by mark laskin, chief investment officer - bp capital · pdf fileby mark laskin, chief...

Dispatch Curve by Mark Laskin, Chief Investment Officer

BP Capital Fund Advisors | 8117 Preston Road Suite 260W Dallas TX 75225 | www.bpcfunds.com

Summary

Since OPEC assumed the leading role in managing oil markets in the 1970s, the market looked to Saudi

Arabia as the leading oil producer within OPEC for signs that might influence future changes in oil prices.

However, the structure of the global oil market changed significantly when OPEC opted not to cut

production in November of 2014. More specifically, the decision marked a profound change by Saudi

Arabia to cede “control” of the market to market forces, instead of joining with other OPEC nations to

collectively manage changes in price. Global markets are still wrestling with this change in policy, and

are assuming that Saudi’s current actions still reflect the previous global construct. In this white paper

we outline the new market construct from the Saudi perspective, as well as its causes and impacts.

A New Framework

Undoubtedly the oil market was surprised by the November 2014 OPEC decision not to cut oil production,

allowing an already oversupplied oil market to remain so. Since its formation in the 1970s, OPEC has

increased and decreased production in an attempt to manage cyclical and seasonal price volatility.

However, in November 2014, and with increasing rhetoric since, Saudi Arabian oil officials have stressed

that market forces should determine global production levels and OPEC would not intervene. As a result

of the November 2014 decision, the price of West Texas Intermediate has fallen from more than

$70/barrel before the decision to a low of $26/barrel.

The change in stated Saudi Arabian policy has caused significant debate within OPEC itself and among

global oil market participants. Since the new strategy reverses over 40 years of practice, Saudi motives

and goals have come under question. Is Saudi Arabia trying to regain market share from global oil

producers? Is Saudi Arabia using oil as a geopolitical tool to economically impact other Middle Eastern

neighbors? Is Saudi Arabia trying to force US shale producers out of business?

In the weeks and months since the November 2014 decision, Saudi comments have remained consistent.

At BPCFA, the answer has become clear. To the Saudis, the decision came down to one factor – pure

economics. As the global oil market moved from being undersupplied to oversupplied, the Saudis and

OPEC had a decision to make. To cut production to balance the market, or to continue producing and let

market forces work to balance the market. Their decision to maintain production levels has had, and will

continue to have painful short-term ramifications. It will take longer to reach a supply/demand

equilibrium than had OPEC cut production, but the end result will be a healthier long-term oil market.

Dispatch Curve

BP Capital Fund Advisors | March 2016

So, if the decision not to cut production was based on economics, it becomes important for us to frame

the “new” economic framework in order to understand the impact. Increasingly, the example of the

deregulated power markets in the United States serves as a relevant framework to help understand the

Saudi thought process.

In deregulated power markets in the United States, at any given time power plants that are available to

provide power are ranked by cost and volume. Every hour, demand is met by the appropriate amount of

power, and the cost of the power plant that acts as the marginal power plant becomes the price of power

for all of the running power plants in that hour. Each power plant is incentivized to run at full capacity,

but only if the price offered exceeds the cost. This concept is known in power markets as a “dispatch

curve”, whereby power plants are “dispatched” to produce power by market forces.

More specifically, as seen in a representative Florida dispatch curve (Figure 1), at any given time a

particular power plant will reside in a given place in the dispatch curve due to idiosyncratic factors. For

example, nuclear power plants generally reside toward the lower end of the dispatch curve, due to their

low operating costs. Within the spectrum of nuclear plants, differences in engineering design can cause

plants to have slightly different cost structures, but in most cases nuclear plants have advantaged

Figure 1 - Example of a typical power plant dispatch curve

Source: Prof Liza Moyer, University of Chicago

Dispatch Curve


operating costs when compared to other types of power plants. As a result, nuclear plants are generally

economically incentivized to run at full power at all demand levels. In most demand environments, coal

plants are similarly incentivized to run. However, the demand curve typically intersects the supply, or

“dispatch” curve in the natural gas (Combined Cycle Gas Turbine, CCGT) plant portion of the curve. That

means that market demand will dictate whether a particular natural gas plant should run or sit idle in a

given hour. Importantly, a natural gas power plant can turn on and off more quickly than a nuclear or

coal plant. Therefore, in the framework of a dispatch curve, the characteristics of natural gas plants play

an important role both from a marginal cost and a time-to-dispatch perspective. The ability of the next

highest marginal cost plant to turn on and off quickly is critical to the dispatch curve working efficiently.

As we relate the dispatch curve framework to oil markets, it is important to put the development of US

shale drilling in the context of the global oil market. There are two important attributes of US shale

production that are important. First is scale. US shale production is approximately 5 million barrels per

day in a 95 million barrel per day global market. Second is the rapid pace of production decline that

occurs for each well soon after production begins. Whereas conventional wells’ production rates decline

approximately 5% per year, the average decline in production for a US shale well is approximately 70% in

the first year, and 25-30% every year thereafter. The combination of these factors means that US shale

production has become large enough to matter in global markets. Additionally, if price signals are

negative, US shale production will fall because fewer new wells will be drilled or completed to offset the

significant declines of already producing wells.

With the framework of a global oil dispatch curve in mind, let’s reconsider the November 2014 decision

of OPEC, and more specifically Saudi Arabia, in this context. Saudi Arabia produces approximately 10

million barrels of oil daily, and is among the lowest cost producers in the world. For decades Saudi

production has maintained these same attributes. So the question facing oil markets is “why would the

Saudis act differently this time compared to any other?”

Ironically, the answer may not be found in the Saudis themselves. Instead, the evolution of the profile of

global production provided a market that better matches that of a global oil “dispatch curve”. In that

context, Saudi’s role is analogous to that of a nuclear power plant. Capable of producing large volumes at

low cost Saudi is one of, if not the most, economically viable producer in the world. Importantly, the role

of US shale production is similar to that of natural gas power plants – marginal on the cost curve and able

to “dispatch” on a shorter time horizon than other types of production. Taking the power market analogy

a step further, the Saudis should act like nuclear power plants and produce at full capacity, and marginal

producers should respond according to price signals to increase or decrease production, as shown in

(Figure 2).

Dispatch Curve


Repeated comments from the Saudis echo this framework. Two in particular highlight the change in

philosophy to a dispatch curve framework. At the CERAWeek conference in February 2016, Saudi oil

minister Ali Ibrahim Al-Naimi was quoted as saying:

In this statement, al-Naimi is unequivocally stating that the Saudis are well positioned as a low cost oil

producer and will not uneconomically reduce production, to benefit higher cost producers. This is in

complete alignment with the concept of the dispatch curve. He goes on:

This comment illustrates that Saudi has no intent as to which specific producers will lose market share,

which is consistent with the dispatch curve thought process. Many analysts in the United States have

understandably viewed the Saudis’ change in philosophy to be a global oil market share war against US

shale producers, since Saudi production has increased significantly since November 2014, as seen in

(Figure 3).

Source: Prof Liza Moyer, University of Chicago, BPCFA

Figure 2 – Dispatch Curve representing oil and gas production

“Inefficient, uneconomical producers will have to get out. This is tough to say, but that is a fact.”

“We have not declared war on shale or on production from any given country or company,

contrary to all the rumors you hear and see”

Dispatch Curve


As a result of increased Saudi production, the oil price continued to fall, as seen in (Figure 4).

With the negative price signals, US shale producers reduced activity as seen in the falling horizontal rig

count data in (Figure 5), and US onshore crude oil production eventually peaked in June 2015 as seen in

(Figure 6).

Source: Bloomberg

Figure 3 – Saudi Arabian crude oil production

Source: Bloomberg

Figure 4 – Price of West Texas Intermediate

Dispatch Curve


Both of these comments illustrate that the Saudis are acting on economics alone and are not targeting

any one country or producer. While geopolitical advantage may also come within this framework, since

Saudi Arabia is most advantaged by the pure economics of the dispatch curve, the thought process is first

and foremost economically motivated at its core.

Source: Bloomberg

Figure 5 – Active Horizontal Drilling Rig Count

Figure 6 – United States Lower 48 Crude Oil Production

Source: Bloomberg

Dispatch Curve


Perspective Applied

So if the dispatch curve framework is true, what does it mean for crude oil markets going forward?

First and foremost, the implication of the dispatch curve framework is that the Saudis will do everything

possible to maintain production at or near full capacity, and force those closer to the marginal

price=marginal cost threshold to act in a rational economic manner, and increase or decrease production

according to price signals. In the near term, since production cannot quickly adjust in accordance with

seasonal changes in demand, inventories will act in the manner that the word would imply – as needed

to balance short term supply and demand. While that seems intuitive, historically seasonal supply and

demand imbalances were traditionally buffered to some degree by seasonal Saudi production. If the

seasonality Saudi production were to wane, then the range of seasonal injections and withdraws from

inventories could increase, surprising the market until a pattern becomes clearer.

Over the next few years, US shale will play the role of marginal supplier of oil in order to meet demand.

However, each year, producing wells’ production declines, and without stronger long term price signals,

investment in new production with low decline rates will not be sufficient. As a result, the price will have

to increase to a level not only to incentivize less efficient basins within US shale production, but also to

incentivize investment in long term production. Figure 2 shows how close 2015 global demand is to the

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Total Production, mbpd

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US Tier 3 & Tier 4

Source: BP Statistical Review, IEA, BPCFA

Figure 2 - 2015 Global Oil Supply/Demand (Dispatch Curve Framework)

Dispatch Curve


low cost tier of US shale production. Over time, as global demand increases, the ability of US shale to

meet increased demand diminishes, and higher and longer prices will be needed for some time to

incentive investment in new sources of production. This explains why the construct of a dispatch curve

is an appropriate framework for the Saudis to use to maximize their economic value, even if in the short

term it may seem counterintuitive.

(Figure 8) shows that small changes in global oil supply and demand can greatly impact the price of oil

required to balance the market. In this case, our 2016 year end estimates for global supply and demand

move the intersection of supply and demand from a low-cost plateau to one that represents a much

higher warranted price.

Why wasn’t this framework used in the 1980s, when OPEC cut production significantly in an attempt to

balance supply and demand?

While the Saudis have stated a profound change in their thought process, a fundamental question persists

– why now? Why wasn’t this same framework used in the 1980s, when over the period from 1980-1986,

the Saudis reduced production from 10 million barrels/day to a trough of 4 million barrels/day as part of

coordinated OPEC production cuts?


Figure 8 - 2016 Estimated Global Oil Supply/Demand (Dispatch Curve Framework)

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OPEC Gulf Coast Countries

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US Base Production

US Tier 2

US Tier 3

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Dispatch Curve


There was one major difference between the 1980s and the more recent past. The difference is not in

the Saudis themselves, but in the profile of production at the intersection between the price and marginal

supply. In the late 1970s and into the 1980s, global supply and demand were approximately 60 million

barrels/day. During the course of the late 1970s into the early 1980s, approximately 12 million barrels of

new supply came into the market from 4 regions - the Alaskan North Slope, the North Sea, the Mexican

project called Cantarell, and deep water Gulf of Mexico. Since all of these projects have very low

production decline curves and combined to cause significant excess supply on a global basis (Figure 9),

the Saudi decision to reduce production was an appropriate reaction to balance supply and demand to

achieve as high a price as possible. However, since global oversupply approximated 20%, Saudi efforts to

balance global supply and demand proved to be ineffective, with the Saudis ceding market share to other

global producers. With that backdrop, the Saudi response was appropriate from an economic perspective

and the Saudis resumed production at close to 10 million barrels/day, sending oil markets into a 20 year

period of low prices and underinvestment which lasted until the 21st century.

Figure 9 - 1985 Global Oil Supply/Demand (Dispatch Curve Framework)


ME OPEC

OPEC Spare Capacity

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Soviet Union

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Dispatch Curve


Conclusion

In order to avoid the fate of an extended low price environment as was the case starting in the mid-

1980s, the Saudi reaction to recent global oil oversupply was appropriate and economic in nature. As a

result, the global oil market will be better positioned to balance supply and demand sooner than it was

during the cycle starting in the 1980s, and will lead to more short term oil price volatility as the market

digests the implications of the Saudi response. Over the intermediate and longer term, the oil market

will require higher prices than those present today in order to incentivize investments in long term oil

supplies. The framework of a slow moving dispatch curve similar to power markets helps BPCFA

understand the unrest in oil markets caused by the Saudi Arabian reaction to the global oversupply of

oil.

Important Disclosures

The views in this material are intended to assist readers in understanding certain investment methodology

and do not constitute investment or tax advice. Please consult your tax advisor. The views in this material

were those of the author as of the date of publication and may not reflect their view on the date this material

is first published or any time thereafter.

As with any mutual fund, it is possible to lose money by investing in the Fund. Energy-related companies

are subject to specific risks, including, among others, fluctuations in commodity prices and consumer

demand, substantial government regulation, and depletion of reserves.

Investors should consider the investment objective, risks, charges, and expenses of the BP Capital TwinLine®

Energy Fund carefully before investing. A prospectus with this and other information about the Fund may be

obtained by calling 1-855-40-BPCAP (1-855-402-7227). Read the prospectus carefully before investing.

Shares of the BP Capital TwinLine® MLP Fund are distributed by Foreside Fund Services, LLC, not affiliated

with BP Capital.

by mark laskin, chief investment officer - bp capital · pdf fileby mark laskin, chief...

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