The (oil price) Crash of ’14: what lessons can we learn?

4 weeks past the helter-skelter Oil Crash, as prices plateau for now (and maybe for the long term) — what have we learned about energy markets in the Age of Alternatives?

No can perfectly predict what will happen with energy prices, over the long period of time, and the relief that the energy sector might be feeling about a recent stabilizing of the crude oil price around $45-$50 per barrel might be temporary.

But during the long-or-short lull, we might turn our eyes from the terrifying act of watching a loved one plunge off a cliff and focus attention towards understanding what happened, and what it means for the future. Especially for unconventional oil and alternative fuels — for it is their influence, and the rising production thereof, that led to the price slide as demand and supply became materially imbalanced when China slowed.

1. A little dab’ll do it: How big was the supply overhang, really?

Perhaps the most awesomely impressive fact of the oil rout is how little and amount of excess capacity and supply can tip this market. When prices respond vigorously to very small changes in supply or demand, they are said to be elastic. And rubber should be so elastic.

As we reported in the Digest last month, it came down to about 4 million barrels per day of new capacity, mostly from North America, mostly unconventional oils. That was the supply overhang that OPEC refused to correct for, by reducing its own production, in order to preserve high oil prices. Instead, Kuwait and Saudi Arabia, looking at marginal production costs as low as $2 a barrel, concluded that they would win a price war handily over unconventional shale oils — and undertook the longer-term strategy of forcing unconventional production out of the market rather than protecting prices by allowing their own market share to erode.

But it would not be the correct to say that they were attempting to flush out every drop of unconventional oil. After all, fracking didn’t arrive yesterday and not every shale oil operation loses money with a $45 a barrel oil price. Perhaps as much as half of it — 2 million barrels per day — is at risk.

What does that translate to?

Nevertheless, from the crash we can learn a lesson that a 2 million barrel supply overhang can spur a $60 per barrel drop in oil prices from $108 Brent in June to $48 last week.

We’ve seen in the past that relatively localized supply disruptions have sent oil prices skyrocketing — such as the Ukraine troubles, or Iraqi or Libyan oil debacles in recent years.

How does 2 million bpd translate into supply at the pump? It’s around 20 billion gallons of road transport fuel, not far off from the current volumetric requirements of the US Renewable Fuel Standard..

Conclusion? You can thank shale oil for prices at the pump that remind you of the 1990s. But you can also thank biofuels — for, without that additional 2 million + barrels coming from this additional supply source, we wouldn’t be seeing a price war between shale oil producers and OPEC. That demand would have simply been absorbed into the pool. You can also thank increased engine efficiency — and down the line, we might find ourselves thanking electrification of the fleet.

2. There is nothing but price. Resistance is futile.

No matter what passion you bring to causes such as climate change mitigation, energy security, or rural development — overwhelmingly what motivates policymakers, consumers, and investors are prices. Can you make money, making shale oil or biofuels or any other way? And, will adding this channel cause prices (farm, fuel, food) to go up or go down.

Naturally, farmers like higher farm prices that come with the additional markets that biofuels bring — it supports farming intensification, and higher yields per acre, and sometimes a floor under crop prices that reduces risk, and all of those mean higher farm prices and more borrowing power, and higher income.

No surprise that consumers like lower food and energy prices where they can get them. Or that energy producers respond to price as well — high price good, low price bad. Policymakers — well, they want prosperity — which comes not from the zero-sum game of high producer prices or low consumer prices, but from productivity gains inspired by industrial or farm intensification. So they tend to like rising demand combined with waves of innovation. And they dislike innovations that cost more — no matter how “nice” the externalized outcomes might be — because they make consumers grumpy.

Right now, few consumers are focused on the plight of energy producers — who are facing Dust Bowl economics if prices don’t recover (and Houston real estate might be facing real challenges) — because they are just too darn happy over the state of prices at the pump.

3. The inescapable importance of inputs.

Prices for given biobased technologies simply have to come down now, and be competitive with $75 oil in the next few years, rising slowly towards $120 oil in constant dollars by, say, 2040 — if we believe the IEA energy price scenarios.

It’s a reset of expectations — not a rout — but it may push some technologies back into the development phase. It may eliminate opportunities for others.

Why $75, not $100, when there’s a Renewable Fuel Standard at hand? Price matters, and the growth scenarios for alternative fuels dictate occasional periods of low prices when rising supply gets ahead of rising (but volatile) demand. And the Renewable Fuel Standard is best understood as a guarantee of an available market for affordable alternatives — not as a guarantee for $6 fuels and in spite of any pain at the pump.

Yes, there’s carbon, there’s energy security and rural development. But, where are the armies marching demanding biofuels for those reasons? Famers barricade highways only during times of low commodity prices — and no other. And energy security hawks generally march in military parades and generally avoid the limelight of politics. Carbon advocates are generally so minimally conversant in farming practices that they are apt to believe that eliminating biofuels will flood markets with cheap grain and drive down food prices around the world — rather than the actual impact, which would be to flood the world with low productivity and drive farmers out of the supply chain and into the cities and welfare rolls.

People like inexpensive solutions to complex problems — and when solutions are expensive or painful, people tend to procrastinate. Just ask the economic managers for, say, Greece.

The USDA and DOE are working on reducing the cost of finance, and the cost of technology — there’s not quite as much work right now on reducing feedstock costs, because it is felt to be outside the orbit or energy ministries and it causes heartache within agriculture ministries.

4. “All Power to the Soviets!”: victory through aggregation of demand

Free feedstocks are very nice when available— municipal solid waste is available with a tipping fee premium right now — so that’s a case of negative cost feedstock. Bagasse is another “free” feedstock, since it is produced as a sugarcane residue at the sugar/ethanol plant — it’s already aggregated and paid for in the cost of producing sugar or sugarcane ethanol.

But they’re not really free — or free for very long. Free, come and pick it up is only “free” as long as you don’t factor in the cost of “picking it up”, which can be substantial.

Yellow grease used to be free. In fact, some restaurants would pay firms to come and pick it up — maybe $20 per pick-up. Today, yellow grease is selling in the 30 cent per pound range — that’s around $2.30+ just for the feedstock used to make biodiesel. Compare that with Saudi Arabia’s crude oil marginal cost of $2 per barrel — according to Saudi Aramco Ventures — or, around 0.6 cents per pound.

Supply and demand is creating that cost structure. But so are weak buying units, and sellers in the driver’s seat.

One of the solutions is to aggregate the feedstock demand and disaggregate the supply — so that giant buyers have more economic power than tiny sellers. That’s the OPEC route, and for sure demand in the biodiesel/grease market is being aggregated, but more is likely needed.

Aggregation costs will need to come down as well — if agricultural residues are going to be viable sources of feedstock. $100 per ton cellulosic feedstocks are great pathways to $4 fuels, maybe even $3 fuels — but not a path to $2.00 fuels.

5. Bolt on, build out, drop-in: Are chemicals a way around the problem, and how?

We see a chemicals strategy that is not well structured within a fuels strategy as risky in the long-term. Coal producers had a chemicals strategy and a power strategy, and not much of a fuels strategy — back in, say, before the 1940s. Then, oil broke into chemicals, and ultimately they killed most of the coal-to-chemicals industry with their technology and economies of scale.

A producer that has an integrated biorefinery and produces chemicals as a high-value portion of “the barrel” — with fuels to provide volume needed for large scale? That sounds like a more robust strategy than building 10 million pound chemical plants based on a great chemicals-focused fermentation technology. We’ll see how it plays out — but we look at Gevo’s “side by side” technology option, where three fermenters produce ethanol and one produces the drop-in fuel/chemical isobutanol, and we wonder.

For sure, many observers will say that Gevo’s SBS system is the product of low yields they are seeing with isobutanol as they optimize the process, and that they would be producing isobutanol in all their fermenters if they could get the rates of production.

But, you see, there’s something in that. With a 19 million gallon plant and a still-emerging isobutanol tecnology, it might simply be easy to dismiss Gevo’s approach as opportunistic, but we see it as, at larger-scale, perhaps the shape of things to come.

We rather like the idea of building out a suit of bolt-on technologies at one site — multiple fermenters, multiple drop-in products (where a fermentation technology is used), each contributing towards aggregate demand and thereby driving up the productivity. At the same time, higher-value chemicals contribute margin which overcomes the increased marginal cost of transporting biomass or sugars over larger distances.

In turn, what can be done with multiple fermenters, might also be done with fractionation, in the case of thermochemical technologies.

The key — drive up the capacity. Bigger, but more diversified.

The Bottom Line

One thing the US Congress got right with the Renewable Fuel Standard is the overall volume target. We have ample evidence in hand that the rise of alternative supply, in the 2-4 million barrel per day range — changes the oil price equation under certain economic circumstances. You don’t have to replace oil entirely in order to change its economics — a relatively small shift might be all that is necessary.

But for all the positive changes that creating an alternative supply of fuels brings — pressure on oil-rich crazy regimes, relief at the pump for consumers, more energy security, better carbon scores, better outcomes for rural economies — they can bring the specter of low producer prices. That puts the innovative challenge right on feedstock cost in the long-term — and some M&A activity might be just what the doctor ordered to increase the economic power of producers and bring down feedstock costs so that they are competitive in the long term within the rollercoaster of commodity fuel prices.