An Interview With John Hofmeister, Former President of Shell Oil

David Fessler
by David Fessler, Energy & Infrastructure Strategist, The Oxford Club

David Fessler: Today, I'm interviewing John Hofmeister, the former president of Shell Oil Company. John and I spoke a few years ago about energy prices. Upon his retirement from Shell Oil Company in 2008, John founded and heads the not-for-profit Citizens for Affordable Energy. This Washington, D.C.-registered public policy education firm promotes sound U.S. energy security solutions for the nation. These include a range of affordable energy supplies, efficiency improvements, a central infrastructure, sustainable environmental policies and public education on energy issues. As Shell president, John started an extensive outreach program. This was an unprecedented effort in the energy industry. The goal of the program was the discussion of critical global energy challenges. Covering 18 months, this 50-city tour took John and 250 other Shell leaders across the U.S. They met with over 15,000 community, civic and business leaders, academics, and policymakers. The goal of the meetings was to determine the steps America needs to take to ensure affordable, available energy for generations to come.

John, I'd like to dig into the meat and potatoes of where oil prices are going, but first, let's take a step back and head up to 50,000 feet. Do you think this is a classic supply/demand situation, or are the Saudis protecting their own interests at the expense of the U.S. and Russia and other producers as well?

John Hofmeister: Well, I think it's a combination, and I do think the expense is also on the Saudis because this is causing them to rely upon their savings, basically, which, of course, we've paid for over many years, but this is costing everybody money, but it is actually a supply surplus that came about through the lack of demand growth that was expected in the 2014 time frame. Here's what I mean: companies make major capital decisions to invest in new production over a long period of time, and as the companies – state-owned oil companies as well as major oil companies and independent oil companies – looking in the 2012, '13, '14 time window, came to a conclusion that demand growth would grow by "X," roughly 3% per year. But it did not. In other words, global economic growth was weaker than was projected two or three years ago, but yet, the companies had already invested the capital to increase production, expecting consumer demand or, ultimately, global demand at about the 93 million to 94 million barrel level, when actually, the demand is actually closer to 92 million.

David Fessler: Sure.

John Hofmeister: And so we have this extra built-in capacity, and we came to realize that about halfway through 2014, when China's growth, India's growth, just wasn't going to meet what was expected, and it looked like we were about a million barrels a day surplus by mid-year. That was aggravated by a lot of financial companies liquidating their hard asset holdings of oil through the summer. Seeing that the price was likely to drop with the surplus oil, they started liquidating hard oil assets, so we got more oil put into a market that was already in surplus, and we ended up with somewhere between 1 million and 1 1/2 million barrels a day of too much oil. And once the traders get a hold of that, then they're going to try to match buyer and seller with – [laughs] – with volatility, is the kind way to say it, but with aggressive lower pricing so they can keep selling oil, 'cause that's what they do. And so that drove the price down, the prices, way too low for normal equilibrium, and dropping 50%, 60% over about a 1% overage or 1% disequilibrium is really dramatic, and –

David Fessler: Yeah, that was my thought. I just think it was a big overshoot here, and I'm of the opinion that oil prices are at or near their lows, and I've been telling my subscribers the selling in the markets is way overdone, as you just mentioned. Additionally, I believe the exploration and production companies are overdoing it with regard to cutting back on new well drilling. Now, clearly, some of them are being forced to cut back because they don't have the capital to continue, but even some of the larger producers are hanging back too, and I'd like to get your thoughts on this.

John Hofmeister: Well, there's no industry that knows how better to cut costs than the oil and gas industry. They've done it frequently enough that they know that the safest way to protect themselves is to slam the door on money going out. Keep it inside. That means shut down rigs, cancel capital spending plans, lay off people and cut expenses on the normal flow of business. Cut travel, freeze wages, et cetera. So I saw today, BP is freezing wages, and so the way in which the companies can cut costs is dramatic, and they're not going to fool around. They see what the Saudis are doing, they see that Saudis are going for market share, and the Saudis are willing to eat some of their savings, that they don't know how long this will last. They're going to cut costs as hard and as fast as they can, regardless of the consequences. Because this is an interruption in the normal business cycle plan, they're going to adjust quickly to the changing circumstances on behalf of their shareholders, and I think they're going to – yes, we've overshot on the low end of the price and I think we're going to overshoot on cutting costs, and so we're in for more volatility, which is why I think prices will rise as we get into the second half of the year.

David Fessler: Okay, so you think – that was going to be my next question: When do you think prices will begin to reverse and head back up? And you think it's the second half of this year, which is my thought as well. I think it's going to take six months of volatility here and more overshoot and cost cutting, and then we're going to see a reversal, and what do you think the – do you think they're going to head back up as fast as they went down?

John Hofmeister: Or faster. Or faster. The reason is, we're so good at cutting costs. You know, we're going to have, like, 500 rigs shut down by the end of this month from last October. There'll probably be another 200 to 300 rigs shut down in February and March, and nobody's going to bring those rigs back up until they have some security that the rise in the oil price will last for a period of time. Because they don't want to go through this again two years, three years from now, and so they will withhold spending money until they really have to get out there, or somebody else is going to take their place. And so what I see happening, and what most of the observers fail to ever mention, is the natural decline rate in 2015 will cost us 5 million barrels of production a year – I mean, a day. 5 million barrels a day by the end of the year.

David Fessler: This is from unconventional wells.

John Hofmeister: Well, from conventional and unconventional. In other words, the conventional wells will decline at the rate of 4% to 5% per year on a per-barrel basis, and the unconventional will decline at 30% to 40% per year, and what we end up with is by June or July, I think we're going to see production growth come to a screeching halt for the most part. That will eat away the current oversupply of oil in the July-August-September time frame, and so we're going to see, in the fall, rapidly spiking prices that will take us back by, say, early next year – early 2016 – take us back to where we were in June of 2014, which is Brent over 100 and WTI, high 90s, near 100, something like that.

David Fessler: Yeah, now, do you do –

John Hofmeister: Then, depending upon when the companies start to reinvest again and gear up, it's going to be another year before we see the impact of new production when we start to gear back up.

David Fessler: Sure, because it's going to take a while to gear back up and take all those rigs and redeploy them. Do you think there's going to be a specific trigger to all this, or do you think it's just going to happen over time, all of a sudden, one day, the traders are going to say, "Man, we've – we don't have any extra now, and supply and demand equalized all of a sudden."

John Hofmeister: Right, the traders will notice it first, but keep in mind, there will be a little bit of surplus hedge in the sense that some of the financial buyers are no doubt storing oil now for the upside. So there are people –

David Fessler: Interesting.

John Hofmeister: – buying low today, filling up supertankers, and holding them so, if the price starts to rise, they will be judicious as to when they sell their current stored oil. And so I don't think we will have – I think they will take advantage of the rapid rise in oil prices, and so there will be a little bit of a cushion there in terms of supply, but not much. That'll be eaten off in a matter of weeks or month or two, and so what we're going to be looking at is the new production required to meet what is still increasing demand. Let's not forget: in addition to the declines that are taking place in existing fields, we're seeing growth in demand. Even if it's not as robust as we thought it might have been, it's still going to be pretty close to maybe 900,000 to 1 million barrels a day of new oil demand with the decline. So we're going to see a shortfall of probably a couple million barrels a year from now, and that's –

David Fessler: Yeah, you know –

John Hofmeister: – going to spike the price.

David Fessler: I think that's lost on a lot of folks. You know, the Chinese and Indian middle classes are buying vehicles at record rates, and when do you see this building a floor under the global demand? I mean, when it's going to start increasing, or do you think that's happening as we speak?

John Hofmeister: It's not happening yet because we still are seeing slight increases in production, even as rigs are getting shut down. So we have to see the – somewhere along the line here, the shutting down of rigs will impact future production, but I could see this sort of reaching an equilibrium where supply and demand are about equal by around June or July of this year.

David Fessler: Okay.

John Hofmeister: And that will be assurance that we'll start to see prices go back up.

David Fessler: Okay. Well, John, I appreciate your insights on that. Let's switch gears just for a second. I'm a big fan of natural gas as a transportation fuel, and I know you are. Every time gasoline prices retreat, talk of natural gas as a transportation fuel gets put on the back burner, no pun intended. With as much natural gas as we have – and l live in Pennsylvania, where we have the Marcellus – and as cheap as it is, why aren't we making more progress transitioning to it? Do we have to live it up, so to speak, on oil production before that happens?

John Hofmeister: I think we're going to need a crisis. I'm sorry to say that, but the only way to move the political system in the United States of America to help enable this to happen is in the face of a crisis. And here's the crisis: the crisis will be $5 a gallon gasoline in the 2017 to 2018 time frame because there's just not going to be enough oil in the world to meet the growing demand. Remember, by 2020, we're going to need 100 million barrels a day of oil to meet the demand. Most people agree with that statistic. A hundred million barrels by 2020. What we don't know how to do is get from 93 million to 100 million. We know how to produce 93 million; we don't know how to get the next 7 additional million barrels a day. Nobody's plans have that baked in. So as we go through the 2017 to 2018 timeframe, so 2017, 2018, and the price keeps rising, we don't seem to be able to catch up with the price rises. That's going to create the crisis at the pocketbook, which will finally, I hope, drive these politicians – now, I hope it's a year earlier. I hope that the candidates for president in 2016, both the Democratic and the Republican candidates, have to explain to the nation, "Why have prices risen so much, and what have you done about it?" Because I submit that they will have done nothing between now and 2016 on the natural gas front or on the oil front to help move the nation to more security. And so you're absolutely correct that the answer is natural gas, whether it's CNG or LNG for trucking, whether it's ethanol or methanol for natural gas for personal vehicles, automobiles, we should be moving at record speed to build the infrastructure, to build the capability, to switch from oil to natural gas, because there's just not going to be enough oil, as we move towards the end of this decade, to satisfy the world, and why should we be victimized by high oil prices when we, as a country, have so much natural gas, we don't even know how much we have? Because the number keeps inflating, keeps rising, because we keep finding ways to produce more and more and more. And it's going to be cheaper than oil for decades to come. So it's shame on us if we don't get behind the natural gas as an alternative fuel to oil as rapidly as we possibly can, and there's no time like the present to begin that process.

David Fessler: Yes, what seems patently obvious to some of us, just it doesn't seem – it isn't even on the politicians' radar screens, and I know you're frustrated by that, and I'm sure a lot of others are as well. John, I'd like to –

John Hofmeister: I blame both parties. Both parties. They're both – you know –

David Fessler: Yeah, I agree. There's no – they're both at fault. It's the U.S. political system, and that's – you and I could talk about that for hours on end. John, I'd like to thank you for joining me today and for providing us with your insights on the oil and gas sectors, and I look forward to speaking with you again soon.

John Hofmeister: I look forward as well. Thank you.

David Fessler: That was John Hofmeister, founder of Citizens for Affordable Energy and former president of Shell Oil. I'm Dave Fessler, Editor of Advanced Energy Strategist. If you have any thoughts or comments on today's interview with John, you can email me at mailbag@oxfordclub.com. Thanks for listening.

Do you agree with John? Give us your thoughts on where oil is heading below.

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