The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
“The nature of this business is that something always happens somewhere, and in the Middle East, especially, these things happen. So, until now, this volatility was complicated by the increase of production in the United States, but it will be hard to sustain the growth ratios at the current levels of the oil prices and at the current level of volatility which has been injected by Saudis exactly for that purpose.”
– Alexander Landia
Kevin: Our guest today, a friend of yours, David, from London at this point, but actually with origins in the Georgia region of Russia – Alexander Landia. One of the things that I have always liked when you talk to Alexander is, when you are talking energy it is so political, it is amazingly political. You talk to somebody in the Middle East, they have one opinion toward it. You talk to somebody in Europe, it depends on where they stand. Or America. But really, Russia is a key area of energy production and politics, and Alexander has a unique insight on it.
David: That’s right. Politics is front and center whenever you are talking about energy, in part, because when you are looking at Europe, Russia, anywhere in the world, energy is one of those things that ends up funding politicians. In some instances, it ends up being the largest source of income for that country, so taxation is a very big issue.
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David: It was a number of years ago, Alexander, that you and I sat on a panel discussion at a conference in Las Vegas, and that brief exchange there at the end of a panel discussion led to us having dinner there in Las Vegas, a wonderful dinner, and ultimately, another opportunity for us to spend time together at the Reform Club in London, and it has been really nice getting to know you. Your perspective on energy, your perspective on oil, your perspective on the entire energy complex is unique in that, as a director of six companies related to the energy coal area, your former chairmanship with the largest coal company in Russia, being a consultant throughout that sphere, puts you in a unique position to have a set of instincts, if you will, that are unique. So, let’s start with a general frame-setting question about energy, and then rove through coal, natural gas, and oil, with a few specifics on our minds. We know that each commodity, of course, has its unique supply and demand dynamics that drive price, but is it, generally speaking, fair to say that as goes oil, so goes the rest of the energy complex?
Alexander: David, first of all, thank you so much for your kind introduction. I’m humbled and blushing (laughs) and I enjoy our relationship very much so and I look forward to seeing you in London soon. In terms of, generally speaking, as goes oil so goes the rest of the energy complex, it’s not quite like that. On one hand, all commodities, and I would say, oil, gas, coal, iron ore, and copper and other bulk commodities are influenced very much by global demand or GDP growth, and move often together when, for example, forecasts for demand in China move, and so on. But in the energy complex, different fuels have different, and their own supply and demand dynamics, indeed, and also seasonal patterns depending on the type of their usage. Oil is mostly used in motoring, gas and coal in power generation, or heating, or air conditioning. And so, there are very different patterns, and they can diverge very substantially.
A good example for that would be oil and gas because if you would take the diesel prices versus gas prices which could be substituting each other in motoring, especially in the U.S., we see that trend, then you would have massive differences in terms of movements in those prices. So, if we take September 2012, and convert the diesel price and gas price into a price per barrel of oil equivalent, then the difference between gas and diesel at that time would have been $122, or something like that, and today that difference is around $50, simply because the oil price dropped dramatically, and the gas prices didn’t move much. So therefore, there is a certain general alignment, but very different patterns for supply demand.
David: Alexander, that’s interesting. Yes, a difference in the way each of the bulk commodities behaves, but most of them moving in lockstep, not because of oil, but because of global demand and GDP growth, either expectations, or actual delivery of an increase in GDP growth. Does that come as a surprise to you, with the narrative, certainly here in the United States, being that recovery is nigh? Certainly that is hoped for in Europe and around the world, and yet, the commodities seem to be telling a very different story, if you were to say that Dr. Copper, or any of the other bulk commodities you listed are letting you know what is actually happening in the world economy.
Alexander: Well, these are very much cyclical industries with very long cycles, which means that when the prices are up everybody is happy and investing into the production capacity, and then there is an oversupply and the prices go down. And because of the nature of the long lead times in all bulk commodity industries, that is the nature of the business. You need probably two to three years to develop a coal mine, you need probably four to five years to develop a substantial oil deposit. Now, that picture has changed a bit with the shale oil and shale gas technology in the United States where the lead times are much shorter and your CAPEX is almost your OPEX, but in general, the cyclicality is simply in the nature of those industries and that is driven, on one hand by demand, but also on the other hand on the supply for the particular commodity.
David: So supply is clear a driver, with a glut now creating the down cycle. Do you think it takes 12, 24, 36 months? What would you suggest in terms of that long cyclicality for the over-supply issue to be addressed?
Alexander: It really depends on the structure of the industry. In the coal market what we have seen was that last year, sometime probably in the spring, Glencoal was saying that probably 20% of the coal traded on international markets was sold at a price which was lower than the cash cost to produce it, and the reason for that was a specific situation in Australia where there were ship-or-pay contracts with the railways and the companies would take a loss, or a smaller loss, rather than not producing and paying the ship-or-pay tariff to the railway operators. Therefore, that is very specific to each industry.
If you are referring to the oil market and oil prices, then that is quite a unique situation, because the over-supply, or over-capacity, is very small, in fact. Often, people compare the current situation with the 1985-1986 situation in the oil market, and this comparison is not correct because in 1986 there was substantial spare capacity and Saudi Arabia, alone, accounted for more than 10% of global spare capacity, and global spare capacity was more than 10% of the global demand. And today, it is 2½% probably, the spare capacity compared to the global demand. And therefore the situation is quite unique, that we have now in the oil market.
If we go back to the coal markets, what I was trying to say is that this statement of Glencoal was made in spring last year. The market didn’t clear until now. The coal is pretty cheap and is staying low on international markets. How long will it take to clear for oil? A very interesting question. What we have is very high volatility of oil price. I think there are two factors. One, I think the market got used to a very stable and high oil price during the last four years, which is very unusual for this commodity. And now we have wild swings. If you take this year only, the oil price during the first two weeks in January went down something like 17-18%, then went up more than 25% until now. And that is 1½ months into the year. So, it is very high volatility which we have, and it is very hard to predict when the market will settle.
I think the fact of the matter is, the quicker the recovery to high oil prices, the higher the volatility will remain, and if we would have a period of time of oil prices around $60 per barrel, I think that the chance of a more gradual recovery of the oil price to a sustainable level would be more probable. The wild swings, when the oil price goes much beyond $100 per barrel, or drops down to $45, as we have seen, are damaging the market. If the oil price is so high, as it was, then it is simply too large a portion of the global GDP. At $120 per barrel it is around 5% of global GDP which is being spent on oil. And if you have the current oil price, then it is probably 2% of global GDP, so that is a 3% stimulus which is repeatedly injected into the system. On the other hand, if the oil prices stay low, then the supply destruction will be probably hard to reverse. We have to remember that every year we are losing probably around 5 million barrels per day of production capacity simply from natural depletion. And this capacity needs to be created. And for that, the investment is needed, and the high volatility and low oil prices do not stimulate it.
David: Is there enough supply that could return to the market from the Iranian fields, from Iraq, from Libya, in terms of production that has been lost, given geopolitical constraints and concerns in the region? If there was a stabilization in the region politically, would that contribution be enough to change that 5 million barrels per day that you describe as natural depletion?
Alexander: Well, what we have seen during the last four years, that was an amazing situation, where we had very high volatility in the Middle East, and in my view the Middle East is the region with the highest influence on the oil prices short term. Then we had a situation where we had problems with Libya, with Iran, Syria, Sudan, and all those supply disruptions were compensated by growth in the U.S. production. Now, from where we are now, to go forward, indeed, while Libya is probably the most volatile producer of oil, and while one could say that the current spike in oil prices, at today’s levels, is probably quite much driven by concerns about the production in Libya and in Iraq, so Libya and Iraq are probably the largest downside potential disruptions of supply, and Iran is an upside, from that point of view, probably more than a recovery of Libya or increase of production in Iraq.
In Iran, if the nuclear talks produce a grand bargain this year with sanctions ending, then of course there will be quite a boost in the production, but the outcome is uncertain, and therefore that is the volatility which we have and the nature of this business is that something always happens somewhere and in the Middle East, especially during the last years, these things happen. So, until now, this volatility, as I said, was compensated by the increase of production in the United States, but it will be hard to sustain the growth ratios as they were in the United States at the current levels of the oil prices and at the current level of volatility which has been injected by Saudis exactly for that purpose.
David: I recall being advised in the Junior Commons at Oxford, and again at the pub, to avoid discussing philosophy, religion, and politics, and of course I had a hard time heeding the advice, and still probably do. But while we are talking about the Middle East – Iran, Iraq, Libya – what, in your opinion, are the politics involved in today’s oil market? You have regional issues, Iran and Saudi Arabia. Beyond just regional issues, Russia and Saudi Arabia, the U.S. and Russia, Russian and Syrian relations – all of these things sort of circling around political issues which may have an impact on the oil markets.
Alexander: I think that the oil market is always subject to substantial political influence, indeed, and I would say there are probably two areas of influence. One is the influence on mostly supply, and somehow on demand, as well, through political events, and for that, I think the most relevant, short-term, is the Middle East, as I said. The situation with Russia, sanctions and cooling down of relations with the West, do not have the immediate impact on the production. Russia had another record year in 2014, but definitely will have an impact on production mid-term, simply because Russia needs to replace the existing Western Siberian production, and for that, technology is needed, and that is under sanctions, so mid-term, until 2020, definitely there will be an impact, but not in very short term.
Also, Russian-Saudi, U.S.-Russian relations obviously are quite strained, but that is, in my view, less relevant for the oil price dynamics right now, except for mid-term impact for sanctions on Russia. That is one aspect which is of the political influence on the supply and demand dynamics, but we should also remember that there is taxation, which is also a very political issue, which is probably one of the highest costs for the industry. The United States is one of the most benevolent taxation regimes, especially with ownership issues and taxation issues combined. In the U.K. you have taxation between 60-80% on profits of oil production, Norway is 78%, and then there are additional charges at the pump, so if you go to a petrol station in Germany, probably 85% of what you pay goes to some government. And therefore, this is also another very substantial political influence which is taxation. However, I would like to say very firmly that, in fact, the current price movements were very much orchestrated by Saudi Arabia, and one should simply take that as a fact of life, and I would say, all other political influences are secondary to the influence which Saudi Arabia took on the market through a change of their policy.
David: If you were to speculate on the Saudis’ policy, is it more directed at U.S. production, or is it with some concern about nuclear development in Iran and the desire to pull the carpet out from underneath the Iranians, so to say?
Alexander: I think I would say, all of that, because, first of all, the Saudis do not want to lose the market share and do not want to lose the global demand growth to other producers, be it North American unconventionals, Russia, Iran, and so on. So, what they did addresses all of those issues because North American unconventionals, a big part of which was driven through leverage, instilling permanent instability into the U.S. shale investment, discourages investment, and therefore that ticks that box. If you look at the investment needs in Russia, in Iran, of course a low oil price discourages that investment, so that box is ticked, as well.
Then, if you look at the market share, which is very much in the focus of the Saudis, they are, in my view, concerned about the market share in the United States and also in China, especially, because these are our largest growing markets, and one could say that whenever the deliveries from Saudi Arabia to the United States fall below 1 million barrels per day then they act. They acted in the ’90s, mostly targeting Venezuelan production. They are acting now. So, it is also very much focused on their market share, in specific, quality, large and growing markets. So, there is an array of multiple issues which they are trying to resolve and they are putting a very concerted effort, coordinated with their JCC partners, especially Kuwait and United Arab Emirates, to orchestrate this decline and keep that low.
David: It is almost impossible, when you are talking about energy, it seems, to ignore the politics involved. What is your opinion of the European/Russian energy relationship, but present and future?
Alexander: I think we are now at a kind of crossroads. Russia has been very a reliable supplier throughout the Cold War to Europe, both for oil and gas. Now, of course, their relations are quite strained, and there is a conflict with Ukraine and in Ukraine, but one has to remember that the problems with gas, especially in Ukraine, are quite old. The disruptions, or potential disruptions, for Russian supplies to Europe started in 1995, when the legal off-takes of Russian gas were registered in Ukraine in quite big amounts and in fact, the Russians had to fill up the gas which [unclear] then refused to deliver to Ukraine because of that. So the issues are not new in some way in respect to gas. Of course, the level of the conflict and the nature of the conflict is very new, but the issues were there.
Where we are now in that regard, especially in gas, I think there is a certain decision point where both Gazprom and European off-takers need to make up their minds where they want to go. There was a kind of negative spiral going on between Gazprom and European off-takers, and especially with the European Union in regard to conflicts about regulation, talks about creation of a single European purchaser for gas from Russia, then Gazprom deciding end of last year that they would not build South Stream anymore but would deliver gas to Turkey through Turkish Stream, and demand that the European off-takers take the gas from there, themselves. There is a lot of hot talk, but how both of those initiatives comply with existing contracts, I don’t know, and how this will be resolved is, I think, yet unclear.
The fact of the matter is that, especially, Gazprom has been an extremely reliable supplier to Europe for decades, but now it seems that there is a big question mark for the future, and what will be the resolution? I think it will depend on the situation in Ukraine, but also on the overall level of partnership and relationship, Gazprom saying if Europeans don’t want our gas we will try to ship that to China. Well, that doesn’t really work that way. And again, there are existing contracts, and so on. So, it is a very complex picture which I think is still evolving. It is a bit early to see where it is going to go.
David: I know you are familiar with coal, still a vital energy source globally. It suffers from a bad image in the United States, but in spite of drawbacks with cleanliness, long-term environmental impacts, including atmospheric issues, and what not, can you imagine a world with radically reduced coal usage? How and when would that be?
Alexander: You have this energy trilemma for any source of energy, so on one hand, you are concerned about the availability and security of the supply which coal has because coal is usually where the markets are. They you have the question of the environmental impact, and coal is, of course, the worst fuel in the world. And then you have the question of price. So, if you walk around these cornerstones of the energy trilemma, then coal, of course, undoubtedly wins in terms of accessibility and availability, and in terms of cost, but loses on environment. And that is a compromise. There is no clean cut solution. If you would look at the IEA’s forecast for 2040, then coal still provides probably something like one-quarter of the energy demand, down from around 30% last year. So, coal will play the role, in my view, but we will need technology development so that the impact on environment is reduced, and CCS, carbon capture and storage, may help, but it is still too immature.
David: On to another energy source which has a PR problem – nuclear energy. We have uranium prices that continue to indicate pressure in that market. Perhaps that is a supply and demand-related thing, perhaps PR-related following Fukushima and the decommissioning of a number of European plants. There was a timeframe where the fissile material from nuclear weapons was being repurposed for energy usage and we have kind of worked through the vast majority of the stocks of warheads today – that has diminished – which kind of puts us to mine supply and annual production of uranium being more critical looking forward. It still seems that if energy costs are not a concern, nuclear power suffers, but again, if energy costs re-emerge, and we see an increase across the whole complex, particularly with coal and gas, then all of a sudden, nuclear benefits and it may be back in the picture, and there are a number of plants that are being built as we speak in South Carolina, and as you look around the world, the prospects are for almost 400 new plants to be built. So, perhaps you could address nuclear energy.
Alexander: Nuclear energy is also an important source, definitely, of energy, but I think the problem with the nuclear energy is not the ongoing cost of uranium, but really, what it is going to cost to decommission and retire the plants, and what to do with the fuels. There is a huge debate in Germany about that, and that is not resolved. Of course, Germany is exiting nuclear energy, in general, and unconditionally. But also in other countries I think it is very hard to calculate the full cost for the cycle for nuclear. And that’s a problem. And then you have a situation where if you are focused on cost, indeed, coal and gas win. If you are focused on environment, then probably, the time is coming where wind and solar could win, especially, for example, if you take Texas where you have abundant sunshine and wind, then definitely, wind and solar would win against nuclear.
So, that is the background for that, and therefore, the point is that in the developed countries, including the United States, it will be less development. In the United States, IEA forecasts a certain increase in the installed capacity until 2040, but you would have absolute decrease of capacity in the European Union and in Japan. Most of the increase which you are referring to, almost all of that comes from China, in fact, and China plans to build something like 130 gigawatts of installed capacity until 2040, net addition, followed by India, so around 30 gigawatts of installed capacity. Russia and the United States will add some, but not as much as the others. So, it’s mostly energy-hungry China and India who are driving that.
David: There is the idea that speculators are driving the price of oil, and you see this commentary come out quite a bit when you get to the extremes in price, when we got to $147 a barrel a number of years ago, everyone was angry that the speculators were driving the price higher. And you see a similar commentary when prices get very low that speculators are driving the price lower. Now, in fact, there are futures and derivatives transactions which dwarf the physical market. Would you care to weigh in? Do you have any thoughts on the paper markets versus the physical commodity markets?
Alexander: In my view, the paper markets are important to provide hedging, to provide ability for the producers, if they need to have certainty about the price of their production for a coming period of time, and therefore that’s a very important function. The speculators were there also during about four years where oil price was very stable at a high level. And there were not many complaints about them, although they were very active. And a large part of production from U.S. shale was hedged, meaning that there were some speculators taking positions on this production. So therefore, I think that the blame for speculation is a bit exaggerated.
Of course speculation has a role to play and if certain short or long positions are being resolved, that can move the prices quite dramatically, as we have seen probably in the beginning of February, but that is a very short-term volatility. It doesn’t have, in my view, the long-term impact on the market. I think, among others, Saudi Arabia also complained about speculators, but frankly, the influence of Saudi Arabia, who basically is setting the price of oil in today’s world, cannot be compared to the influence and power of speculators.
David: They make speculators seem like dwarfs by comparison, I think you would conclude. Now, it’s interesting, as we wrap up, there are about 1,000 things that you could throw into the air and try to juggle as you’re making heads and tails of the energy markets. As an investor, as a director on a number of boards, as a participant, as a shareholder, where do you see the greatest risks in the energy complex, still, and where do you see the greatest opportunities?
Alexander: I think that the greatest risk remains, if we are looking at the oil market, in the political unpredictability, especially in the Middle East. Short-term, I think that is because the spare capacity is so thin, if there is a further disruption of demand, then the oil price could hike to $100 and beyond very quickly. And that, again, sends the global economy into recession and that is not healthy. And therefore, I think that the volatility of the oil price is a major risk which we will have, and that will be fueled short-term through the political volatility in the Middle East, most of that, in my view. But also, longer-term, we need to find an answer how to replace the 5 million barrels per day production which we will lose every year. The current volatile climate doesn’t support that, and if we go five years from now to 2020 and we need 25 million barrels per day of replaced production that is 2½ times Saudi Arabia.
So where does it come from? And therefore, I think the challenge is for the industry to find the right balance to invest the monies needed to be invested in the industry and that is the biggest challenge. On the other hand, there are opportunities in the market, and they are, I think, opportunities to increase efficiency. The oil industry has been quite complacent in many cases because $100-plus price per barrel covers lots of inefficiencies in the system. And if you have a situation where in many mature provinces you have probably up times of 60%, meaning that the production is only going for 60% of time of the year, or 50% of time of the year, then of course that is an inefficiency which needs to be squeezed out. And if you have a lower oil price you have to do these things.
Therefore I think that there is a chance for the industry to re-invent themselves, to increase their efficiency. There will be [unclear] opportunities, there are [unclear] opportunities, plenty, in the market, and they are very interesting and attractive. And also there are opportunities to do profitable investment. Well, interestingly, Statoil recently made an investment decision, FID, final investment decision, to develop a major oilfield in Norway, Johan Sverdrup. This field is going to produce, in ten years’ time, more oil than the U.K., so that’s a giant development, and that is in accordance with the publicly available information. That field seems to be profitable at around $45 per barrel prices, giving more than 20% internal rate of return. So, therefore, there are very good opportunities, also, to develop the assets. They need to be developed, but one has to focus on those and to dream about those assets will need $100 plus dollars price in order to be developed.
David: So many of the future tense opportunities may be when we are in a different environment with oil between $60 and $100 to inspire higher internal rates of return, and perhaps go back to deep sea projects, arctic projects, things that are far more costly, but still prove to have a decent amount of reserves to replace that 5 million per year in lost production.
Alexander: Indeed. I believe that oil prices, sometime, will revert to above $80 per barrel. I don’t know when. That’s a billion dollar question.
David: Of course. And if you can tell me when, there will be a billion dollars. (laughs)
David: A billion dollar question has a billion dollar reward, if you can answer it. Well, thank you, Alexander, for joining us and discussing some Mid East dynamics, some dynamics between Saudi Arabia and Russia, OPEC internal dynamics, and their priorities of market share and some of the risks and rewards in the energy sector. We have been able to distill what is a career of experience. I did have a question for you. Mathematics – this was your original field of study. How did you transition from being a mathematician to being so deeply involved in the energy space?
Alexander: Oh, thank you. Well, I was a scientist, and science is a wonderful field where you contemplate, and have extremely high gratification in terms of intellectual effort and intellectual gratification, but that is quite a lonely field. So, I simply liked interacting with people, and businesses involve people, especially energy businesses.
David: Business is about people, that is very true. I look forward to seeing you next time we are in London. I wish you well, and thank you for joining us again.
Alexander: Thank you very much.