As long as prices for crude oil remain high, record levels of production in the United State as well as new discoveries of unconventional oil around the globe can be expected to continue. Unconventional oil supply is thus expected to remain responsive to crude oil prices. The average cost of Gulf conventional oil production is around $3-15/B, while the cost of unconventional oil production ranges from $50-80/B. Consequently, unconventional oil supply can be expected to fall if oil prices drop below $80/B.
The increase in world oil supply reflects the expansion of non-OPEC oil production, primarily unconventional oil from the US (tight oil) and Canada (oil sands) as well as conventional oil production in Kazakhstan and Brazil. In addition, OPEC member countries plan to increase crude oil exports in order to maintain revenues. In 2012, total world oil supply exceeded demand by approximately 1mn b/d compared with 200,000 b/d in 2011. Based on currently available data, the surplus in crude oil supply will continue to grow, and the disparity between oil supply and demand will continue to widen, exceeding approximately 1.5mn b/d in 2013 and 2014.
Accordingly, the oil market has become a buyer’s market; customers have an advantage over sellers in price negotiations. In response to customers’ demands, oil sellers might reduce crude oil prices further in order to maintain or enlarge their market shares, thus causing cyclical price reductions below the breakeven cost of unconventional oil production. This would set alarm bells ringing regarding the world’s oil supply as unconventional oil production becomes uneconomic. In this case, the oil market will be in shortage of supply and crude oil prices will rapidly increase.
The growth of unconventional oil production means that the market share of producers of conventional oil and that of OPEC members will decline. The central question is therefore how oil producers can counter the emergence of unconventional oil without causing oil market failure. The answer to this complex question is a set of long-term cooperative measures aimed at alleviating the challenges associated with retaining or expanding market share and preserving oil revenue for oil-producing countries.
The rise of unconventional oil has reshaped trade flows, necessitating greater collaboration between oil producers and consumers in order to sustain both conventional and unconventional oil production, maintain oil demand growth and balance oil trade between regions.
NINE WAYS OF ADAPTING
This paper presents a manifesto for oil producing companies and nations to adapt to increasing unconventional supplies. By means of studying the oil market it attempts to identify approaches that create a win-win scenario for producers of both conventional and unconventional oil. The methodology used is based on both normative analysis and value judgment to determine what producers and/or exporters of conventional oil should do in order to reform their economic policies and marketing plans in the face of a saturated and highly competitive oil market.
1. COOPERATION AND COMPETITION
Since the beginning of the twentieth century, oil demand has fostered cooperation between oil producing and consuming countries, and regional and international economic integration. However the oil industry is currently undergoing dynamic evolution. Historically there have been neither losers nor winners among exporters and importers. But redirected trade flows have changed the game and led to greater competition. In order to adapt to these changes, companies that produce conventional oil could expand their relationships by either cooperating with other oil firms and/or by forming economic partnerships with oil-consuming countries. In the oil industry, cooperation both in the upstream and downstream sectors consists of joint ventures (JVs) and strategic economic alliances. In a very competitive oil market, upstream and downstream JVs between national and international oil companies mitigate market risks and uncertainty and enable technology transfer and the sharing of know-how. Unconventional and conventional oil are complementary to each other. Cooperation between unconventional and conventional oil producers in the upstream and downstream can therefore be expected to expand in the coming years through various types of contractual arrangements.
2. WORKING GLOBALLY
By definition, two key types of companies exist in the petroleum industry, international and global. International companies merely export their goods and/or services abroad, whereas global companies not only sell their goods and/or services to numerous other countries but also invest in these countries’ markets. Global companies aim to enlarge business opportunities that increase regional and global economic integration and collaboration by sharing knowledge and fostering relationships between nations. They also aim to encourage cooperation and economic interdependence, thus alleviating potential economic challenges and geopolitical tensions.
In addition, global companies offer several benefits to the oil sector. First, they encourage international economic integration; second, they share the responsibility for ensuring that oil supply and demand are secure and sustainable; and third, they support foreign oil entities (including upstream, downstream and service companies) in working towards their common goals.
From a strategic standpoint, in a competitive business environment such as the oil market, companies can shift from an international to a global focus by increasing their investment abroad in order to gain profitable returns and income and/or to expand their market shares. Accordingly, many oil companies focus their operations abroad on either the upstream or downstream sectors of major oil-consuming countries, regardless of whether they are in declining, mature, growing or new markets.
Clearly, both the world oil industry and global economic structures have changed, requiring a new form of collaboration which strengthens multilateral and bilateral relationships among regions and countries. This in turn requires increasing collaboration between national oil companies, international oil companies and service companies.
3. CREATE A NEW AFRICAN MARKET
The world’s oil markets are continuously evolving. With the current changes in the market and the boom in unconventional oil, the oil market is now divided into four geographic segments: Europe (declining), United States (mature), Asia (growing) and Africa (new market).
A declining market exists in areas where oil demand is falling, in Europe, for example, due to the emergence of natural gas as a substitute for oil. At this juncture, oil demand is vulnerable to the price of substitutes, such as natural gas. In order for oil exporters to sustain their market shares, the responsiveness of the demand for natural gas to changes in crude oil prices should be determined by calculating the cross-price elasticity of natural gas demand.
A mature market exists in areas such as the US, where oil demand is stagnant. In addition the market is highly challenging due to the rise of domestic unconventional oil in shale formations such as Bakken, Eagle Ford and Utica. In this market, oil prices are volatile and depend on other domestic prices as opposed to imported crude prices. In order for oil exporters to sustain their market share, the price level that leads domestic consumers to give up domestic crude in favor of imported crude should be determined by calculating the price elasticity of the supply of unconventional oil.
A growing market exists in areas such as Asia, where oil demand continues to grow due to a combination of shifts in industrialization, factories and capital investment from West to East. A surplus in world oil supply and the expansion of shale oil in the US have led oil producers in the Middle East and West Africa to target the Asian market as an outlet for their crude. As a result oil prices in Asia are sensitive and respond rapidly to official selling price variations. In order to sustain or expand the market share of Middle Eastern and African exports to Asia, the price level that leads buyers to give up less lucrative crude in favor of more attractive crude should be determined by calculating the price elasticity of demand.
Due to the increase in unconventional oil production, world oil supply is expected to continue to exceed demand. There is thus an incontrovertible need to create a new market that will increase the number of customers and sustain the flow of crude oil and petroleum products. Creating these markets requires changing consumers’ behavior through capital investment. Increased capital will stimulate growth in the demand for goods and services, proving the adage that “good companies will meet needs; great companies will create markets.”
Looking to the future, the most promising area for new markets is Africa. Despite slow development and high investment risk, the African continent represents an attractive opportunity for investors because minimal capital investment is required to generate potentially high returns. New capital and technology would result in rapid economic growth and create a new market that would merit political and economic attention. With this context in mind, the Kuwait Ministry of Foreign Affairs organized an Arab/Africa Summit in November 2013 in Kuwait City to discuss economic opportunities and cooperation in Africa. This summit’s main objective was to attract foreign capital investment and to offer Africa an opportunity to sustain its economic growth, improve its standards of living and increase oil demand in the long run, as Asian countries did in the 1980s.
Establishing liaison offices in a new market such as Africa enables investors to identify business opportunities, build relationships with local companies and increase the number of customers. The office should include commercial attaches and economic advisors who gather market data and information about legal amendments and government mandates in host countries.
4. DETERMINING ELASTICITY
With world oil supply exceeding demand by 1.5mn b/d due to rising production of unconventional oil, the oil market has become a buyer’s market. In order to address the emergence of unconventional oil, producers of conventional oil should evaluate the reaction of customers and/or competitors to oil price changes by measuring oil price elasticity in various market segments. Periodic measurement of elasticity provides an equilibrium crude oil price for both consumers and producers and shows how the market responds to price changes. Oil producers can also identify how much customers are willing to pay for crude by quantifying the following four elasticity measures:
• Cross-price elasticity of demand measures the responsiveness of natural gas demand to changes in crude oil prices in declining markets such as Europe. Once oil prices top $100/B, natural gas appears to become a substitute for crude.
• Elasticity of oil supply measures the responsiveness of domestic unconventional oil supply to changes in crude oil prices in mature markets such as the US. It appears that conventional oil has less supply elasticity than unconventional oil; thus if oil prices drop below $80/B, the supply of domestic unconventional oil will decline and crude imports will increase.
• Elasticity of oil demand measures how oil demand responds to changes in the oil price in growing, competitive markets such as Asia. Current oil price data suggest that if oil prices exceed $120/B for two consecutive months, oil demand growth will decline. Conversely, if oil prices drop below $90/B, oil demand growth will increase.
• Income elasticity of oil demand measures the responsiveness of oil demand to changes in income in new markets such as Africa. The standard of living and gross domestic product are key measures of macroeconomic performance and ultimately oil demand growth.
5. MARKETING, NOT SELLING
Generally, substantial differences exist between marketing and selling. Marketing views the entire business process as consisting of a tightly integrated effort to discover, create and satisfy customer needs, whereas selling concerns itself with employing techniques to convince prospective customers to exchange their cash for a product while ignoring other aspects of the transaction.
Marketing rather than selling is therefore the necessary response to counter the emergence of unconventional oil. Countries that produce conventional oil should focus not only on production increases and product development but also on changes in the market and understanding customers’ future requirements in order to identify their changing needs and desires.
A major part of the marketing plan should be to continue the global energy dialogue with rival oil firms and energy consumers in order to emphasize that producers of conventional oil are reliable suppliers of affordable and sustainable energy. In other words, public relations and energy diplomacy should be emphasized in an effort to secure future supply and demand
The world oil industry is adopting new approaches to marketing aimed at strengthening the relationships between buyers and sellers. For instance, the stated aims of the Kuwait Petroleum Corporation (KPC) are:
• To make KPC a leading marketer of high-quality products and services to the international market;
• To become a reliable, secure, and efficient supplier that is fully responsive to global customer needs;
• To respond proactively to oil market dynamics, opportunities and challenges.
6. MARKET RESEARCH
Research provides the primary source of information used in decision-making. Producers of conventional oil need to expand the scope of their market research in order to come to terms with current challenges and opportunities in the oil market. They should participate in research and development (R&D), focus on the economics of alternative energy sources, and seek to establish research agreements with various countries, think tanks and academic institutions. Other responsibilities of R&D centers include studying the cost of producing energy from renewables and employing renewable energy domestically. The purpose of such involvement is to determine the impact of other energy sources on conventional oil in both the long and short run.
As an example, the MIT Energy Initiative was established in 2006 to help transform the global energy system to meet the needs of the future and to build a bridge to that future by improving today’s energy systems. In addition, the US State Department has signed agreements with several countries to cooperate in research in the fields of natural resource management and energy.
7. COMPARATIVE ADVANTAGE
Comparative advantage, as conceived by David Ricardo, is the concept by which the benefits of international trade are considered in terms of the opportunity-cost of producing the same commodities domestically. The theory is generally believed to favor international trade because it postulates that countries should export the goods and services they are best at producing and import goods and services in which they are less strong. According to comparative advantage theory, everyone should be better off.
Applying Ricardo’s theory to international trade between the producers of unconventional and conventional hydrocarbons involves tradeoffs between natural gas and oil. The production of unconventional hydrocarbons primarily yields natural gas, as well as high-cost crude oil. Producers of conventional oil mainly produce crude oil at a low cost. Trading oil for natural gas helps to ensure sustainable exports and imports for all the parties involved.
In this scenario, the reliance of conventional oil producers on natural gas imports to meet the growing domestic energy demands of power stations would increase crude oil and product exports to the world marketplace. Typical reasons for conventional oil producers to import natural gas are: 1) natural gas prices are relatively low in comparison with crude prices; 2) geopolitical tensions and non-fundamental factors have no impact on determining natural gas prices; 3) global natural gas production exceeds consumption; and 4) natural gas prices are decoupled from crude oil prices.
8. ECONOMIC DIVERSIFICATION
The growth of unconventional oil will likely mean shrinking market share and revenue for conventional oil exports. To overcome these challenges and protect revenue flows in the long run, countries that produce conventional oil can diversify economically in order to attract foreign direct investment (FDI). To do so, host countries must provide an appropriate legal framework, and the legislative branch should accordingly take steps to ensure sustainable economic development, political stability and an adequate rate of return on investment.
Economic diversification through the expansion of a country’s manufacturing, service and agriculture sectors will also broaden its revenue base. In order to diversify national revenue Kuwait is establishing economic programs designed to transform the nation into a financial center that is attractive for both business and FDI. This financial center is intended to strengthen the multilateral and bilateral economic and financial relationships that exist between various regions and countries and the Kuwaiti economy. Kuwait is also enhancing its economic diversification by promoting other sources of energy, such as solar, with the objective of meeting the energy needs of the present generation without compromising future generations’ ability to sustain their livelihoods.
9. IMPROVING THE SUPPLY CHAIN
In the oil industry, the supply chain consists of all of the parties involved in meeting demand and includes transportation, storage facilities, refineries, retailers and customers as well as services such as product development, marketing, operations, distribution and finance. Improving the supply chain mitigates financial risks, provides access to backstop technologies and minimizes costs.
The term ‘economies of scale’ refers to the cost advantages of expansion; in other words, the concept of “bigger is better.” In the oil sector, economies of scale apply to facilities, refineries and logistics but not to exploration and production. Economies of scope provide a competitive advantage to refineries that produce several types of products rather than just one – for example, ethanol and biofuels.
With the rise of unconventional oil and a crude oil supply surplus, the demand for and marketing of crude oil will become more complicated, with refineries and petroleum products being key elements of the oil supply chain. Economies of scale dictate that refineries with high crude oil throughput are more economical than smaller refineries. As refinery product quality shifts to meet greater demand for light, low-sulfur and environmentally friendly products, deep conversion refineries and fully integrated petrochemical complexes are the most economically sound organizational structures.
Producers of conventional oil should therefore expand their refinery throughputs and build petrochemical complexes either domestically or abroad. Internationally, the ultimate objective is to secure the market for conventional crude through mergers and acquisitions or JVs. Oil logistics (ie pipelines, tankers and railways) are another vital part of the supply chain because they secure refineries’ supplies and demand for crude oil.
The advantages of international downstream JVs are technology transfer, cost minimization and market risk mitigation. Producers of conventional oil can also export their crude to refineries abroad, locking in long-term demand for crude oil and ensuring an adequate supply of crude in the host country.
A number of countries that produce conventional oil have adopted policies which aim to secure outlets for their crude in a very competitive future oil market. For example, KPC has several downstream JVs in Europe, and plans to expand its market in Asia by participating in building grassroots refineries in China and Vietnam and potentially in other countries, such as India and Indonesia (MEES, 25 October 2013).
These nine approaches can help producers of conventional oil counter the rise of unconventional competition. Producers of both share a responsibility to ensure that both supply and demand are more secure, less price-volatile and more conducive to sustainable energy growth. Increased research collaboration would allow the world to identify reliable, sustainable and affordable energy for many decades to come, whilst investment in new markets will stimulate demand.
Finally, to counter the emergence of unconventional oil, producers of conventional oil should cooperate globally in working towards common goals. Downstream cooperation, including the expansion of the supply chain via JVs and strategic alliances, will maintain oil flows for producers of conventional and unconventional oil alike.
*Mr Alattar is head of Kuwait Petroleum Corporation’s (Western Hemisphere) Houston Office