Editor’s Note: Our energy industry insider – who for professional reasons must remain anonymous – yesterday explained how the Keystone XL Pipeline debate is largely a political football. Today, he advances his controversial expose of Keystone in the context of today’s cheap oil, and whether the project would do more harm than good. This shows how energy investors should position their portfolios to reap the best returns at the lowest risk.
To understand the logic behind the Keystone XL pipeline requires a trip back in time. When Keystone and its associated 830,000 barrels of oil per day were announced in 2008, U.S. crude production was at lows generally not seen since 1950 – right around 5 million barrels per day. Meanwhile, U.S. oil imports were rampant, near their all-time highs of 10 million barrels a day. Worse yet, over half of U.S. imports, again a near-record high of 5.6 million barrels per day, came from countries that don’t like us very much (i.e., OPEC).
In a nutshell, the U.S. oil and gas industry was in decline, without much hope for a real renaissance. We were meeting a whopping two-thirds of our appetite for oil with imports, and over half of those imports were coming from potentially unstable if not outright hostile nations. In that context, Keystone looked like a great idea.
Decisions based on these assumptions – such as the decision to green-light Keystone – seem in retrospect to be perfectly reasonable. Unfortunately for the project and the economy at large, the energy industry has since changed dramatically. These changes have altered the project’s consequences for everyone.
A Solution Looking for a Problem
New technology innovations that were starting to reinvigorate natural gas drilling in the United States turned out to be equally applicable when drilling for oil. The shale boom soon hit the oil patch, and we drilled – boy, did we drill! While the Keystone pipeline has sat in regulatory limbo, U.S. production has skyrocketed over the past five years or so – as of last count we are at more than 9.3 million barrels per day, nearly double U.S. production back in 2008. This is a level not seen since the oil heydays of the early ’70s.
This production boom has managed to squeeze out some of those imports. Total imports are now down to 7.1 million barrels per day, less than three-quarters of what they were in 2008.
This near doubling of U.S. production has also had a huge economic impact, pumping billions of dollars in capital investment, equipment demand, and jobs into an economy that was otherwise mired in an extremely sluggish recovery from the Great Recession. The exact degree to which the oil and gas industry has helped America claw its way out of recession is debatable. But the evidence is strong that its impacts have been powerful.
A recent study by the National Association of Counties looked county-by-county across the nation to measure the degree of recovery from the Great Recession. The study found that just 65 counties nationwide had fully recovered, and roughly 60% were in Texas and North Dakota, the home of some of the most prolific oil shale in the country. The industry has once again become a significant part of the economy, amounting to a near-$1.2 trillion-dollar-per-year industry representing over 9 million permanent jobs.
Unfortunately, these fat years for the oil and gas industry are now facing daunting headwinds in the form of a massive oil glut. The production surge I just laid out has been great for American energy independence, and also for a time has reinvigorated important sectors of our economy, in addition to positive ripple effects for retail and other tangential sectors in boom towns in North Dakota, Texas, and elsewhere. But America’s refinery and petrochemical base is simply unequipped to process this tidal wave of oil fast enough.
If you look at crude storage in the United States over the past several months, particularly in the pivotal Gulf Coast and Cushing, Oklahoma, crude storage regions, you might as well be looking at the much-touted hockey stick chart. These regions play home to the vast majority of our country’s storage capacity, and they also have the most impact on the U.S. crude price benchmark, WTI.
An Embarrassment of Riches
The Gulf Coast is America’s factory for gasoline, diesel, and most of the other things we make using oil. There is plenty of storage nearby for use as needed. Now think of Cushing as the reserve fuel supply. The town consists almost entirely of miles and miles of huge storage tanks, and recent pipeline expansions have connected the two points extremely well.
Cushing became jammed up to record levels a few years ago, but it was no big deal, because at the time Gulf Coast storage was comparatively low, so that regional glut was able to eventually work its way down to the Coast, being drawn down as needed.
Today, Cushing has once again glutted, surpassing even the record levels of 2013, except this time Gulf Coast stocks are also at all-time highs. This imbalance between supply and demand forced U.S. crude prices to implode, falling nearly 60% from their highs last June and marking the biggest crude sell-off since the Great Recession. While prices have stabilized for now, most experts expect U.S. storage capacity limits to be heavily tested in the coming months, and if Cushing is capped, the bottom is likely to fall out of oil prices yet again.
This massive oil price decline has worked wonders on the price of gasoline, and the common wisdom would suggest this is doing great things for the economy. So what’s the problem? While the jury is still out on what cheaper transportation fuels will mean for America in the longer term, there are two dynamics that are casting doubt on the trend as an additional spur for the economy going forward.
First, the huge oil price drop has made drilling in most of the country uneconomical, and is gutting the oil and gas industry. Recall that the advent of the shale boom for oil roughly coincided with the worst of the depths of the Great Recession, and that the U.S. has averaged moderate to low single-digit growth since emerging from the downturn. On the whole, the CME Group’s chief economist estimates that the shale boom has added between one half and one percentage point to GDP growth per year.
Playing those numbers against the backdrop of the moderate recovery suggests that on average from quarter to quarter, the industry may have accounted for anywhere from 10% to as much as the entirety of U.S. GDP growth. During the boom, the industry created hundreds of thousands of jobs (oil hub Houston alone added 100,000 new jobs every year since 2011 according to the University of Houston), and it is fair to say that this was an integral part of speeding America’s recovery.
This growth has now rapidly deteriorated and reversed — as of the end of Q1, independent oil major producer Continental Resources calculates sector-wide industry job losses at around 91,000 jobs cut since December. Given that we are still in the early days of the new price paradigm, additional damage to the industry is very likely. Moody’s estimates that net losses in the U.S. mining sector — which includes oil and gas — will come in at 37,000 more jobs lost over the next two quarters, although about half of that sum is expected to be recouped by early next year.
"Okay, that’s awful," you might say, "but doesn’t the broader benefit of cheap gasoline to the economy as a whole more than make up for that damage?" Not necessarily…
Cheap Gas Is No Economic Panacea
First let’s consider the impact at the individual level. Cheap gas means people should be spending more on other things, boosting demand and leading to job creation, right? Not necessarily. The change in oil price does not carry fully through to the consumer at the pump (more on this later).
Of what’s left, real disposable income is trending higher for U.S. consumers — up 0.4% and 0.5% respectively in January and February, but flat in March according to the Commerce Department; and most of that is going into savings. The U.S. savings rate hit a two-year high in February at 5.7%. While this will be good for individuals later, and is nice for bankers, it doesn’t do much for direct economic growth today.
March job numbers also supported the idea that cheap fuel is not a cure-all for the economy. Non-farm payrolls grew by just 126,000 jobs, the weakest jobs number since December 2013 and less than half of average monthly job creation over the past 12 months. A good portion of underperformance was related to losses in the oil and gas industry.
These figures suggest that, if you want to wait tables for a living, the sky now appears to be the limit. Meanwhile, we are seeing rampant destruction of great middle class jobs often paying $75,000 to $150,000 per year without an advanced or even bachelor’s degree. What does this do to the American Dream, to the already devastated middle class, to spending power, and ultimately to long-term economic growth? If we could create these low-level jobs while maintaining a healthy middle class, that would be wonderful. But right now, cheap gas appears to actually be doing more harm than good.
Now, enter Keystone. It would admittedly add to energy security. But given the damage to the very important oil and gas industry, and potentially to the broader economy, is this really a situation we want to exacerbate by pumping nearly one million barrels of foreign oil per day — oil which America did not produce and which does not benefit the domestic oil and gas industry I might add — to the glutted Gulf Coast?
Granted, the project would take several years to build, but it also seems likely that this industry-specific downturn will last for quite some time. Eventually we will see prices recover, along with jobs, although probably not in the numbers we saw last cycle.
But adding Keystone into the mix, that recovery could be derailed as even more oil floods the region. So when we consider the broader economic backstory, suggesting we should be in favor of Keystone because it creates jobs, we need to weigh those 4,000 construction jobs (plus some unspecified number of jobs to manufacture the remaining pipe) against delaying a recovery of hundreds of thousands of jobs perhaps indefinitely. That choice smacks as uninformed at best and dishonest at worst. So why on earth are we still hearing about this?
Having examined the political, economic, and market implications of the Keystone project, in tomorrow’s issue, our guest commentator determines which companies will be the winners and losers if the project goes forward, giving Money Morning readers a unique opportunity to position themselves to profit.