1979 was a pretty interesting year to be in charge of international energy policy for the U.S. Department of State. The world was still recovering from a crippling energy crisis six years earlier, and the Iranian Revolution sparked a second oil shock that triggered a recession that would last for much of the early 1980s.
“It was a wonderful time to actually learn, not only about the politics of energy, but really markets, because markets way back then were still controlled,” said Ed Morse, the former Deputy Assistant Secretary for International Energy Policy. “The United States had controlled prices at the wellhead and the burner tip, and actually that created an incredible amount of learning, because, as a person in the government when markets started to get liberalized, I knew as much about the markets as anybody in the world did because there was no trading system involved.”
Morse served under both Presidents Reagan and Carter in the late 1970s and early 1980s, and now works as the Global Head of Commodities Research at Citigroup in New York. He says in both the 1980s and 2014, Saudi Arabia was at the heart of the collapsing oil prices, due to the growth of production outside of the Organization of the Petroleum Exporting Countries, or OPEC. In order to compete with oil from Alaska, the North Sea, Russia, and Mexico, the Saudis had to drastically reduce the amount of oil they produced. That hurt them throughout the 1980s as they struggled to get market share back. He says that same mindset triggered the collapse last year.
“Sort of like the lessons the generals learn about past wars, the Saudis learned that, in a bear market, go after market share,” Morse said.
But a critical difference in the 21st century involves how much more parity there is on the oil market. Morse said OPEC supplied roughly half the world’s oil in the 1980s, and that’s down to one-third today.
“Today, even with this imbalance, the Saudis producing what they’re producing, there’s virtually no spare capacity in the world,” Morse said. We have a market in which we can accept supply disruptions from countries that are squeezed by a lower price – whether it’s Nigeria or Venezuela or Iraq.”
While at Lehman Brothers in the 2000s, Morse and his colleagues predicted another oil bubble burst, saying $150 per barrel wasn’t sustainable and oil prices would eventually return to $90 per barrel. In 2012, he authored a paper called Energy 2020 where he calls North America “the new Middle East.” For decades, Saudi Arabia served as the world’s “swing producer,” a kind of central banker by providing liquidity to the market – adding or subtracting barrels of oil when the market needed to rebalance. He says North America is now the world’s swing producer for two reasons – production and capital markets.
“The shale revolution was significantly financed by risk capital, not generated by oil companies, but came out of debt or equity issuance through the financial services sector. That is not available in any other oil patch of the world. We are seeing the first big adjustment to market imbalances since the shale revolution,” Morse said. “Clearly, a lot of this imbalance is being absorbed by production in the U.S. It’s a slow absorption of production, so it’s a longer sweat-out at a lower price.”
Morse said when prices finally do rebound, that less-robust infusion of capital will force the production community to finance renewed growth in the U.S.
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FULL TRANSCRIPT
BRIAN HARDZINSKI, HOST: Ed Morse, welcome to World Views.
MORSE: Pleasure to be with you.
HARDZINSKI: Ed, I'd like to start early in your career. You were the Deputy Assistant Secretary of State for International Energy Policy in the late 1970s and early 1980s under both Presidents Carter and Reagan. Take me back 35 years. We were dealing with an energy crisis then, an Islamic Revolution in Iran. I have a hard time imagining a more interesting time to be in that position.
MORSE: It was a wonderful time to actually learn, not only about the politics of energy, but really markets because markets way back then were still controlled. There was no free market in energy. Yeah, Japan and Germany, to some degree, allowed prices to be freely formed. They were importers. So, they didn't have much choice in that, but, if you looked around the world, the United States had controlled prices at the wellhead and the burner tip, and actually that created an incredible amount of learning, because, as a person in the government when markets started to get liberalized, I knew as much about the markets as anybody in the world did because there was no trading system involved.
HARDZINSKI: What changed? How did that evolve? How did those markets liberalize?
MORSE: So the U.S. decontrolled oil prices, literally, the day Ronald Reagan was inaugurated. Although, we were in the process of ramping up prices to world levels, and there were several things that happened as a result of that. One of the most critical issues was that, in a world of fixed prices where the prices were set, essentially, by OPEC countries internationally, they could adjust their volume to meet whatever the prices were. As soon as the U.S., which was the largest energy consuming country in the world then as it still is and as the largest oil importing country as it no longer is, having ceded that to China, but it meant that what was and had been a seller's market became, overnight, a buyer's market - not quite overnight literally, but it became a buyer’s market and as a buyer's market, it was a market that foreign governments and foreign companies were competing against one another to have access to. It was also a rapidly growing market. So, you wanted to have access to it, and, as a result and part of the growth and volumes in the U.S. which suddenly decontrol the price of oil and gas, we had what naturally evolves with markets: a forward curve, a forward market and then futures contracts actually started to be written on the New York Mercantile Exchange, and that was very revolutionary to the market depriving producing countries of a lot of the freedom they had to determine prices.
HARDZINSKI: Looking at today as the price of oil continues to fall as it has over the past year, we've heard so many comparisons to the oil bust of the early 1980s. I wonder what lessons you or your colleagues have learned that you can apply to the current crisis, and what are some of the differences that you've noticed between now and 30 years ago.
MORSE: Sure, there are two characteristics of these markets that I think are worth looking at, and in many ways Saudi Arabia is at the heart of the collapsing prices. Prices were softening because of the growth of non-OPEC production then as was the case at the beginning of 2014, but it was the Saudi decision that triggered the really precipitous drop in prices in both instances. In the 1980s, the Saudis were the keeper of the price of oil. The price of oil for OPEC was the Saudi market, 34 degree API Saudi-like crude oil, and as new oil was coming into the market from Alaska, the North Sea, Russia, Mexico. The Saudis, in order to maintain that price, had to reduce their production. So, they went from around 10 million barrels a day in 1981, similar to where their production is now. Keeping the price firm, they, by 1985, were producing 2 1/2 million barrels a day, and their lesson was very instrumental in what they did last year. Their lesson was, in a bear market, in an oversupplied market, the thing you don't want to do is lose market share because, if you lose the market share, you will eventually have to see prices go down anyway and then you'll have to struggle to get the market share back as they did after 1985-86 because in ‘85-‘86 the Iran-Iraq war was still going on. By 1988, the war was over and that oil came into the market in a big way in the Saudis were struggling to keep market shares. So, in many ways, to trigger the collapse was the same. It was the Saudi move the first time. It was defensive, and they were in a corner because their production had fallen to the degree it had. This time they didn't want to be in the corner. So, sort of like the lessons the generals learn about past wars, the Saudis learned that, in a bear market, go after market share. So, that's one of the critical commonalities of both that period and this period, but there is, really, an amazing and critical difference between now and then that people tend not to focus on. Right now we have an oversupplied market. It's a market that is a 94, 95 million barrel-a-day market. Then the market was a 60 million barrel a day market. Then, as now, OPEC was about 30 million barrels a day on the market, but now their share of the market is a third rather than a half of the overall market. Today, even with this imbalance, the Saudis producing what they're producing, there's virtually no spare capacity in the world. So, we have this, kind of, two percent over supply in the market, but we have a market in which we can accept supply disruptions from countries that are squeezed by a lower price. Whether it's Nigeria or Venezuela or Iraq, nobody really knows, but we're in an era of the challenge to the Petro state, and there is no real spare capacity. Then there was a lot of spare capacity. OPEC had been producing 30 million barrels a day. They went down to 15. So, as the Saudis were fighting back for the market share, you could expect that the world would be in a very low price environment for a long time given all of that spare capacity. Now we know that $50 are not sustainable, $40 prices are less sustainable and the world doesn't have this cushion of un-produced but produceable oil behind it.
HARDZINSKI: And you and your colleagues at Lehman Brothers kind of predicted this in the mid-2000s. Is that right? You and your research team put together a paper saying that these high oil prices, these $100 a barrel, $120 barrel that they weren't sustainable and, eventually, this was going to fall apart.
MORSE: Yes, that's absolutely correct. We did a couple of pieces. One was called oil.com arguing that 150, which is closer to the mark where oil prices hit, was unsustainable and bubble-like, and we were wrong as to where we thought prices would be going. We thought they'd fall to below 90 at a time when most of the consensus was oil prices were heading to $200 a barrel. They actually fell to the high $30 barrel level. They eventually rebounded to that $90 number which we felt kind of comfortable about given the cost of finding and developing oil and giving some other measures of where fair market value is.
HARDZINSKI: Here in the United States, these low oil prices translate to low gas prices for you, me and the everyday consumer. What's it like in other countries that are oil rich, say, Russia and Venezuela? How does this downturn affect those citizens?
MORSE: Well, we're in a lucky position as are most other, so-called, oil consuming countries in that we have a very low share of our GDP that is involved in energy. It's less than 10 percent as opposed to a petrostate that has 80-90 percent dependence in GDP of revenues from oil and natural gas. This hurts a country like Venezuela far more than it hurts a country like Russia for a couple of good reasons, but one of them to bear in mind is that they have a free floating currency. A lot of the adjustment can happen through a free flowing currency, particularly, and here's the difference between Russia and Venezuela: In the case of Russia, virtually all of the operating costs and all of the capital costs are Ruble denominated. Ruble has depreciated close to 50 percent against the U.S. dollar, so the costs of finding and developing oil has actually gone down, and Russian production has actually gone up as a result of that factor. In Venezuela, most of their costs are not local currency related, but they are based on effectively the U.S. dollar. So, they suffer doubly. The consumer is hit or the government is hit in Venezuela because they have very low controlled oil prices. They are actually an importer of petroleum products. So, that puts a tremendous burden on a government budget to try to deal with the situation. Russia has a little bit of an adjustment ease through the currency that floats in through the local costs, but there too costs of energy go up for the consumer, and Russia doesn't have the same privilege that the Middle East countries have in terms of stabilization funds. Russia's stabilization fund sits around $145 billion this year. They are growing down at a rate of $75 billion annual wise. So, that's a cushion for adjustment that Venezuela doesn't have, but they can look toward the end of the tunnel and see the day when that reserve is going to vanish. So, they are in for a day of reckoning, and they've got a couple of years to, kind of, work on how they adjust to it.
HARDZINSKI: I want to go back to something you said at the beginning of our conversation, and you were describing how interconnected OPEC and the Saudis are. I watched a Bloomberg Television interview you gave recently, and you and a panel were discussing the falling oil prices and you said everything about OPEC revolves around Saudi domestic politics. What are we to make of the instability there right now? King Abdullah passed away recently. The current monarch is rumored to be in ill health. If there is a power vacuum, who steps up and how does OPEC's role change and what countries would fill that hypothetical void in leadership?
MORSE: First of all, I wouldn't go too fast in saying that Saudi Arabia is facing a period of deep instability. It's a country that has managed to adjust to changing circumstances rather remarkably. They've had a very small number of kings over the last 75 years. There have been transitions from one king to the other, only one of which was a rough transition. So, I'd say the Saudi's are challenged, but the level of instability that some people fear is not all that large. Clearly there are adjustments that have to be felt by and accommodated by the royal family. It's a large group of people. I suspect one of the accommodations that has to be made is an adjustment to effectively a smaller royal family, and how they do that remains to be seen, but clearly, if they think that we're in a lower price environment for a long time, and they've said publicly that they think that this is going to be a $70 world after all things are balanced out in the market. That's not an environment in which you can remain a petrostate. So, they must take measures to adjust. They must take measures to change the dominance of oil in their national economy. Fortunately, they have neighbors who have done so quite successfully. In the UAE, which is clearly a smaller country than Saudi Arabia, but right next door, they're only about half dependent on oil revenue as Saudi Arabia. Like Saudi Arabia, they have huge sovereign wealth investments around the world to draw down, but the Saudis have to find a way to do what the UAE has done in several respects. One is to end the controlling of oil prices, something that Venezuela and other OPEC countries have found it very hard to do, but the UAE has actually moved like that, suddenly overnight to market pricing and the citizenship has adjusted to it. That takes a big burden off of a government in terms of subsidies. So, the Saudis, I think, will clearly be moving in that direction. Another is to find ways to diversify the economy. The UAE has done it through energy intensive industries and through tourism. Saudi Arabia will find it more difficult to do it through tourism, although they probably can push religious tourism to a significant degree doubling if not tripling the earnings from that. So, it will be a struggle, but I wouldn't say that the legitimacy of the royal family itself has been challenged. The differences of views are emanating from different parts of the royal family rather than from society as a whole rebelling against the royal family.
HARDZINSKI: Finally, in the short time we have left, I want to look ahead. You're now the head of global commodities research at Citigroup, and you're the lead author on a paper I have right here in front of me called "Energy 2020" where you call North America the "new Middle East." What did you mean by that?
MORSE: Yeah, fortunately I just reread a piece that I also wrote in 2012 where I was really specific about what I meant by that, and what I meant by that is something that impacts the state of Oklahoma a great deal, and it is that Saudi Arabia had been the swing producer of the world for a long time. It was the central banker of the world, so to speak, providing liquidity or adding barrels to the market, when the market was short. Taking away liquidity when the market needed to rebalance to take supply out of the system. North America is now the swing producer. That's a remarkable change. You could say that it's a combination of two things that are North American related. The production side of North America and the capital markets of North America are playing the role of swing producer. The shale revolution was significantly financed by risk capital, not generated by oil companies but came out of debt or equity issuance through the financial services sector. That is not available in, kind of, any other oil patch of the world. We are seeing the first big adjustment to market imbalances since the shale revolution. Clearly, a lot of this imbalance is being absorbed by production in the U.S. It's a slow absorption of production, so it's a longer sweat out at a lower price so long as the Saudis have abandoned the role of swing producer which I think they have fairly permanently, but eventually the markets will balance. We're going to see capital less robustly coming into the sector for a while, but when prices go up, as they eventually will, we will see production swinging back in and we'll see the production community financing that renewed growth in U.S. Production.
HARDZINSKI: Ed Morse, whose career has taken him from the State Department to Wall Street as an international energy analyst, thank you so much for being here.
MORSE: It's a pleasure spending this time with you.
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