Pau Morilla-Giner oversees alternative investments at London and Capital and is also the manager of London and Capital’s equities and commodities funds. He started his career at JP Morgan Asset Management in Madrid and New York. In 2001 he joined Omega Capital, a multibillion investment company, where he became head of traditional investments and senior hedge fund analyst. From 2005 he was investment manager and head of research at Pragma Wealth Management, a London-based alternative investment company. Pau obtained his BA summa cum laude in economics from Universitat Pompeu Fabra, Barcelona, in 1999, followed by a masters degree in finance from CEMFI (Bank of Spain) in 2001. He has been a visiting professor of finance at the RiskLab School of the Spanish Financial Futures and Options Exchange (MEFF).
Energy has always been both a fundamental issue for nations and an extremely volatile commodity. What are the implications for energy markets following the Japanese earthquake and tsunami and the Libyan war and unrest in the Persian Gulf?
It is already abundantly clear that the Japanese earthquake has created problems for the global nuclear industry. Going forward, industry regulators will pay much more attention at the planning stage to issues such as the location of nuclear plants and how many of them it is sensible to put in the same locality. On older nuclear plants, which is to say plants where the basic design is more than 20 years old, governments are going to have a much more difficult job granting end-of-life extensions. I cannot for a minute think that this will be the end for the nuclear industry, but it does mean that a highly regulated industry is going to become even more intensely regulated, which adds an additional layer of difficulty for potential investors in new nuclear plant.
In Germany, for example, the average age of nuclear plant is 23 years, and Germany has already called a halt to any license extensions while the issue is reconsidered. The United States too is reassessing the way it uses nuclear. The danger for business, in all of this, is that countries could hit periods of brownouts and blackouts if aging nuclear plant is retired on safety grounds before there is adequate alternative generating capacity.
China has given some mixed signals. The ruling State Council suspended all new approval for nuclear plants on March 16, 2011, pending an inspection of existing plants and the issuing of revised safety rules. However, according to an article in the Washington Post of April 2, Xie Zhenhua, vice chairman of the National Development and Reform Commission, told a meeting on climate change in Australia that China’s nuclear goals remained unchanged. The article’s author was deeply unimpressed by China’s current safety planning and noted the absence of real or workable evacuation plans for people living within a mile or two of existing nuclear plant facilities.
However, when all is said and done, nuclear remains one of the most efficient ways of generating a large component of base-load electricity. The “easy” alternative, namely massive coal-fired power plants, is either environmentally unacceptable, or, if clean-burning technologies and carbon capture are introduced, becomes hugely expensive. Which brings us back to the impossibility over the next 30 years of moving away from nuclear.
There will be serious questions around design issues, however. We have not yet seen a great deal of technical information coming out of Japan, but there were clear concerns about the ability of the elderly reactor design to provide unambiguous temperature readings in the core as the crisis developed. This same design technology has been used a great deal in Europe, and if it shows real deficiencies, then that is going to pose some real problems.
By the same token, nuclear power’s difficulties smooth the way for other technologies, and one of the fastest and safest replacement technologies available is natural gas. By fast, I do not mean overnight. It takes a lot of time to switch electricity generation capacity from one technology to another.
If we look at the situation in North Africa, it seems clear that the price of oil is destined to be somewhere between US$110 and US$115 or more for some considerable time. This is high enough to bring projects forward that were impossible at sub-US$85 oil. In Canada, the oil tar sand deposits contain huge reserves, but this is very heavy oil and is very expensive to refine. Unit production costs are around US$85 to US$90 a barrel, and the further north in Canada you go, the higher the cost of production. Northern Canada requires US$110 a barrel before companies can break even. Clearly, if we had stable pricing at US$125 a barrel, there would be a real incentive for projects to go forward here.
What this tells us is that the “peak oil” story is not the full picture. There does not have to be less oil available in the world for prices to climb. The determining factor is not just available supply, but how expensive, effectively, oil drilling becomes. Oil, in other words, is expensive not simply because of demand dynamics or inventory dynamics, but because of supply dynamics, which are all about the marginal cost of extracting additional oil from sources that are nontraditional, more expensive to get at, and more expensive to produce and refine.
There is a huge amount of oil still in the ground, but the technology to get at it is fiercely expensive, so for this reason, once these technologies begin to be deployed in any scale, you will not see much retrenchment of oil prices below the breakeven costs for these nontraditional reserves. On the same theme, there is a huge amount of oil in offshore Brazil, but this is deep-water drilling and the cost of extraction is very high. You would not see breakeven with oil at $110, which, again, points to oil moving higher in the near future.
On top of all this, if you add instability in the Middle East into the equation, the problems are compounded. Bahrain is looking difficult, but without doubt the last barrier holding back the oil price from going beyond $120 a barrel is Saudi Arabia. Today, Saudi Arabia can absorb any dislocation to world supplies coming from disruption to Libyan oil production. Libya produces less than 2% of world oil and replacing it absorbs about 12% of Saudi surplus capacity. So it is not a problem for them. But this means too that they are not in a position to absorb further shocks to production from the Middle East. If another major country in the Persian Gulf reduced supply, or if there were to be a problem which impacted the passage of oil tankers through the Suez Canal, that would be a huge event for global oil prices.
The key point to grasp here is that as we near the end of March 2011, we are seeing unusually high, cyclically high, inventories in oil stocks coinciding with the oil price at very high levels above $100 a barrel. If there were no instability in the Middle East, at current inventory levels oil would not be above $85 a barrel.
The Bahrain situation is not that big an issue purely from the standpoint of the country’s oil reserves. But it is a highly dangerous issue from another standpoint, and in fact is far more dangerous than either Libya or Egypt. The issue with Bahrain is not a population that is revolting against a leader. It is the fact that it is a minority Sunni ruling elite being confronted by a majority Shiah population that is being stirred up by Iran. The big fear in the market is that this will lead to a direct confrontation between Sunni Saudi Arabia, which is committed to defending the Sunni regime in Bahrain, and Shiah Iran. That would be catastrophic for the oil and gas sector. Bahrain itself is not the issue. It is the fact that it could create a domino effect, drawing more and more parties reluctantly into a conflict that no one country wants to precipitate.
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- Next section Both oil and natural gas are hugely important fuels for industry. If we look at the relationship between the price of oil and the price of natural gas, that relationship varies dramatically from one region to the next. What are the implications for natural gas pricing in the medium term?