Oil Geopolitics: the Shale Saga and Shifting Sands (Part 1/4)

TL;DR

  • Exploring oil geopolitics is a useful approach to understanding how the world works for two reasons.
  • First, observing the energy flows within a complex system provides a first principles based perspective of that system.
  • Second, getting a grasp on oil politics prompts one to read up on and synthesize ancillary topics such as history, financial markets, and game theory.
  • Politics is about keeping, increasing, or demonstrating power.
  • It’s important to first understand where oil is produced and consumed before further exploring geopolitical dimensions.
  • US security imperatives in the oil-producing Middle East was largely shaped by its oil import reliance from the 1970s through to the late 2000s.
  • But the US recently reclaimed its spot as the world’s biggest oil producer thanks to new extraction techniques (the Shale Revolution).
  • Just a few years ago, the US became a net exporter of energy.
  • This extends the range of possibilities for the role that US wants to play in oil producing regions.
  • Whatever move the US makes, it’ll have momentous second and third order effects on the world. 

 


Why oil geopolitics?

I don’t think oil geopolitics comes as a topic many would be naturally interested in. 

There’s two primary reasons why this topic has captured a disproportionate amount of my attention in recent months.

First, observing at any complex system through the lens of energy flows provides a first principles based perspective of that system. After all, energy is one the universal fundamentals (along with mass, time, and information). This can be applied to a chemical reactions at a molecular level, biological organisms at a multicellular level, to entire countries at a macro level.

“To talk about energy and the economy is a tautology: every economic activity is fundamentally nothing but a conversion of one kind of energy to another, and monies are just a convenient (and often rather unrepresentative) proxy for valuing the energy flows.” – Energy and Civilization, Vaclav Smil

There’s even a compelling case that most of humanity’s economic gains throughout history was really just the ability to harness more energy: from plows, to mills, to fossil fuels, etc. Since a bulk of our energy demand continues to be met by oil, it makes sense to take a closer look at it.

Source 

Second, exploring the components and constraints of oil geopolitics is an effective means of understanding how the world works. Energy security is paramount to nation states, and oil is at the heart of this global competition for natural resources and influence. So trying to wrap your head around oil geopolitics forces one to also read up on ancillary topics to merely grasp what’s going on. From political development history, economics, game theory, financial markets – the list never ends. It necessitates transdisciplinarity. And to make matters even more difficult, even if you know understand each component really well, you still need to synthesize everything into a coherent manner as geopolitical dynamics is a complex system. There’s emergent behaviour and second-order effects – that is, understanding the parts doesn’t mean you understand the whole. In short, oil geopolitics acts like a map that guides one to look in places one would never have even considered before.

While this series will attempt to provide a tour on some of the most critical components of the oil geopolitics puzzle, it’s also intended to demonstrate just how complex things can get.

 


Contents

Part 1 (this post)

1. Fundamentals: source, sink, and route of oil.
2. US and the Shale Revolution: US production history; net exporter status; withdrawal from Middle East.

Part 2 

3. Messy mosaic of the Middle East: complicated relations; an over-simplified history of last 600 years; lessons from history.

Part 3 (coming soon)

4. Saudi-Iran conflict: ideological divide; oil production and sanctions; proxy wars.

Part 4 (coming soon)

5. China and Belt and Road: big appetite; Belt and Road; Petrodollar and Petroyuan
6. More oil geopolitics
: other key players (inc. Russia, Turkey); non-state actors; other ancillary factors (inc. natural gas, environmental sustainability).

 


1. The fundamentals

1.1. Politics, game theory, and a complex systems lens

There are 3 motives for political action: keep power, increase power, or demonstrate power.

“Whatever the ultimate aims of international politics, power is always the immediate aim. Statesmen and peoples may ultimately seek freedom, security, prosperity… But whenever they strive to realize their goal by means of international politics, they do so by striving for power.” – Hans Morgenthau.

While power is often linked to economic might, it’s also entangled with other, sometimes conflicting, objectives. Political and religious ideology for instance.

Power is also relative. So on a global level, it is to a large extent a zero-sum game.

Since every zero sum game contains non-zero sum sub-games and vice versa, game theory provides a useful framework for analyzing shifts in power. Who are the key players? What’s in their best interest? Who are the biggest winners and losers for a given structural change?

Also, what kind of relationships do they have with each other? How has this changed over time? Complex systems thinking emphasizes paying more attention to relationships between components just as much as, or even more than, the components themselves.

All of the above higher level considerations are useful to keep in mind when looking at smaller level, individual pieces of the puzzle.

 

1.2. Source to sink

From first principles, the ‘geo’ part in oil geopolitics essentially comes down to 3 things.

(i) Source. Some countries have oil, some countries don’t.

(ii) Sink. Some countries need to import lots of oil, and some countries are self-sufficient.

(iii) Route. Some countries have control over key shipping routes, and the rest are at the mercy of others.

Okay, maybe 4 things if we add the time dimension as the above factors will inevitably change. New discoveries are made. New extraction techniques are perfected (more on the US shale boom later). And non-oil factors such as revolutions, economic crises, wars, and soon-enough environmental factors feed into the perpetual tug-of-war where countries gain and lose relative power.

The following subsections are a tad dry but it’s important to get a grasp on the key sources and sinks, and the order of magnitudes.

 

1.3. Crude

A refresher:

  • Crude oil is the naturally-occurring black liquid that’s drilled out of the ground.
  • It’s shipped around in this unprocessed form (why oil spills are black) before being refined into other types of oil such as the transparent petroleum we’re familiar with.
  • Main reasons for its popularity relative to other energy sources: cheap, easy to use, store, transport, and reliable performance.
  • Also has military importance: powers vehicles, ships and planes 
  • Standard unit is barrels (~160L).
  • Not all crude is the same. Densities vary. But most crude types would be about 135kg/barrel.
Source

 

1.4. Production

The source.

  • Common unit is barrels per day (bpd).
Based on this
  • US is global #1 with 15m bpd.
  • Saudi Arabia and Russia in definitive top 3 with ~12m bpd.
  • Global production is ~90b bpd.
  • Here’s a dynamic view.

To get a more meaningful grasp on oil flows, however, we need to look at net production. That is, production minus consumption, i.e. estimated net exports (assuming all excess production is exported rather than stored).

Here are the same top 15 gross producers as above with its corresponding net exports.

Based on this and this

And here are the top net exporters. This chart is a more meaningful visualization of the ‘source’ than just gross production.

Based on this and this

 

1.5. Reserves

The source of the source. Production is a flow, reserve is a stock.

Oil reserve: amount of crude oil confirmed by geophysical studies in a country’s territory that can technically be recovered at a feasible cost. 

3 factors make this a dynamic variable:
– equipment/technology availability (which changes over time)
– feasible production cost (depends on spot market price) 
– new deposits that could be discovered (depends on exploration investment and just luck)

Am I the only one that thought oil reserves referred to the amount of oil held by the nation’s storage facilities, in case of a war etc? Gold reserve is the amount of gold held by a central bank – not the amount of yet-to-be-mined gold underground… Source.

 

1.6. Consumption

The sink.

Based on this

Nothing too surprising here. Big countries consume more. And as expected, gross oil consumption and GDP (in purchasing power parity terms) correlate.

Based on this and this (World Bank 2019)

Roughly speaking, $1 trillion annual GDP demands about a million barrels per day.

But just as we distinguished gross and net production, it’s more meaningful to look at net consumption i.e. net imports.

Based on this (World Bank 2019 table), this, and this

 

1.7. Value chain

When it comes to the ‘route’, it’s helpful to look at the value chain. Simplified version is:

  • Production: Exploration, extraction, pay tax to producing country
  • Wholesale: Ship it, refine it. It only $1 to ship a barrel to anywhere in the world. So proximity to oil sources is not a substantial geopolitical factor. While the distance of the shipping route is negligible, the security of the shipping route, however, is significant. More on this later.
  • Retail cost: Distribute it, pay tax to consumption country. An often neglected fact is that the oil importing Western countries actually make more money from oil taxes than OPEC. In 2014, taxes in G7 countries accounted for about 47% of the price of a litre of oil, compared to 39% going to producers (47/39 average ratio). 60/30 for UK, 52/34 for Germany, 15/61 for US.

Note: Western governments actually make more money from oil than the oil producers.

 

1.8. Production unit economics

Varies materially.

Production cost (2019): about $10 a barrel in Middle East, and about $20 elsewhere.

As of 2019. Source: Visual Capitalist

Important to know as cheap producers have volume play and price war levers available.

Regarding consumption economics, we won’t get into it as it’s a more domestic matter but more on this here.

 

1.9. Oil markets, futures contracts, and the COVID-19 oil crash

As with most commodities, oil is traded via financial instruments called derivatives. Futures contracts are type of financial derivative used to buy and sell oil. For example, if you own a manufacturing operation and need to top up your oil in 6 months from now, rather than buying it now and dealing with storage, you buy a piece of paper that guarantees your oil delivery for a set price at a set date. If you’re holding a piece of paper that says, “we will deliver this much oil to you on this date,” and you don’t have any storage you need to go as far as paying someone to take this paper off your hands.

US-based West Texas Instruments (WTI) and UK-based Brent crude are the most commonly traded oil futures, and hence, the standard benchmarks to indicate global crude oil prices. 

Remember headlines in April 2020 about negative oil prices? Most articles illustrated the contango situation (when future price is higher than spot price) with catchy charts like this:

Source

But as with many aggregate representations on rapidly moving prices, it’s not factually incorrect, but it’s misleading.

If we look at the intra-day one, we can see that prices were only negative for a few hours as futures contracts neared the expiry date. 

Source

Additionally, it was just the WTI futures contract that was negative. Brent crude (shown in blue below) did not dip below zero over the same time period.

Source

 


2. The US and the Shale Revolution

2.1. US crude production history

The US was actually the biggest oil producer since the 1860s through to the mid 1970s.

Then the Soviet Union became the top producer in the 1980s, before being overtaken by Saudi Arabia in 1990s and 2000s.

But the US reclaimed the #1 spot in 2015.

Source

So what happened around 2010?

The glorious Shale Revolution.

 

2.2. The Shale Revolution

Conventional extraction techniques typically drill vertically and pump black gold from a reservoir pool. 

Shale oil, in contrast, is trapped between shale rock formations, making it more difficult and expensive to extract.

Source

Hydraulic fracturing i.e. fracking, is an ‘unconventional’ extraction technique where shale is drilled through horizontally, before forcing chemically treated water into the rock to release oil.

2 minute explainer video:

Another way of looking at it:

Source

While this technique has been around since the 1940s, improvements made it commercially viable only a decade ago. This is what enabled the Shale Revolution.

Indeed, shale oil has higher production costs. At ~$25 a barrel, it’s almost triple Saudi’s.

2019. Source

So yes, most shale operations need crude prices to be around $40 a barrel to stay profitable.

Source

However, this break-even price continues to trend down.

Source

Additionally, shale oil operations are more responsive than conventional ones. It goes online really quickly and offline really quickly.

This means that US Shale can effectively act as a soft floor for global oil prices, as opposed to supply-side price determined by OPEC and the likes of Russia.

 

2.3. Net energy exporter

While the US is still a net importer of crude…

Source

… in September 2019, it became a net exporter when also considering refined oil products (such as petroleum, diesel, jet fuel etc). 

Source

Add in natural gas, and the US’s net exporter status becomes more thoroughly pronounced. All thanks to fracking.

Source

Consequently, the US has been importing less from OPEC, while keeping non-OPEC imports constant (although giving Canada a bigger share of wallet within non-OPEC imports). 

Source

Here’s another chart showing changing sources of US crude imports since 2000. Notice how much smaller the ‘blobs’ from Africa and Middle East get over time. From 2005 to 2015, Canada went from ~15% of US oil imports to ~45%.

Source
 
 

2.4. Withdrawal from Middle East

Almost 200k troops were in Afghanistan and Iraq by the late 2000s. By 2011, most in Iraq withdraw.

Source

And a couple years later, in Afghanistan too.

Source

Unsurprisingly, US troop withdrawal from the Middle East coincides with the timing of the Shale boom. This is reflective of the drastically shifted energy security imperatives in the region.

Now there’s only about 70k US troops in all of Middle East. And with Trump’s contractionist stance on foreign policy, this figure is likely to decline even further. 

We shouldn’t overplay this withdrawal though. Middle Eastern oil is still important to the US as the US needs to maintain its control to flows to other countries such as Japan.

Regardless, the US’s new net exporter status extends the range of possibilities for the role that US wants to play in oil producing regions. And whatever moves the US makes, it’ll have momentous second and third order effects on security and markets. When the giant sneezes, the world shakes.

Next, we explore the oil geopolitics of the Middle East, and the new global challenger to US dominance: China.


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Oil Geopolitics: the Shale Saga and Shifting Sands (Part 2/4)

An old meme from a time when I had an overly simplistic view of oil geopolitics…