The Economics of Oil and Gas

A review of a new book providing a helpful reference guide to the complex economics of the hydrocarbons sector

The byzantine economics of oil and gas can baffle even industry professionals. Just how do companies calculate the risk of committing substantial resources to testing a possible petroleum find amid so many uncertainties?

And how, given those unknowns, can exploration licences be designed respecting the interests of all parties? How can the security oil and gas travelling through pipelines and shipping channels that cross volatile borders be assured? Why have so many countries found the presence of significant oil and gas resources to be a curse as much as a blessing? What on earth are hydrocracking, alkylation, isomerisation, delayed coking, and crack spread? Why is the oil price so volatile?

The Economics of Oil and Gas by Xiaoyi Mu of the University of Dundee’s Centre for Energy, Petroleum and Mineral Law and Policy, offers a guide to the vexing commercial judgements that accompany each stage of the process of getting oil and gas out of the ground and bringing it to market. Mu’s survey seeks to untangle the knotty intricacies of the sinuous network of laws, markets and pricing mechanisms that have evolved through reason, custom, chance and political expediency.

Filling a gap

The book, which will be of interest to engineers, managers, business writers, marketeers and others seeking a birds eye view of the industry, fills a gap in the literature on oil and gas. There are several fine popular histories that tell the bracing and often brutal story of the industry’s development, notably Daniel Yergin’s classic The Prize, perhaps now superseded by Matthieu Auzanneau’s eloquent Oil, Power and War. There is a growing library of more theoretical works assessing the industry’s profound social, cultural and ecological significance, including Carbon Democracy: Political Power in the Age of Oil by Timothy Mitchell, Fossil Capital by Andrea Malm, and On Petrocultures by Imre Szeman. And there are a few useful introductions to the science and technology of oil and gas, such as Morgan Downey’s Oil 101 and Vaclav Smil’s Oil.

Mu’s book focuses squarely on economics, referring to the industry’s history and politics while remaining scrupulously impartial. It is a dense book that crams a huge amount of information into 250 or so pages, and is perhaps better read as a reference than sequentially. And non-economists should be aware that there are mathematical equations here and there, and some rather forbidding diagrams and flowcharts. But the bulk of the book is written in clear prose requiring no technical expertise or prior knowledge. And it is not without a certain dry sense of humour, Mu observing that ’the demand for oil is a derived demand. It is hard to imagine that anyone really enjoys directly consuming gasoline, diesel, kerosene or LPG; doing so would be unpleasant at best and fatal at worst.’

A mixed blessing?

The opening chapter makes clear how tightly oil and gas are stitched into the fabric of everyday life, even as the world seeks to make the painful transition to renewable energy. Oil and gas provide fuel, are crucial constituents for plastics, chemicals, lubricants, solvents, waxes, tars, asphalts, textiles, paints, detergents, perfumes, pesticides and fertilisers, and power iron and steel foundries, aluminium and nickel smelters and many manufacturing industries.

Together, they still provide more than 50 percent of world primary energy supply. Oil’s high energy density and portability offer considerable economies of scale, made plain by the simple mathematics of a storage tank. The cost of a tank is determined by its surface area but the output by its volume, so when ‘the size of the tank doubles, the surface area increases by four times but the volume increases by eight times. As a result, the unit cost of the materials used in the storage tank halves.’

And yet, though they remain such crucial lubricants for the world economy, oil-and-gas exporting countries have not necessarily prospered from their seeming windfall. Mu discusses the tendency for an oil-rich country’s total exports to fall, the so-called ‘Dutch disease’ that takes its name from the decline of the Netherlands’ manufacturing after the discovery of the Groningen gas field in 1959. The discovery of oil often leads to currency appreciation that makes exports more expensive. Then there is the ‘resource curse’ that can overwhelm countries with weak political institutions, opening opportunities for patronage, bribery and entrenchment of authoritarian regimes.

Mapping uncertainty

One of the book’s most useful sections shines a light on the complex analytical tools exploration and production companies have evolved to quantify the risk of committing substantial resources to surveying and drilling prospects. There is a particularly clear breakdown of the decision tree methodology that seeks to map all contingencies in advance, peering for a route through dark forests of possibilities.

Another surveys the various regulations for licensing oil and gas exploration that apply across differing jurisdictions. Mu notes that production sharing contracts (PSCs) have emerged as useful solutions that go some way to addressing the inherent imbalance in power relations between stage agencies and oil companies. Before the decision to invest there is relative parity: companies spy an opportunity, and governments want to attract investment. But once firms have made their commitment, and incurred sunk costs, the bargaining power shifts to the state, opening the way for higher taxes, or even asset appropriation. By specifying the terms according to which investors can explore within a specified area for a limited time, a PSC can offer a blend of security and flexibility fair to both sides.

Mu goes on to discuss the licensing issues peculiar to the United States, where the ‘rule of capture’ grants subsurface property rights to landowners rather than the state. The rule has been rather too successful in stimulating exploration, tending to generate overproduction as landowners whose property runs over the same underground resource compete to deplete reservoirs before their neighbours. History’s most famous example is perhaps the rapid exhaustion of the legendary Spindletop field in Texas, where production fell from 17.4m a year after its 1901 discovery in 1901 to just 1.6m in 1905.

Oil tankers for every occasion

A chapter on oil and gas transportation opens up the esoteric world of shipping and pipelines. There’s some oil tanker spotting, identifying the ‘Panamax’ and ‘Suezmax, designed to pass through the Panama and Suez Canals respectively, and the ‘Aframax’ mainly used in the basins of the Black Sea, the North Sea, the Mediterranean, and the South China Sea. The proverbial difficulty of turning an oil tanker around is true: a 250,000 tonnage tanker travelling at 16 knots takes three miles and 20 minutes to stop, and a 300,000 tonnage tanker travelling at less than five knots cannot be steered at all.

Then there is the curious balance of power attending the practice of ‘flags of convenience’, according to which tankers sail under the flags of their registered country not the home country of their owners nor charterers. The right of the country of registration to determine the laws under which the ship is required to operate accounts for the unusual power that small nations such as the Marshall Islands, Liberia and Panama exercise over the shipping of the world’s most valuable commodity. The delicacy of this transportation network is starkly illustrated by its dependence on the four-mile shipping lane of the Strait of Hormuz, connecting the Persian Gulf with the Gulf of Oman, the Arabian Sea and the Indian Ocean, through which 30 per cent of all seaborne-traded crude flows.

Pricing oil and gas

There’s an extensive chapter on the increasing importance of the natural gas industry, in which Mu attempts to navigate the dense cloud of regional pricing mechanisms, and discusses the emerging alternatives for monetising gas that don’t rely on pipelines, liquefied natural gas and gas-to-liquids. He also covers the rapid growth of shale that has enabled the United States to break new ground as a net exporter in natural gas, and considers whether the blend of circumstances that have made it possible — such as mineral property rights, a robust pipeline infrastructure, and a supportive government — could be replicated elsewhere.

The book concludes with an analysis of the vagaries of the oil price, from the birth of the modern industry in mid-19th century Pennyslavania, through the ‘As-Is Agreement’ worked out by oil barons in the 1920s to limit excessive competition causing overproduction, to the price shocks of the 1970s and beyond. Mu argues that the role of OPEC in the latter has probably been overstated: the 1970s saw substantial increases in the price of all commodities, a trend that had little to do with Middle Eastern geopolitics.

There’s also a look at the opaque world of energy derivatives — forward contracts, futures and options — that has evolved to help producers hedge decisions that depend on oil price horizons that are effectively unknowable, and at the state subsidies designed to keep domestic oil prices below market value. The provision of such subsidies, which according to IEA estimates can reach five per cent of the total GDP of the countries that provide them, is increasingly controversial as ecological sensitivities sharpen. But their removal can spark serious civil unrest, as in Yemen (2005) and Nigeria (2011).

Managing the transition

The challenge of managing an oil and gas business through the energy transition is perhaps the one major omission from the book. It predates the pandemic, so Mu could not have foreseen how suddenly the Covid-19 crisis would intensify pressure on the industry to plan for post-carbon futures, an increased urgency perhaps most clearly manifested in the recent restructuring announced by BP. But the complexities of managing investment in renewables while continuing to secure a return on oil and gas exploration and production have been pressing on the industry’s larger companies for some time, adding another layer of complexity to the commercial decision-making process.

That, perhaps, is an issue that would require a book of its own. With The Economics of Oil and Gas Xiaoyi Mu has given us a useful guide that covers as much as we might hope for from an introduction to such a sprawling subject.

The Economics of Oil and Gas by Xiaoyi Mu is published by Agenda Publishing.