The following interview with Trevor Houser [1] was carried out via Skype, February 13, 2014 by Patrick Renz and Frauke Heidemann. The main focus of the interview was on the economic effects from the U.S. shale boom, China’s shale development and Iranian exports after sanctions. All footnotes are remarks by Patrick Renz and Frauke Heidemann, aimed at giving some additional background knowledge and especially giving the links to the cited documents so that the reader can follow up on these issues easily.
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. Economic Effects of U.S. Shale Boom and Outlook
In your recent book “Fueling Up: The Economic Implications of America’s Oil and Gas Boom” [2] you argue that the shale gas and tight oil boom might not have such a large impact long-term and that parts of the manufacturing sector are mainly profiting from it right now. In how far does this change the comparative advantage of the U.S. manufacturing sector as opposed to the Chinese manufacturing sector?
The surge in the shale gas and tight oil production in the U.S. is having an important effect on the economy in the short term. Those effects can be summarized by lowering energy prices, increasing investments in oil and gas production and pipelines as well as in the manufacturing capacity required to feed that investment such as the production of steel pipes or compressors. Our estimate is that this is adding 20 to 30 basis points to annual economic growth, 0.2% to 0.3% increase in the rate of growth, which is very helpful at a point where the U.S. economy is still struggling to reemerge after the recession. Long-term the impacts will be more modest, because as the economy returns to its pre-recession levels of employment, the investment in oil and gas comes at the expense of investments in other sectors. Most of that investment is going to come at the expense of the manufacturing sector. Traditionally when countries have a natural resource boom they see their manufacturing competitiveness suffer. This is referred to in the academic literature as the “Dutch disease” or the “resource curse” [3] and you saw it in the Netherlands in the 60s. There are also a number of contemporary examples as well such as Canada, Australia and Brazil, [4] which over the past decade saw a dramatic growth of their natural resource trade surplus. For Australia that was iron ore and coal, for Canada it was crude oil and for Brazil it was iron ore and crude oil. This resource boom pushed up the value of their currencies and made their manufacturing sectors less competitive leading to a decline in their manufacturing trade balance commensurate with the increase in their natural resource trade surplus.
There are a number of reasons to think that the U.S. might be different. First, the size of our resource boom relative to the U.S. economy as a whole is much smaller. Australia, Canada and Brazil have massive resource sectors as part of their countries’ economies. Even if the U.S. becomes the largest oil producer in the world, which could very well happen some time over the next decade, oil production will still be a relatively small share of the U.S. economy compared to Saudi Arabia, Russia or other large producer states. There is also a disconnect right now between domestic energy prices in the U.S. and domestic energy prices in a number of our peer economies such as China and Japan. The price of natural gas in the U.S. for industrial consumers is half of what it currently is in China and Europe and a third of what it is in Japan. [5] The question therefore is to what extent will cheap energy offset the traditional impact of a more expansive exchange rate on the competitiveness of U.S. manufacturing. Additionally, it depends on what part of the U.S. manufacturing sector you are in. Very energy intensive parts of like chemicals production and fertilizer production are today seeing considerable improvements in their international competitiveness: a reduction in their overall costs of 10%, 15% or 20%. [6] You can see that in the profit margin of U.S. chemical companies today. However, it turns out that the share of U.S. manufacturing that is really energy intensive is pretty small. The majority of U.S. manufacturing employment is in the production of goods where energy is about 1% to 2% of their total costs. Therefore, even if you gave that energy away for free, it is not going to significantly impact the positions of Boeing, General Motors or the numerous U.S. technology companies. It does not really change their costs.
If you think about comparative advantage of the U.S. vs. China, then we are certainly becoming more competitive in energy intensive manufacturing just at the time that China is trying to get rid off its energy intensive manufacturing. There is a number of policy initiatives in China aimed at slowing the growth in energy intensive manufacturing and aimed at economic rebalancing. [7] If there were any change in relative competitiveness, I would expect it to be there. This is not about a relocation of factories but about where the growth in production occurs. More of that growth in production capacity is occurring in the U.S. and less in China. However, for the manufacturing sector overall, I think that the U.S. manufacturing trade deficit could actually increase not decrease going forward. That is what we were seeing over the past few months. The overall U.S. trade balance has dropped considerably but the manufacturing trade deficit has actually gotten worse [8] and that is what economic theory suggests would occur.
In China experts expect the U.S. to be exporting oil and LNG at some point and discuss if buying from the U.S. would help lower the price. We know that crude exports are banned but if the U.S. would start exporting crude as well as LNG, do you believe this could affect the respective prices China has to pay?
It is mostly about total availability on the market and that does not have to happen just through the export channel, it can also happen through less imports. Less U.S. imports free up more gas and oil for the global market. We have to consider that prior to the shale gas boom the U.S. has been projected to become one of the largest LNG importers of the world. The U.S. has not exported a single drop of LNG yet. The first terminal will not come online until 2015, but just the withdrawal of the U.S. from the import market has had a considerable impact on LNG prices and the prospects of LNG exports are increasing the negotiating leverage of all consumers. Just because there is a new country entering the market, more contestability on the supply side means more leverage on the demand side.
The same is true for oil. China does not actually have to buy a single barrel of oil from the U.S. to benefit from a change in the U.S. oil trade balance. The U.S. has added 3 million barrels per day (bpd) of production over the past five years. This is more than ¾ of the total growth of oil supply over the time. If we hadn’t had those 3 million barrels a day of additional output, global prices would have been considerably higher including for China. [9] The question that the U.S. is now facing regarding the U.S. crude oil export ban is whether the export ban does reduce the total rate of supply growth of the market. That is what China should be looking at more than whether they will have the ability to buy U.S. crude oil directly. The most important consideration is whether the crude oil ban will slow the rate of production growth in the U.S. in a way that increases global oil prices.
In San Francisco we talked to technical experts that were more critical of a long-term shale gas and tight oil development. They especially see tight oil as a rather short-term phenomenon in the U.S. due to the high depletion rate and argued that the U.S. will go back to importing oil some time in the medium term future. How do you assess that?
We don’t know. It really is too early to tell. When the EIA each year is revising the U.S. oil production forecast by almost 2 million bpd – everybody who claims to have a crystal ball as to what the future of the U.S. oil production will look like is lying to himself. It is going to depend on a couple of thing such as the rate of learning and production – because we do know that the decline rates are relatively steep and so you have to get more productive in your drilling activity. You have to learn and you have to reduce drilling costs. It will depend on the ability to access other liquids in shale plays outside the Bakken like the Monterey shale, which is comparably sized to the Bakken but it happens to be under Los Angeles, a harder place to drill for oil than North Dakota. Most importantly it is going to depend on the price of oil and the price the producers in the Bakken, the Monterey, the Eagle Ford or other places are able to charge for their crude. If as a result of the surge of U.S. production over the next couple of years global oil prices fall and make some of that production uneconomic whereby it comes offline, then future U.S. production will be much less. From a U.S. economic standpoint that would be great news because the price of oil will have dropped and it won’t really matter that production is not growing as much, given the primary benefit to the U.S. economy is lower oil prices. As there is uncertainty about how OPEC is going to respond and about global oil prices, predicting 2020 U.S. crude oil production is difficult. The unconventional production is very different from conventional production where the projects are so large and capital intensive, you pretty much knew what was going to be online five years from now. Tight oil production is much more distributed, much less capital intensive and so there is a lot of uncertainty about how fast production is going to grow.
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. China’s Shale Development
In an interview with the Financial Times [10] you argued that if Exxon Mobile and Chevron had held 90% of the U.S. shale acreage, the shale boom would not have taken off. That argument can certainly also be made for China’s National Oil Companies (NOC) as so far the Chinese shale production has not taken off. Do you think it is really comparable? There is the similarity of the big companies not being willing to invest in shale when they have more lucrative opportunities in the conventional field but the one major difference regarding China’s shale development could be that if the government decides to push shale development, NOC might have to follow.
It is theoretically possible that a concerted push by the Central government in China could get CNPC and Sinopec to develop the shale resources regardless of the economics of these resources and whether CNPC and Sinopec want to produce them. The history of the government being able to force State Owned Enterprises (SOE) to do things they don’t see in their interest is pretty mixed. It generally requires a very high level and concerted political push. Right now there are regulators in the Chinese government that would like to increase competition, would like to see a more rapid growth in shale production but just are not that powerful relative to the ones that hold the power in the SOEs. Those policy initiatives have been halting in their progress. Even if Xi Jinxing’s top priority above restructuring the financial system or above ending corruption were shale gas production and it became the single overarching political priority in China – in what is a pretty busy policy agenda right now – that would not have the same impact on competition in terms of the rate of development. Shale production is a process where you learn by doing, you iterate by doing. U.S. producers have gotten more productive and competitive and better at fracking by learning as they go. The competition among producers has created that space for innovation and the same is going to be true for China. As companies learn more about the resource, as they take practices developed in the U.S. and try to apply them to the Chinese geology and the Chinese market, they are going to have to iterate, they are going to have to do incremental innovation in the application of hydraulic fracturing and horizontal drilling and that happens most rapidly in a competitive environment. Additionally, there are a number of other barriers to shale gas development in China. Those are mostly technological barriers, water barriers and infrastructure barriers. Those alone are probably going to be enough to gate the pace of development in China. Even if you remove those barriers you are not going to see anything as aggressive as it occurred in the U.S. without fundamental reform of the market structure.
If those reforms would theoretically take place and China would develop shale resources, do you think that would also lead to the Dutch disease? And if yes, would the development still be beneficial for China?
The U.S. economic growth and the level of GDP will be higher as a result of the shale boom. The exchange rate effect just changes the distribution within the economy. So there are winners and losers but overall the economy is better off. There are just going to be parts of the manufacturing sector that will loose. The same would be true for China. Overall, if the Chinese saw a resource boom at the scale the U.S. is currently experiencing, which I think is extremely unlikely within the next two decades but let’s say that that occurred, the Chinese economy would also be better off as a whole. Parts of the Chinese economy would be less well off, namely the ones vulnerable to exchange rate appreciation. For both the U.S. and China the impacts are pretty modest. For the U.S. we talk about the relative benefit for energy intensive manufacturing, the relative cost for manufacturing that is exposed to exchange rate appreciation – but those impacts are pretty modest. The fate of U.S. manufacturing is still going to be determined by broader trends happening in the U.S. economy such as labor costs, technology improvements and tax regimes. The same is true for China. They are big economies and thereby the fate of manufacturing of either country is going to be determined primarily by factors other than what happens in the natural resource space, but the impact of the natural resource boom itself on manufacturing is likely to be a net negative for both countries.
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. Iranian Exports after Sanctions
As China is always looking for new oil suppliers or existing suppliers increasing their supply volume, the discussion often times go to whether the nuclear agreement with Iran could lead to more oil exports to China. [11] Do you think the lowering of the sanctions can at some point affect the export volumes to China or is it more an infrastructural problem in Iran that will hinder larger exports in the future?
There is oil export capacity that exists in Iran that has just not been utilized because of the sanctions. If the sanctions on oil exports in particular are loosened, then Iranian exports will recover to some extent. There was some damage as result of the sanctions to productive capacity but it was clearly modest. The question is about long-term investment in Iranian oil and natural gas production. Before the sanctions Iran was on the precipice of becoming a very large LNG producer. [12] Theoretically those are projects that Chinese companies were actively involved in. Because of market and regulatory issues in Iran, Chinese companies were however having a pretty hard time moving those projects forward even before the sanctions. If the sanctions were removed, the question would be what is the government’s posture towards foreign investment, development in the natural resource space and whether this environment is attractive for investments from Chinese and foreign companies. However in terms of the immediate impact of the lifted sanctions on the oil market it will be fairly significant. An additional 1 to 1.5 million bpd Iranian exports could come back to the market fairly quickly if they actually got rid of the entirety of the sanctions structure, which is unlikely to occur in the next year. It will be an incremental reduction of sanctions, not a wholesale removal, but if you did have a wholesale removal and you added 1 to 1.5 million bpd of crude into the market, the impact would be meaningful.
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. Investment Trends in the Energy Sector
The Rhodium Group has recently issued a report on Chinese investments in the U.S. energy sector. [13] We were wondering whether you believe those investments are mainly financial investments since they are only minority stakes or if they are made to get access to technology?
Over the past few years the center of global gas and oil M&A activities moved to North America. About ¾ of global oil and gas M&A occurs in North America right now. It is not really that complicated. If you want to be in the game as a Chinese oil company, you have to go where the deals are and right now the U.S. is that place. It is a pretty attractive environment to work as there is less legal risk. If you had a choice between investing in an onshore Kurdistan project or onshore West African project or you could go invest in Texas, most people are going to choose Texas. For diversification of resources alone, the portfolios of Chinese oil companies are very concentrated in domestic production; they try to diversify their resource base. Certainly there is an interest in learning – not in technology. Tight oil production is not a secret sauce technology. Right now, most of the existing investments are financial stakes only, but you are still going to learn what the economics of the projects look like. That is a benefit but I don’t think it is the primary driver for most of these investments.
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Thank you very much for the interview.
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[1] More about Trevor Houser and his recent publication “Fueling Up” at: http://rhg.com/people/trevor-houserand:http://www.piie.com/staff/author_bio.cfm?author_id=495.
[2] This fascinating study on what the U.S. shale gas and tight oil production really means for the U.S. economy, going beyond the short-term impact of jobs being created in the energy sector, can be bought at: http://www.amazon.de/Fueling-Up-Economic-Implications-Americas/dp/0881326569.
[3] This phenomenon was first explained in „Booming Sector and De-Industrialization in a Small Open Economy“ in The Economic Journal of December 1982 (Vol. 92, No. 368) by W. Max Corden and J. Peter Neary and has since then become a prominent discussion in academic circles both in the sphere of economic theory and international political economy. For the article go to: http://www.jstor.org/discover/10.2307/2232670?uid=3739256&uid=2129&uid=2&uid=70&uid=4&sid=21103401613961.
[4] The fear that commodity trade alone can lead to the “Dutch disease” in countries such as Brazil was also mentioned in The Economist article “It’s only natural: Commodities alone are not enough to sustain flourishing economies”, September 9th 2010, at: http://www.economist.com/node/16964094.
[5] The difference in natural gas prices as measured by the Henry Hub for the U.S., the UK NBP as well as the LNG import price for Japan can be seen at the graph provided by BP: http://www.bp.com/en/global/corporate/about-bp/energy-economics/statistical-review-of-world-energy-2013/review-by-energy-type/natural-gas/natural-gas-prices.html.
[6] The positive prospects for the U.S. chemicals industry are promoted by the PwC study of October 2012 on “Shale Gas: Reshaping the U.S. Chemicals Industry“, at: http://www.pwc.com/en_US/us/industrial-products/publications/assets/pwc-shale-gas-chemicals-industry-potential.pdf.
[7] An overview over current energy consumption and changes planned is provided in the International Energy Outlook 2013 by the U.S. Energy Information Administration (EIA): http://www.eia.gov/forecasts/ieo/industrial.cfm.
[8] An overview over the U.S. trade deficit is given by the U.S. Census Bureau with the latest numbers being from February 6, 2014, at: http://www.census.gov/foreign-trade/data.
[9] On January 9, 2014, the EIA published an analysis on the impact of U.S. crude oil production on price stability in 2013 at: http://www.eia.gov/todayinenergy/detail.cfm?id=14531.
[10] The Financial Times article was about “Oil and Gas: A New Frontier” and was published on January 7, 2014: http://www.ft.com/intl/cms/s/0/e434912c-7781-11e3-807e-00144feabdc0.html.
[11] Exemplary for this discussion: http://www.thetower.org/reuters-new-china-iran-oil-contract-may-boost-exports-pre-2012-levels-gut-efforts-cap-nuke-deals-financial-relief.
[12] The prospects for Iranian pipeline natural gas exports were evaluated by the Oil & Gas Journal: http://www.ogj.com/articles/2013/12/prospects-improve-for-pipeline-natural-gas-exports-by-iran.html.
[13] The report on “Chinese FDI in the US: 2013 Recap and 2014 Outlook” by Thilo Hanemann and Cassie Gao of January 7, 2014, is available at: http://rhg.com/notes/chinese-fdi-in-the-us-2013-recap-and-2014-outlook.
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