Pressure on oil prices is building
The rally in oil prices, which started early Q2 and even accelerated in Q3, finally came to a halt at the end of September. The three most important reasons for the stagnation of the rally were: market anticipation of the Fed tapering its bond purchases, Iran trying to improve relations with the US and the compromise between Russia and the US regarding the Syria conflict. As the market was anticipating a start of the Fed tapering its bond purchases ahead of the meeting, oil prices were already under pressure. Although the fact that the Fed decided not to start tapering took markets by surprise, a strong rise in oil prices did not occur. After all, the market probably realised that tapering is not a matter of if, but of when. Our economists now expect the Fed to start scaling back its asset purchase programs at its December meeting. In our view, the actual announcement could lead to a stronger USD, higher yields, and therefore lower oil prices into 2014. The partial shutdown of the US government, due to the failed budget talks, also increased the pressure on oil prices.
The other two developments (regarding Syria and the rapprochement with Iran) both led to a decline of the risk premium on oil prices. After weeks of diplomatic negotiation, the US and Russia agreed on a draft resolution that would demand Syria to give up its chemical arms, but does not rule out military force if the Syrian administration fails to comply (Reuters). Earlier, Russia did not approve military action against Syria, which led to a difficult situation. Increased tensions resulted in higher oil prices, as investors feared a spill-over to other oil producing countries. The draft resolution eased these tensions and may lead to a politically acceptable solution which shows decisiveness without bearing the immediate risk of escalation.
After Iranian President Rouhani indicated several times that he would like to improve relations between Iran and the West, oil prices eased. After the phone call between Rouhani and US President Obama last Friday (the first direct contact since 1979 between the two countries’ presidents), oil prices dropped even further. President Obama called this a ”unique opportunity” to make progress on the issue. For the moment, Iran still suffers strong EU and US sanctions, which have a seriously negative effect on the Iranian economy. If Iran and the West actually come to a solution that is acceptable to both sides, not only would the risk premium diminish, but Iranian oil exports could also be rebuild. This would lead to higher (OPEC) oil output. As a result, Saudi Arabia should cut back its production to prevent overproduction. This would lead to a rise in spare capacity, and thus lower oil prices.
Also adding to recent oil price pressure were the partial shutdown of the US government (due to the failed budget talks) and higher oil production in Libya. Although the intentions of the parties involved in the Syrian and Iranian issues give reason for hope, they must yet be followed by action. The risk premium dropped following recent developments and, in our view, could fall even further if Iran would suit the action to the word. We should, however, not expect confirmation of any actual action within the coming weeks. Therefore, we expect oil prices to trade within small ranges but with a negative bias in October.
While US energy took flight, infrastructure lagged
The US has become the largest natural gas producer in the world, and it is the third-largest oil producer. The US is also the world’s biggest energy consumer. Its domestic energy infrastructure needs to be extensive and up to date in order to ensure a reliable and safe energy offering to consumers and industry. This is especially true given the quickening pace of US economic growth. A large part of the US energy infrastructure, however, is outdated and not adjusted to current energy demand. In fact, some parts of the energy infrastructure are from the 1880s. Overall, the infrastructure has failed to keep up with changing requirements.
A substantial (>80%) part of the US energy infrastructure is privately owned. Basically, infrastructure usage can be divided into three categories: electricity, petroleum and natural gas liquids. For electricity transport, there are four integrated transmission grids: the Western Interconnection, the Eastern Interconnection, Electric Reliability of Council of Texas and the Province of Quebec. Transactions between the separate grids are very limited. Oil and gas, as well as many petroleum products, including gasoline, are mainly transported by pipelines. Other oil transport methods are railroads, tankers (ship) and tank cars.
Great new possibilities…
As a result of the shale revolution, the need for new pipelines as well as road and railroad infrastructure has massively increased. Both shale gas and shale oil must be transported from drilling wells to US refineries for further processing. The existing pipeline capacity, however, is insufficient and outdated. So far, congestion problems have been largely avoided, due to investments in the grid, selective pipeline systems and new technologies. But, as oil and gas are produced in new areas, there is a rising need for new energy infrastructure. There are also adjustments that must be made to the existing infrastructure in the coming years. Moreover, the focus on mitigating climate change and reducing carbon emissions will stimulate the switch from coal to natural gas-fired generation capacity. As a result, natural gas, nuclear and renewable energy will all play increasingly important roles in US electricity generation.
Estimates of future shale oil and shale gas production vary widely, but the overall direction is similar. The International Energy Agency (IEA) expects oil production to expand until 2020 (figure 2). As a result of declining conventional production, unconventional oil is expected to account for half of total oil production in 2035. Unconventional production of gas would even account more than 65% of the total production in 2035. The Energy Information Administration (EIA) estimates that US gas output will increase by 50% in 2035 (from 21.2 to 31.3 trillion cubic feet (tcf)), while oil production will increase from just over 9 to approximately 11.5 million barrels per day (mbpd).
The risk remains, however, that the depletion of shale wells will occur sooner than anticipated. The shale revolution could therefore come to an end earlier than expected. To keep production at current levels, a significant number of new wells should be added every year. Natural gas and oil resources & reserves, however, have also been adjusted higher every year for the past five years. Therefore, the need for US energy infrastructure investments will remain high in the coming years, even if shale wells are depleted more quickly than expected.
… but also several difficulties
One of several difficulties concerning the US energy infrastructure is that, up until now, it has not been maintained so that it could actually move energy from storage to consumers (both industrial and private). The base infrastructure was built more than a century ago to transport crude from the Gulf region to the Northwest and the West. It therefore failed to move the energy to where it was needed most. One good example is the US crude storage facility in Cushing, Oklahoma. For decades, crude was transported from many locations, including the US Gulf Coast, to Cushing to be stored and transported to refineries elsewhere in the country. Due to this history, Cushing was chosen as the official delivery point for the light sweet crude futures contract in 1983. However, with WTI trading at a significant discount to Brent, US refineries in the Gulf Coast region were motivated to switch from Brent to WTI crude. This resulted in regional bottlenecks. As a result, extra pipeline capacity was needed to transport crude back to the Gulf region and other oil- and gas-poor regions. Some existing pipelines are now being reversed, which is time-consuming.
Issues related to pipeline permits and siting are also causing problems, which could result in long delays in finalising several major projects. If permission is not granted or if the government does not allow use of federal lands, it will automatically lead to extensive constraints. Siting issues are often seen as those covered by local governments, not the federal government. Furthermore, public resistance to pipeline projects has also been encountered, which can also lead to delays or, even, cancellations, driving up costs. One example is the Keystone XL pipeline, which is still not fully approved by the Obama administration, although phase one of the project was finished in 2010. This pipeline will transport oil from Canada and North America to the Gulf Coast region. Some parts of the pipeline, however, have not received permits, due to environmental uncertainties.
The final factor which is threatening the US energy infrastructure is safety and reliability. A changing climate, leading to weather extremes, is a significant issue for the energy transmission system. As a result of extreme weather, the fragile US energy infrastructure (pipelines, power plants and the electric grid) is being hurt much more often than in the past. Furthermore, due to new technologies, a large part of the energy infrastructure is automated. As a result, there is a larger vulnerability to physical and cyber disruptions. This could be triggered by natural events, system failures or even by sabotage and terrorism.
Infrastructure boom to continue
The US economy is currently much more dependent on a reliable electricity offering, as it is a component supporting economic growth. Despite the difficulties, the US energy infrastructure will have to continue to restructure and to expand in the coming years. Not only must pipelines for oil and gas be installed in new regions, replacements and adjustments to the existing infrastructure are also needed. Furthermore, since petroleum products are allowed to be exported, unlike oil and gas, the refinery infrastructure will need to continue to grow as well. In addition, electricity transmission lines will need to be upgraded and should be able to integrate and deliver renewable energy to the energy grid. Finally, investments in the rail network, truck lines and marine transportation will also remain substantial.