Russ: Coming to you today from the Baker Institute on the campus of Rice University where my guest is Dr. Kenneth Medlock III, the James A. Baker III and Susan G. Baker Fellow in Energy and Resource Economics and Senior Director for the Center of Energy Studies here at the institute; Ken, welcome back to The EnergyMakers Show.

Dr. Kenneth Medlock III: Well thank you for having me Russ.

Russ: It was about a year and a half ago that we sat at this table and talked quite extensively about the momentum going with the shale production and how successful and since then, my god, it’s gone through the roof but it did a lot better it seems like at a hundred dollars a barrel than where we are today at.

Dr. Kenneth Medlock III: Well a lot of things do a lot better at a hundred dollars a barrel than at 60 and actually we’re down below 50 right now so it’s been a – a pretty colossal decline in the price of oil and that’s, you know, sent some shockwaves through the oil patch certainly. I mean there are silver linings of course, when I say everybody does better at a hundred dollars, of course consumers don’t, so there is sort of a catch-22 when you’re thinking about, um, things from the standpoint of the long term health of the energy sector lower prices are generally better because it encourages more demand which means there will be more appetite for what you’re producing if you’re in the – in the upstream but in the short term under – under their current circumstances it will definitely create some pain.

Russ: Okay. Well we’re kind of feeling it here in Houston, Texas for sure so – but there have been a few interesting conspiracy theories about what caused it; is that it or is it strictly supply and demand?

Dr. Kenneth Medlock III: Yeah, the conspiracy theories really started to mount after the OPEC decision at their last meeting not to cut production and these range from, you know, the Saudis and the – and the U.S. government struck a deal to really punish the Russians to punishing the Iranians to the Saudis are just really – really trying to push shale out of the market. These are sort of wild and in a lot of ways maybe attractive theories, but in reality it really is an issue of Supply and Demand.

You know, the Saudis, when you think about their decision, there’s a long held and – and widely used framework in economics to describe OPEC decision making – it’s dominant firm or dominant producer theory – and given what’s been going on in oil markets the Saudis did exactly what that economic theory would predict they would do which is hold serve or increase production and so it’s hard to, when you look at that, you know, rational sort of economic approach and – and then try to juxtapose that against all these conspiracy theories, rationalize the two together.

And so really it is about Supply and Demand and firms acting in a rational way to hold market share which is a really important point for the Saudis, particularly in Asia. Current price environment is a little bit below long run marginal cost and I say that because really one of the things you have to look at to understand, you know, where the price is relative to the long run lifting cost of crude is look at the inventory situation and crude oil inventories today are burgeoning. And so that’s a signal of basically a very well supplied market and in fact over supplied in a lot of ways so that means you’ve got to figure out a way to, in the marketplace, simulate demand and discourage new supply and so that’s why price dips.

We’ve already seen some signs of demand being stimulated with some of the recent announcement by some of the U.S. auto makers that there have been record sales for, you know, big trucks all of a sudden so it’s really interesting to see how rapidly the U.S. consumer has responded to prices at the pump dipping below $2.00 a gallon. So, you know, when you look at that and you look forward to the next 6, 9, 12 months you say well, there’s a big supply overhang and we’ve got to work through some rig inventory and some supply inventory but given the demand stimulus it’s likely coming, particularly this summer with the health of the U.S. economy, we might eat through that and by the end of this year be back on the up – upswing to something that’s more – more relevant when it comes to thinking about long run lifting cost for oil.

Russ: Okay. When you talk about price, you know, being below the cost are you strictly talking about Saudi costs because I know it varies significantly.

Dr. Kenneth Medlock III: No, no, it’s – when we say cost in that sense – or marginal cost – it’s really the – the cost to lift the last barrel to meet demand. So the Saudis are a low cost producer, they’re what we would call infra-marginal so they’re not at the margin, they basically can produce, you know, all out and do so at well below what the – what the producer at the margin say in the United States or in the North Sea can produce oil at. So really what happens when price dips is you start to eat at the margin, so you start to really hit the places that are the most high cost producers and so some of the shale in the United States sits in that category; not all of it because even in shale there’s a lot of heterogeneity.

There’s some shale that does well at 100 and some shale that will still, you know, make money at 60. So, you know, that’s a really important thing to reconcile because in point of fact the shale that makes money at the lower costs are the productive wells, so the ones you lay down when price starts to fall are on the least productive end of the scale so it doesn’t really hit production that heavily. Now the North Sea is an area that’s really feeling it. You’ve seen some recent announcements out of the UK that, you know, lower prices are really going to hammer production and some of the planned production and investment activity there, so, you know, you look around the world and you start to see these responses and you start to recognize that well, price isn’t going to keep falling, you know.

We’re probably close to the bottom, maybe not quite to the bottom but at some point it’s going to have to turn around because lower prices will discourage that supply at the margin but also encourage demand and those two things work in opposite directions.

Russ: Okay. I – I don’t think of the – the oil market, OPEC, the whole world as being really kind of a free market until it came to this and -and it really feels that ways to me and in a market like this it seems the low cost producer prevails – wins; maybe you’ve already said that in saying they kind of have the – have the power and too but boy they could – they could carry this for a long time, if they had just competitive intentions, could they not?

Dr. Kenneth Medlock III: Well, I mean that’s part of the point right? When I was talking about, you know, the rational sort of economic decision for Saudi Arabia to make was to either hold serve or grow production and they basically held serve. So the idea there is they’re looking out at a world that, you know, is effectively overpriced and when they see that they see that it’s enticing new production into the marketplace and it threatens market share and so they’re faced with one of two things; they can either cut production and support price which only going to encourage more supply from competition or they can say all right, we’re going to hold serve and let you guys realize all of a sudden that you’ve brought too much online effectively and so what that does is it ends up pushing price down and they end up maintaining or – or growing their market share to a place where they’re comfortable.

So, you know, it very much is a – a market share story, a very – it is really a very sort of competitively driven type of discussion, right? You know if we took oil out of the equation and didn’t talk about Saudi Arabia and we’re talking about Walmart and, you know, something in the – in the consumer durables and goods space then it would be a different conversation. But the emphasis and the – and the – and the points would really be the same.

Russ: Okay. So what happened? 2005 the late Matt Simmons wrote Twilight in the Desert as though the Saudis didn’t have nearly the reserves that we thought, was he just wrong?

Dr. Kenneth Medlock III: Well I think that’s being born out to be true, absolutely and there were a lot of people that didn’t agree with – with the premise of the book to begin with. You know Matt, in fairness, he did some – some real data analysis; he was actually looking at production data from some Saudis – Saudi Arabia’s, you know, larger fields and seeing, you know, that increasing water drive was being used for production and things like that and he started to think about well what does that mean? It’s going to raise cost, it means maybe they don’t have as much oil down the road but you know, that’s a – a little bit of a misnomer because the thing we need to look at is not reserves but resource and so when you look at resource that’s remaining in places around the world you see that there’s, you know, there’s plenty of oil, really it’s just about lifting cost.

And so that’s where technology plays a really critical role and we’ve seen some pretty amazing technical innovations in the – in the oil patch over the last 20 years and that’s, you know, when you look forward there’s plenty of oil, we’re not going to run out any time soon.

Russ: Okay. Well that’s what we talked about, technology a lot, last time I mean because that’s what brought on the shale thing and – and completely changed it, can technology play a big role you think in lowering the cost of production?

Dr. Kenneth Medlock III: Oh yeah, it’s – it’s not just technology though. I’m glad you asked that question because it’s something that people have to, you know, recognize is the cost environment’s critical for determining, you know, profitability in the oil space. So we’ve seen real negative pressure on price but what that does is it has a ripple effect to the cost side as well because you’ve got to think about – about what comprises cost when you’re an oil producer. You’re out there, you know, contracting rigs, you’re contracting wellhead services; service companies are really big in that space. When demand for all those things goes up as it has, you know, in the past few years with prices up near $100 or higher you run into constraints on the ability to provide all those services and so the price of those services goes up.

And so that’s exactly what happened, you saw the cost environment rise dramatically from the early 2000s through – through 2008 and then it sort of stabilized. So – but see, you know, the common sort of anecdote is that when you look at a $20 project in the early 2000s – and this is, you know, pick a – pick a location, right – $20 a barrel would be your – your – your break-even price say for a project in location X, well by the time you got to 2008 that same project would have cost $85 – $90 a barrel and it’s the same geology, there’s nothing different, right? Nothing different about the regulatory environment, it’s just about the cost to actually do the project. And so when you look at what happened over the last, you know, decade, you recognize that, you know, cost was a major driver in seeing the – the price of oil go up.

Of course when prices fall you start laying rigs down, you start relaxing those constraints, costs will begin to fall and – and anecdotally I’ve heard some stories about some of the – the costs in the procurement chain for upstream activity have already dipped by about 30%. So and I think you’re seeing some of that with – with some of the announcements out of places like Schlumberger and – and Halliburton and Baker Hughes with the layoffs and stuff like that so…

Russ: Okay, okay. Say – say the Saudis do continue to hold firm and do exactly what they’re doing and you already mentioned, you know, people are laying down rigs now, I also heard on the street – and these are the kind of rumors and stories you pick up these days though – that – that they could do it so long that – that production decreases significantly and then – then all of a sudden we start heading back in the other direction but it would take a long time to get back to the production level that we were at causing prices to skyrocket, maybe $200 a barrel; I mean, is that scenario possible?

Dr. Kenneth Medlock III: So this is the idea that first if all prices cycle, right? And there’s been a lot of discussion that maybe the cycles will be shorter now because – to your question – because you can actually move in and out of the – out of the oil space more quickly. I’m not so sure I agree with that; the reason is…

Russ: Meaning you’re not so sure you can do it that fast?

Dr. Kenneth Medlock III: Yes, exactly. So I’m not so sure that you can actually move in and out more quickly now; I mean physically yes you can. As a matter of fact you can actually drill and complete wells in the shale space very, very quickly which means you can bring production online pretty quickly but you still have to recognize that firms have to allocate capital to do that. And so to the extent that they’re reluctant because they’re worried about price dipping very quickly again and they’re going to have to pull back then what that’ll do is it’ll inject delays into the process. So really what you have to look at more than just how quickly can I ramp production up is how quickly will firms respond by allocating capital into the space? And I think that’s where the delays will come.

It’s certainly not the same when you think about onshore production as it is when you think about offshore production. Offshore you’ve got massive lead times, if I make a decision to do something offshore it’s going to be 8 to 10 years before I see first oil, right; from the time I actually move into inception on the project. So, you know, that’s a very different thing but when you look offshore firms haven’t really stopped moving offshore, right? They still, just as they always have, take the long run view because they recognize the long lead time associated with bringing new oil online in offshore ventures. So it really is an onshore story but again, I don’t think – I think the issue really is about firms allocating capital, not that they’ll just jump in immediately.

Russ: Okay. One thing I always enjoy about interviewing you is your economics background as well as your energy and, you know, you’ve already talked about, you know, there’s a clear benefit in what’s going on today because the price of gasoline going down really benefits the economy totally. When you kind of balance the two is there – do you think it’s even better now that – that the – the consumer is paying less and they’re going out and buying Hummers and stuff now and – and the world’s turned back to the way it was or – or – or on the other hand I hear people talk about the amount of debt that’s sitting out there holding up some of these deals and – and is that as big as the mortgage debt that caused the financial crisis? I mean there’s a lot in that question.

Dr. Kenneth Medlock III: There’s a lot in that question. We’ll kind of take it step by step. All right, so the energy sector is actually a relatively small fraction of the U.S. economy. So yes, when energy prices rise typically what happens is there’s a negative correlation between energy prices and – and overall economic activity; so higher energy prices usually mean the U.S. economy slows down. Now there are areas of the U.S. economy – both geographic areas as well as sectors, right – that tend to do better when prices are high; so states like Texas, Louisiana, Oklahoma, you know, North Dakota, right, when energy prices are high these – these states are pretty counter-cyclical to the rest of the country. But it’s not that everybody in those states does better, right? As a matter of fact, you know, the – the evidence holds that with lower prices the U.S. economy will generally do better.

Okay, so in terms of, you know, the outlook for the overall economy you would say lower prices are – are sort of a better – better situation to be in. Now places like Texas, Houston in particular, there’s going to be some pain and we’ve already seen some indications of what that’s going mean with some of the layoffs that have been announced at different companies and that’s going to trickle down into the real estate market because demand for housing might actually change and soften and that will affect, you know, real estate values, that will affect tax receipts associated with real estate values which is a major source of revenue for local municipalities, counties and the state. So – so all of those things have sort of ripple effects right and that has an impact on – on the local economy. Now will that mean that -to the, I think, second part of your question – will it create a crisis related to the debt? I don’t think so largely because again, it’s a relatively small fraction of the economy.

In reality, you know, easing of energy price will actually allow most households around the country to have more disposable income and so that usually means they start doing other things that stimulate other activities so they maybe take longer vacations this summer, right? They maybe get in their cars and drive to Disney World, those sorts of things. Of course the interesting thing about that is that it ends up – ends up raising demand for gasoline and other fuels like jet fuels so that just gets back to the whole cyclical nature of prices, right? But in general no, I don’t think this is going to create an issue for the overall economy.

There will likely be some firms in the energy space that are going to be stressed because of the debt that they hold and I think rather than that being cataclysmic for the space what it usually does is trigger a lot of Mergers and Acquisition activity because you’ll have firms that are too heavily levered and they’re going to have to either sell assets or be outright takeover targets.

Russ: Okay, okay, interesting. So changing subjects to natural gas; so how does this impact that because natural gas is not this sort of global marketplace and – and we’re doing real well here and have real cheap gas.

Dr. Kenneth Medlock III: It impacts it on a couple of different fronts. On the production side you have to realize that a lot of the natural gas – a lot of natural gas was being produced that was associated with oil, in particular light tight oil in shale formations, so the extent that firms back down on the activity in the – in the – in the shale space you’ll see some of that associated gas production subside. Now it’s not a one for one because a lot of what’s going to happen is firms will high grade acreage and so you’ll still see some gas production that’s associated with oil but you’ll also see less flaring because to the extent that firms are backing off on oil production that’s usually where you see the flarings in the oil space. And that will, you know, convey some benefit obviously. But it also means if you’re flaring the gas yes you’re producing at the wellhead but it’s not getting to the market anyway so we have to reconcile that.

The interesting thing really when you think about the emerging globalization of natural gas markets, because the U.S. is, you know, going to become an exporter of natural gas through LNG – there’s a project already under construction for example that’s supposed to I guess deliver first cargo by – by next year – beginning of next year I think. So that will likely continue, the U.S. will definitely remain a low cost location for natural gas production but the health of export facilities, particularly ones that haven’t really launched yet but have received a certification or a license to export, could be challenged because overseas historically what you saw was that natural gas prices were linked to oil. And with oil prices coming off, you know, that – that’s going to compress the margin of profitability for, yeah…

Russ: So our competitive advantage is going to decrease, yeah, wow.

Dr. Kenneth Medlock III: Exactly, exactly so that’s an interesting one to watch. I don’t think again it’s long term because I think the thing that – that ultimately will happen is oil prices will bounce, the oil index contracts for natural gas will go with them, that will encourage more demand for natural gas that’s not indexed to oil and so that’s going to bring a lot of consumers, particularly in Asia, to the United States. So, now I still don’t think we’re going to see a massive amount of exports – I’ve written about this and talked about this – of LNG from the U.S. largely because I think it’s an economic issue.

Russ: Even – even before the price dropped?

Dr. Kenneth Medlock III: Yeah, even before the price dropped. As a matter of fact I wrote something about 2 ½ years ago now where I talked about, you know, the reason price in Asia was as high as it was in the spot market was because of the realization of the deliverability constraint and when that constraint gets relaxed – when you add supply the price action is not in the United States, it’s overseas and you’re starting to see some elements of that already because you’ve seen a couple of LNG projects come online over the last year.

Russ: Okay. All right, so I’ve really enjoyed this, one – one other energy category though, sustainable energy, you just don’t – you just don’t hear – I mean they’re being impacted too as well, right?

Dr. Kenneth Medlock III: Oh yeah. So when we think about the renewable space, you know, this – this was happening though before the collapse in oil prices because really when you – particularly in the U.S. – when you talk about oil it’s almost a – a mistake to talk about renewables because, you know, there’s no oil consumes in the power sector here really so that’s not really impinging on the competitive viability of renewables, it really was a natural gas war.

So that space was really being challenged because of what’s happened here with regard to shale gas production for – for the past few years and you’ve seen it with, you know, the – the continued debates on extending the production tax credits and things like that, the federal and even state levels and you know it’s going to be interesting to see what happens. At the end of the day what has to happen for renewable energy sources to really matriculate into the market in full force is they’re going to have to be competitively viable without subsidies. And hopefully we’re moving in that direction; I think we are largely because of technical improvements but they’re chasing a moving target because there’s a lot of technical improvement in the upstream oil and gas space as well.

Russ: Right. You know, just mentioning tax credit – kind of off the topic right now too – but I get into discussions with people that are anti fossil fuels all the time talking about, you know, the tax credits that the big guys get and stuff and I go well, I don’t know, I – to me at the end of the day what matters is what their paying and I think there’s a lot of people that don’t understand that some of the largest tax payers in the United States – income tax payers, corporate – is Exxon and – and Chevron and Conoco Phillips; I mean it’s huge what these guys contribute.

Dr. Kenneth Medlock III: Oh that’s – that’s definitely true and – and, you know, over the last few years there’s been a lot of discussion about tax reform specifically targeted on the oil and gas sector. I think the Treasury Secretary Lou actually made a statement to that effect yesterday or the day before yesterday. Here’s the issue, things like the intangible drilling cost expensing rules, which is something that’s been targeted for example in tax reform efforts that have been proposed, that’s not unique to oil and gas.

Those are the types of things that basically all manufacturing enjoy, so the New York Times enjoys that with regard to things that are intangible costs associated with running it’s printing presses. So – so really what you’re doing is talking about reforming the tax code specifically for one segment of industry, that’s a little bit different discussion than saying, you know, oil and gas is receiving subsidies because in reality they’re not subsidies, it’s actually just a different tax treatment. So I think these things have to be rationalized a little bit when we start talking about the competitive viability of U.S. manufacturing in general because that’s really where oil and gas sits is in that industrial space.

Russ: And the size of the checks they write, they’re unbelievable. I mean I think Exxon I saw was like – in 2012 was something like 31 billion, you know, which is way, way up there. Well I really appreciate you spending some more time with me but before I let you go, you know, all of this stuff that we’ve talked about – about the market – it’s all possibly disrupted by – by all the disturbances that seem to be taking place worldwide which seem to be like at an all time high right now; I mean that could change everything we’re talking about, right?

Dr. Kenneth Medlock III: Absolutely. I mean, you know, it’s – it’s interesting to look at the world and see what’s happening with regard to energy, with regard to security concerns in various places around the world and interestingly enough the two are linked. And I say that because if you look at the planet, you know, the classic Earth at night picture that National Geographic made famous, you can look at all the places around the world where there are no light son at night, that basically tells you where we don’t have access to modern energy services. Those also happen to be places that are hotbeds for terrorist activity, hotbeds for civil unrest, so that tells you something, right? It tells you that when you have access to energy it creates economic opportunity; that gives people hope, it discourages them from doing things that are extremist – on the extremist end and in reality when you think about energy and foreign policy and security they’re all intimately interrelated.

So when we think about the state of the world today, you look at places like Iraq, right, where obviously the, you know, the ISIS movement in particular in Northern Iraq has got a lot of people worried a little bit about the oil space but given what’s happening in Kurdistan with growth and oil exports there, given what’s happening in Southern Iraq which just set a record for oil shipment orders for the next coupe of months it’s kind of interesting to juxtapose those two things against one another and realize that production’s still going up.

Russ: Right, wow. And so – and so your point too is that production might go up enough that commerce comes back and commerce has this settling affect on…wow…

Dr. Kenneth Medlock III: That’s precisely my point – that’s precisely the point, that economic opportunity will – will hopefully cure a lot of ills.