Vai dal Barbieri: The unsuspected abundance of hydrocarbons

After an interesting conversation with a friend, a civil engineer who builds pipelines globally, I delved into some of the dynamics of the oil world.

Currently, attention is catalyzed by the surge in the major global benchmark indices; however, it is necessary to frame this performance in time and in the global context in which it occurs. Once inflationary effects are taken into account, the real value of oil is currently at a low level compared to past values. In fact, expressing it in ounces of gold, a measure necessary to correct the valuation of the commodity from fluctuations in the currency in which it is priced, oil is now in the lowest quartiles compared to the past, testifying to a general equilibrium in this market, with no particular signs of a substantial change in supply in the vicinity. Despite this, the combination of shocks throughout the supply chain brought about by conflicts, the re-emergence of concerns about the possible decline in marginal production resulting from Hubbert's theories, and a general catastrophism about this industry are fueling concerns about the future supply of the material and its general affordability.

After various insights, I believe that this concern is misplaced for several reasons, including misleading interpretations of data, dated approaches in valuation, and the general opacity of the industry, which does not make prospective readings easy. Let us start with an example of misinterpretation: investigating even the reserves data, we find some misreadings that add stress on the supply side, such as that of the IEA. In fact, global oil markets slipped into a “structural deficit” in the summer of 2020, causing OECD crude and refined product stocks to fall by 600 million barrels over the next 2 years. To avoid a price spike, OECD governments organized a coordinated release of 320 million barrels from their strategic oil reserves. In response to the releases from government strategic reserves, commercial inventories increased. Since March 2022, when strategic reserve releases began, OECD commercial stocks have increased by nearly 175 million barrels. Many analysts, including the International Energy Agency (IEA), have not commented on the real reason why commercial stocks have increased-strategic reserve releases. Instead, the IEA has implicitly suggested that stocks have risen simply because supply has exceeded demand. However, if liquidations of strategic reserves are taken into account, inventories remained unchanged, still suggesting a balanced market.

In general, there is increasing use of theories based on the work of King Hubbert, a Shell geologist who conducted pioneering studies of oil production trends in the 1950s. Hubbert developed a predictive model that described oil well production trends as a bell curve, predicting with remarkable accuracy the decline in U.S. oil supply following the 1970s.

As of today, concerns stem from the possibility that shale oil (an unconventional oil produced from oil shale rock fragments) will follow a similar dynamic as conventional wells, after it was the main architect of a real revolution in increasing supply after the 2008 crisis, during a period of stagnant production for both OPEC and non-OPEC countries. This breakthrough in the past decade has introduced to the markets a volume equivalent to twice the annual production of Saudi Arabia, supplying all the needs of the markets and leading the West to be a true hydrocarbon factory resulting in considerable prosperity. The decline in the supply of this resource would have significant impacts according to many, making oil increasingly expensive and less accessible.

Although a very similar trend to traditional wells can be found, this does not detract from the fact that there are many areas that, due to political constraints, are not arbitrarily exploited, either traditionally, such as areas in front of California, in Guyana and in Venezuela (which produces at practically ⅙ of its total capacity) or for deposits for hydraulic fracturing such as those in Argentina, Germany or Russia. To be sure, exploration and extraction take time to get up and running but, as has happened in Germany recently, in times of real crisis political dictates are the first to jump in order to calm basic needs. In addition to an artificially limited supply, which as we have seen in Germany post-closure of nuclear power plants are easy to overcome, there is a reliance on an overly traditional definition of oil, neglecting the substantial innovations brought by the big players in both extraction (the Deepwater Horizon, despite the accident, had more sophistication than the Space Shuttle) and refining.

Listening to experts and consulting the annual review of BP, the energy market bible, one realizes that the definition of what is Oil has broadened; this stems from the fact that more materials (such as diesel, jet fuel, etc.), in addition to conventional oil, contribute to the formation of those standard outputs that the world needs to operate. An example of this addition is NGLs (Natural Gas Liquids). Currently, nearly 7 million barrels per day are produced; 10 years ago they were zero, and the sankey diagram provided by the IEA shows how they are now an integral part of the standard output of petroleum products.

Further reflection referring to this example leads to questions about the fundamental role of refineries in this supply chain, both at the production and technological level. These players, major buyers of “crude” material-not just strictly crude, but of a whole range of different inputs that are then processed and transformed to refine the finished product-have the task of transforming inhomogeneous inputs into standardized outputs.

This industry, in labile equilibrium, works mostly on margins and capitalizes on the relative spreads of abundance and scarcity of a given reagent, depending on the levels of demand in the market. The very high level of refinery engineers within them allows them, under the right incentives, to transform hydrocarbon chains so that they can also be used with different inputs to produce the same finished product. NGLs are the perfect example: they are derived from the capitalization of the byproduct of natural gas processing, a material found in significant quantities around the world. This activity is not new and is already used by the Germans in World War II for aircraft fuel.
This means that, corresponding to incentives that may also be shortage moments, refineries are able to process different inputs. There might be moments of shortage, but they would be abruptly calmed by these companies because of the incentive given by the price. This is one reason why the supply of hydrocarbons will not decrease, but rather increase over time. It is now easy to understand how we tend to underestimate the ability of this industry to adapt and innovate.

An additional aspect, certainly conditioned by my work experiences, is the impact of Artificial Intelligence in research and exploration, which could over time bring enormous help to this industry in terms of, for example, accuracy of excavations or, more generally, a reduction in costs associated with geological studies.

In conclusion, the current surge in the most relevant global benchmark indices in the oil sector is mainly attributable to the role of oil as an indicator of geopolitical risk, especially in conflict contexts such as the Middle East and Ukraine. This phenomenon does not necessarily reflect market supply and demand dynamics. Despite fluctuations and possible shocks in a market as sensitive as the oil market, with a maximum surplus or deficit margin of ±2 percent, it is important to consider that demand in 2024 is projected to reach 1.3 million barrels per day, a significant increase over 2019. This demand growth is driven by energy-intensive economic development involving unprecedented numbers of people. However, it is important to recognize that despite short-term uncertainties, in the long run, the abundance of oil resources is likely to remain a constant, allowing for continued availability of hydrocarbons for the future.