technically recoverable resources.  The Arctic National Wildlife Refuge (ANWR) contains another 10 billion.  In contrast, the entire Bakken Formation in North Dakota is estimated to contain less than 10 billion bbl., though the original estimate was less than 1 billion bbl until development was well underway (see figure in written testimony p. 5).

With no credible forecast for how energy markets will evolve, Cass said the best course is to let markets work:

• Private industry is the best positioned and the most incentivized to back its judgements with its own capital about what investments at what scale make sense. It will place bets efficiently as long as it can trust the regulatory environment.
• Government must make clear that it is “open for business,” supportive of efforts to expand production, and committed to not changing policies frequently in response to changing markets.

Reforms should focus on establishing clear and legislated roadmaps for opening new onshore and offshore areas over the coming five and 10 year periods, including ANWR and closed OCS areas.  USGS should regularly update federal land and water inventories of federal lands and the Energy Information Administration should forecast development timelines and peak output levels in order to form a baseline for measuring production increases.  States should be granted permitting authority over lands within their borders.  Federal lands should be subject to clear procedures and timelines.

Additionally, downstream timelines should be shortened, and oil and natural gas pipelines and export terminals should be deemed as in the national interest.

Leslie Palti-Guzman, Director Global Gas with the Rapidian Group LLC, testified on the new global gas order that has emerged since the second half of 2014 and what it means for U.S. LNG exports, the global gas trade, and gas geopolitics.

The new gas order is characterized by large oil price declines reflected in oil-indexed gas prices (notably Asia), the abundance of new LNG supplies, and European and Asian rock bottom stock prices at a time when traditional Asian demand is muted.

The 2016 global gas market features:

• A buyer’s market with greater flexibility.
• Growing competition between exporters.
• The entry of more diverse LNG players.
• A convergence of European and Asian spot prices below $5/mmbtu.
• A wait-and-see approach on LNG infrastructure investments.

Roughly 58 million tons of U.S. LNG has been sold under long term contracts out of the five facilities currently under construction, although there is no guarantee that the customers which have contracted the volumes will actually use their option to export the gas if the economics don’t work.  U.S. LNG is all about flexibility, making it appealing to purchasers, but also leaving buyers free to give notice and walk away from previously agreed purchases.

Furthermore, buyers are free to send their LNG without a fixed destination attached, meaning a predetermined dedicated market for U.S. exports doesn’t exist.  Current narrowing price spreads make an Asian LNG market for the U.S. unlikely.  Even though Asia was initially the destination of half of the LNG export projects, the distribution will now be one-third for Asia, one-third for Europe, and one-third probably for South America.

Oil price levels, project cost mitigation, competition between supply sources, and natural gas demand will shape U.S. supply flows in the coming years.  Final Investment Decisions (FIDs) in the next four years will feature either major cost reductions, competitive technologies, capacity downsizing, or large-scale resource or strategic market strategies.  U.S. LNG will continue to be attractive for new investment because of low cost, unique pricing, and stable supply source.

“However, it is important to keep in mind that Asian and European buyers like to diversify their sources of supply and pricing exposure, which implies that they don’t want solely U.S. LNG in their portfolio,” Palti-Guzman said.  “Some in Europe do not want to replace a Russian dependence with a U.S. dependence.  In Asia they want a portfolio as diversified as possible (supply from Russia, Qatar, Australia and others).  Delays in other plays (Mozambique, Western Canada) will be a boon for new investments in U.S. LNG.  But the most important competition to additional U.S. LNG capacity will be unsold volumes from operational export plants.”

Medium and long-term demand for LNG will be one of the most critical elements to watch in determining whether the world needs more U.S. LNG.

In many countries, natural gas must compete for market share with cheaper coal and zero-emission renewables, which makes future demand uncertain.  In Europe, gas cannot compete with coal without a carbon price.  Post COP21 has raised the profile of gas as a means to achieve a greener economy, but competitive prices matter.

Additionally, spot market LNG opportunistic demand is rising.  LNG is gaining traction in new niche markets that see it as a stop-gap solution or as supply security.  However, demand from these new, opportunistic importers could be fickle if prices rebound.

The flexible supply surge will make the market freer and more transparent by the end of the decade, Palti-Guzman said.  In addition, oil price gyrations will make oil-gas pricing less predictable, speeding LNG buyers’ push away from oil-indexation.  At a time when lower pricing and cost inflation increases project risk and tempts companies to defer investment, financing reform for LNG projects might be needed.  Once Hubs will be liquid enough, especially in Asia, investments will increasingly rely on market forces and reliable price signals.

The rise of more politically stable suppliers, such as Australia and the U.S., reduces the exposure of global gas markets to geopolitical disruptions, which means enhanced energy security for consumers.

A simultaneous cutoff of Algerian and Libyan gas to Europe is the highest probability event for this year, but odds are still low.  Longer term, Russia’s continual threats to long-term gas diversification and the evolution of Qatar-Iran relations pose risks in Europe, the Caspian, and across the Middle East, but near-term disruptions are unlikely.  The more liquid, competitive and transparent the market is, the more established suppliers such as Qatar and Russia will continue to adapt their pricing downward and offer more flexible terms, which in turn improve the odds of a golden age of gas.

Sen. Murkowski said LNG exports may have a narrowing window of opportunity, given witness comments.  Sen. Murkowski said Alaska has historically exported to Japan, and is trying hard to open new markets, but logistical challenges are in the way.

In the interim, LNG geopolitics are playing out.  Sen. Murkowski asked if Asia is a less popular destination.

Palti-Guzman said traditional buyer (Japan, South Korea) demand has declined or stagnated, and a lot of uncertainties exist.  Japan is trying to restore its nuclear reactors, and continue market deregulation.  India and China have a huge upside for LNG markets.  Southeast Asia is a growing niche market.

Ratner said Alaska is viewed differently than the lower 48.  Asia is definitely the most relevant market given its geographical proximity, and any new Alaska project will need more than two years to enter the market, so the market will be determined by how low prices affect it.

Sen. Murkowski said that people look at today’s low prices and say it is a lousy time to make investments.  But, any project will take eight to 10 years to develop.  She said the challenge is to get people to focus on where the country will be in a decade.

Sen. Murkowski asked if the Strategic Petroleum Reserve (SPR) and a decent level domestic oil production could mitigate any sort of prolonged disruption and have importance from a national security perspective.

Bordoff replied that if there is a world supply shortage, prices would go up globally for everyone.  The SPR can play an important role in mitigating that, but given the changing market, the U.S. Department of Energy should look at whether the U.S. should change its energy mix.

In terms of global market supplies, on the margin it helps with supply security.  The macroeconomic vulnerability to price shocks is lower when the U.S. is less of a net importer, so increasing the domestic supply has economic and geopolitical benefits.

Sen. Murkowski said all of the panelists claimed that oil prices will rise at some point in time, it is just a question of when and how much.  She asked how the U.S. should prepare for the next increase and if preparations should start now.

Bordoff agreed with Sen. Murkowski’s statement and said that reducing energy dependence also reduces vulnerability to sharp swings in price.

Cass responded that he is not sure if prices will go up.  The government can play a role in maintaining the market, and private investors can place their bets where they will.

Ratner commented that shale gas and tight oil are good examples of things that happened when nobody was looking for them.  Energy sources that encourage supply and demand market efficiency also encourage price stability.