The Basics Petroleum Economics

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The Basics of Oil Gas Economics

• Dr Aloys Rugazia (PhD)
• Email aloys.rugazia_at_afrifalegalconsultants.com

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Introduction

• To understand oil economy it is important to
  understand the following basic concepts in the
  energy sector and Market.
• Energy sources include
• (i) Solar Energy
• (ii) Biofuels.
• (iii) Wind Energy.
• (iv) Biomass
• (v) Water and geothermal.

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• Solar energy radiant energy emitted by the sun.
• Solar energy is created by nuclear fusion that
  takes place in the sun. Fusion occurs when
  protons of hydrogen atoms violently collide in
  the suns core and fuse to create a helium atom.
• Solar energy is constantly flowing away from
  the sun and throughout the solar system. Solar
  energy warms the Earth, causes wind and weather,
  and sustains plant and animal life.

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• Solar energy is a renewable resource, and many
  technologies can harvest it directly for use in
  homes, businesses, schools, and hospitals.
  Some solar energy technologies include photovoltai
  c cells and panels, concentrated solar energy,
  and solar architecture.There are different ways
  of capturing solar radiation and converting it
  into usable energy. The methods use either active
  solar energy or passive solar energy.

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• Photosynthesis is also responsible for all of
  the fossil fuels on Earth. Scientists estimate
  that about 3 billion years ago, the
  first autotrophs evolved in aquatic
  settings. Sunlight allowed plant life to thrive
  and evolve. After the autotrophs died, they
  decomposed and shifted deeper into the Earth,
  sometimes thousands of meters. This process
  continued for millions of years.Under intense
  pressure and high temperatures, these remains
  became what we know as fossil fuels.
  Microorganisms became petroleum, natural gas, and
  coal.People have developed processes for
  extracting these fossil fuels and using them for
  energy. However, fossil fuels are a nonrenewable
  resource. They take millions of years to form.

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• Oil resources are not as extensively distributed
  worldwide as coal, but oil has crucial
  advantages.
• Fuels produced from oil are more ideal for
  transportation.
• They are energy-dense, averaging twice the energy
  content of coal, by weight. But more importantly,
  they are liquid rather than solid, allowing the
  development of the internal combustion engine
  that drives transportation today.

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Different fuels carry different amounts of energy
per unit of weight.  Fossil fuels are more energy
dense than other sources. 
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• the British and American navies switched from
  coal to oil prior to World War I, allowing their
  ships to go further than coal-fired German ships
  before refueling.
• Oil also allowed greater speed at sea and could
  be moved to boilers by pipe instead of manpower,
  both clear advantages.
• During World War II, the United States produced
  nearly two-thirds of the worlds oil, and its
  steady supply was crucial to the Allied victory.

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• Natural gas, a fossil fuel that occurs in gaseous
  form, can be found in underground deposits on its
  own, but is often present underground with oil.
• Gas produced with oil was often wasted in the
  early days of the oil industry, and an old
  industry saying was that looking for oil and
  finding gas instead was a quick way to get fired.
  
• In more recent times, natural gas has become
  valued for its clean, even combustion and its
  usefulness as a feedstock for industrial
  processes.
• Nonetheless, because it is in a gaseous form, it
  requires specific infrastructure to reach
  customers, and natural gas is still wasted in
  areas where that infrastructure doesnt exist.

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• Electricity is not an energy source like coal or
  oil, but a method for delivering and using
  energy.
• Electricity is very efficient, flexible, clean,
  and quiet at the point of use. Like oil,
  electricitys first use was in lighting, but the
  development of the induction motor allowed
  electricity to be efficiently converted to
  mechanical energy, powering everything from
  industrial processes to household appliances and
  vehicles.
• the energy system transformed from one in which
  fossil energy was used directly into one in which
  an important portion of fossil fuels are used to
  generate electricity. The proportion used in
  electricity generation varies by fuel.
• Because oil an energy-dense liquid is so
  fit-for-purpose in transport, little of it goes
  to electricity in contrast, roughly 63 of coal
  produced worldwide is used to generate
  electricity.

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• Methods of generating electricity that dont rely
  on fossil fuels, like nuclear and hydroelectric
  generation, are also important parts of the
  system in many areas.
• However, fossil fuels are still the backbone of
  the electricity system, generating 64 of todays
  global supply.

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Fossil fuels still dominate global electricity
generation
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• Transitions through history has not just been
  about moving away from current solar flows and
  toward fossil fuels. It has also been a constant
  move toward fuels that are more energy-dense and
  convenient to use than the fuels they replaced.
• Greater energy density means that a smaller
  weight or volume of fuel is needed to do the job.
  Liquid fuels made from oil combine energy density
  with the ability to flow or be moved by pumps, an
  advantage that opened up new technologies,
  especially in transportation. And electricity is
  a very flexible way of consuming energy, useful
  for many applications.

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• The advantages of fossil fuels come with a
  devastating downside. We now understand that the
  release of carbon dioxide (CO2) from burning
  fossil fuels is warming our planet faster than
  anything we have seen in the geological record.
• However, unlike fossil fuels, wind and solar can
  only generate electricity when the wind is
  blowing or the sun is shining. This is an
  engineering challenge, since the power grid
  operates in real time Power is generated and
  consumed simultaneously, with generation varying
  to keep the system in balance.

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• Wind turbines and solar photovoltaic (PV) cells
  convert solar energy flows into electricity, in a
  process much more efficient than burning biomass,
  the pre-industrial way of capturing solar energy.
  
• Costs for wind and solar PV have been dropping
  rapidly and they are now mainstream,
  cost-effective technologies. Some existing forms
  of generating electricity, mainly nuclear and
  hydroelectricity, also dont result in CO2
  emissions.
• Combining new renewables with these existing
  sources represents an opportunity to decarbonize
  or eliminate CO2 emissions from the
  electricity sector. Electricity generation is an
  important source of emissions, responsible for
  27 of U.S. greenhouse gas emissions in 2018.
• However, unlike fossil fuels, wind and solar can
  only generate electricity when the wind is
  blowing or the sun is shining. This is an
  engineering challenge, since the power grid
  operates in real time Power is generated and
  consumed simultaneously, with generation varying
  to keep the system in balance.

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THE ADVANTAGES OF FOSSIL FUEL OVER OTHER SOURCES
OF ENERGY

• Industrial processes that need very high heat
  such as the production of steel, cement, and
  glass . The steel blast furnaces operate at about
  1,400 C. These very high temperatures are hard
  to achieve without burning a fuel and are thus
  difficult to power with electricity.
• Renewable electricity cant solve the emissions
  problem for processes that cant run on
  electricity. For these processes, the world needs
  zero-carbon fuels that mimic the properties of
  fossil fuels energy-dense fuels that can be
  burned.
• Biofuels also compete for arable land with food
  production and conservation uses, such as for
  recreation or fish and wildlife, which gets more
  challenging as biofuel production increases.
  Fuels made from crop waste or municipal waste can
  be better, in terms of land use and carbon
  emissions, but supply of these wastes is limited
  and the technology needs improvement to be
  cost-effective
• Another pathway is to convert renewable
  electricity into a combustible fuel. Hydrogen can
  be produced by using renewable electricity to
  split water atoms into their hydrogen and oxygen
  components. The hydrogen could then be burned as
  a zero-carbon fuel, similar to the way natural
  gas is used today.
• However, when we split water atoms or create
  liquid fuels from scratch, the laws of
  thermodynamics are not in our favor. These
  processes use electricity to, in effect, run the
  combustion process backwards, and thus use large
  amounts of energy. Since these processes would
  use vast amounts of renewable power, they only
  make sense in applications where electricity
  cannot be used directly.

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Gasoline carries much more energy per unit of
weight than a battery. A gas-powered car with a
12.4-gallon tank carries 77.5 pounds of gasoline
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• Carbon capture and storage or use is a final
  possibility for stationary applications like
  heavy industry. Fossil fuels would still be
  burned and create CO2, but it would be captured
  instead of released into the atmosphere.
• Processes under development envision removing
  CO2 from ambient air. In either case, the
  CO2 would then be injected deep underground or
  used in an industrial process.

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• The most common use for captured CO2 today is in
  enhanced oil recovery, where pressurized CO2 is
  injected into an oil reservoir to squeeze out
  more oil.
• The idea of capturing CO2 and using it to produce
  more fossil fuel seems backwards does that
  really reduce emissions overall?
• But studies show that the captured CO2 stays in
  the oil reservoir permanently when it is injected
  in this way. And if enough CO2 is injected during
  oil production, it might make up for the
  combustion emissions of the produced oil, or even
  result in overall negative emissions. This wont
  be a panacea for all oil use, but could make oil
  use feasible in those applications, like
  aviation, where it is very hard to replace.

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• In addition to the engineering challenges, the
  nature of climate change makes it politically
  challenging to deal with as well.
• Minimizing the impact of climate change requires
  re-making a multi-trillion-dollar industry that
  lies at the center of the economy and peoples
  lives. 
• In the wealthy world, current efforts focus on
  reducing the greenhouse gas emissions from our
  energy-intensive lives. But the second part of
  todays energy challenge is providing modern
  energy to the billion people in the developing
  world that dont currently have it. You dont
  hear as much about the second goal in the public
  discourse about climate change, but its crucial
  that developing countries follow a cleaner path
  than the developed world did. The need to provide
  both cleaner energy and more energy for
  developing countries magnifies the challenge, but
  a solution that leaves out the developing world
  is no solution at all.
• In other words talking of clean oil in Africa is
  like talking about animal rights in the continent.

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Is Africa ready yet?
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The Basics of Petroleum Economics in the
Sub-Saharan

• 6000 years of civilisation, Africa is still
  struggling to light its scantly distributed
  households according to the World Bank as of now
  70 of the Rural population do no have access to
  electricity.
• Petroleum products are thus used across the
  entire economy in every country.
• Oil in in particular is used in road transport to
  cater for more than 26 Million cars distributed
  across the continent.

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• Adequate and reliable supply of transport
  services of electricity are resultantly essential
  to the economy.
• Kerosene lights up 70 percent of the households
  that are out of the electricity grid. Kerosene is
  also used in cooking and heating.
• LPG (Liquified Petroleum Gas) also for cooking
  and heating.
• Gasoline and diesel for private vehicles as well
  as captive power generation.

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Oil and Gas What is it?

• The different between oil and gas is usually
  blurred.
• Fossil fuels in the liquid state is called oil,
  while those in the gaseous state is called
  natural gas.
• On the other hand, Liquefied petroleum gas (LPG
  or LP gas) is a fuel gas which contains a
  flammable mixture of hydrocarbon gases,
  specifically propane, propylene, butylene,
  isobutane and n-butane.

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Oil Prices and the economy

• Prices users pay for these petroleum products
  have macroeconomic and microeconomic
  consequences.
• At the macroeconomic level, oil price levels can
  affect the balance of payments
• gross domestic product (GDP) and,
• where fuel prices are subsidized, government
  budgets, contingent liabilities, or both.

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Oil Prices Macro- Economic Level
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Oil Prices Micro-Economic Level

• At the microeconomic level, higher oil prices
  lower effective household income in three ways.
• Households pay more for petroleum products they
  consume directly. Most poor households in
  low-income countries do not own motorized
  vehicles or electricity generators and therefore
  purchase little or no gasoline or diesel many
  people not yet connected to electricity rely on
  kerosene for lighting.
• Second, higher oil prices increase the prices of
  all other goods that have oil as an intermediate
  input. The most significant among them for the
  poor in many low-income countries is food, on
  which the poor spend a high share of total
  household expendituresoften exceeding 50
  percent. Food prices increase because of higher
  transport costs and higher prices of such inputs
  to agriculture as fertilizers and diesel to
  operate tractors and irrigation pumps.
• For the urban poor who use public transport,
  higher transport costs also decrease effective
  income.
• Third, the extent that higher oil prices lower
  GDP growth, household income is reduced.

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• Generally, petroleum product prices have
  adversely affected most economies that are not
  large net exporters of oil.
• Earlier studies showed that the countries most
  vulnerable to oil price shocks are low-income oil
  importing countries, which are disproportionately
  concentrated in Sub-Saharan Africa.

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Oil Prices Micro-Economic Level
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Oil Markets in the Sub-Saharan Region

• All productive sectors of the economy can benefit
  from an efficiently managed downstream petroleum
  sector.
• High fuel costs increase the operating costs of
  the transport sector, this in a region where
  transport costs are already high for a variety of
  other reasons.
• In the power sector, a recent publication
  identified more than 30 African countries that
  experience power shortages and regular
  interruptions to service.
• A common response to the crisis is to resort to
  diesel-based emergency power at least 750
  megawatts of emergency generation are operating
  in Sub- Saharan Africa, which for some countries
  constitute a large proportion of their national
  installed capacity.

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Market Structure

• There are two major types of oil markets-
• Concentrated Market,
• Unconcentrated Market
• A standard measure of industrial concentration is
  the Herfindahl-Hirschman index (HHI), which is
  calculated by summing the squared market shares
  of all of the firms in the industry.
• An industry concentrated if the HHI exceeds
  1,800 it is unconcentrated if the HHI is below
  1,000.

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Concentration or non concentration of the Market

• Concentration or non concentration of the market
  answers to the question of fair competition and
  non monopoly of the business
• Countries with the largest number of operators
  and are the least concentrated.
• The Niger market is the most concentrated and is
  closely followed by Malawi, Madagascar, Senegal,
  and Botswana.
• Legislative measures could thus be taken to
  promote open access to the depot capacity in
  Dakar.
• In countries like Madagascar, Malawi, and South
  Africa, the actual HHIs do not depart
  significantly from the theoretical values
  assuming equal shares by all firms, suggesting
  that the market is fairly evenly shared.

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Tea Break
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Oil Pricing

• As seen earlier the supply chain finally affects
  pricing which the affects the economy.
• Although, currency is often tied to dollar, what
  is not often said is that oil seems to have
  replaced the role of Gold ( Bretton Woods gold
  standard) in giving value to currency.
• The explanation for this relationship is based on
  two well-known premises. A barrel of oil is
  priced in U.S. dollars across the world. When the
  U.S. dollar is strong, you need fewer U.S.
  dollars to buy a barrel of oil. When the U.S.
  dollar is weak, the price of oil is higher in
  dollar terms.

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Us Dollar relationship with Oil
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• There is a hidden string that ties currencies to
  crude oil. Price actions in one venue force a
  sympathetic or opposing reaction in the other.
• This correlation persists for many reasons,
  including resource distribution, the balance of
  trade (BOT), and market psychology.
• Oil and currencies are inherently related wherein
  price actions in one force a positive or negative
  reaction in the other in countries with
  significant reserves.
• Countries that buy crude oil and those that
  produce it exchange USD in a system called the
  petrodollar system.
• The USD has benefited from crude oils
  precipitous decline since the energy sector is a
  significant contributor to U.S. GDP.
• The U.S. shifted from being a net importer to a
  net exporter of energy in 2020 and was the
  largest global producer in 2021.
• Countries that depend heavily on crude exports
  experience more economic damage than those with
  more diverse resources.

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Net Importers of oil
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Factors Affecting Oil Pricing

• Crude Oil Price
• Crude oil prices are determined by global supply
  and demand. Economic growth is one of the biggest
  factors affecting petroleum productand therefore
  crude oildemand.
• Growing economies increase demand for energy in
  general and especially for transporting goods and
  materials from producers to consumers. The
  worlds transportation sector is almost totally
  dependent on petroleum products such as gasoline
  and diesel fuel.
• Many countries also rely heavily on petroleum
  fuels for heating, cooking, or generating
  electricity. Petroleum products made from crude
  oil and other hydrocarbon liquids account for
  about a third of total world energy consumption.

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• The Organization of the Petroleum Exporting
  Countries (OPEC) can have a significant influence
  on oil prices by setting production targets for
  its members. OPEC includes countries with some of
  the world's largest oil reserves. At the
  beginning of 2020, OPEC members controlled about
  71 of total world proved crude oil reserves
  (plus lease condensate), and they accounted for
  36 of total world crude oil production in 2020.
• OPEC attempts to manage oil production of its
  member countries by setting crude oil production
  targets, or quotas, for its members. Compliance
  of OPEC members with OPEC quotas is mixed because
  production decisions are ultimately in the hands
  of the individual members.

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Crude Oil Pricing ctd

• In general, the main factors determining OPEC's
  effectiveness in influencing oil prices include
• The extent to which OPEC members actually comply
  with production quotas.
• The ability or willingness of consumers to reduce
  petroleum consumption
• The competitiveness of non-OPEC producers when
  oil prices change
• The efficiency of OPEC producers to supply oil
  compared with non-OPEC producers
• The difference between oil market demand and
  supply from non-OPEC sources is often referred to
  as the call on OPEC because OPEC members maintain
  the world's entire spare crude oil production
  capacity.
• Saudi Arabia, the largest OPEC oil producer and
  one of the world's largest oil exporters,
  historically has had the largest share of the
  world's spare oil production capacity.
• Developing and maintaining idle spare production
  capacity is generally not cost-effective for
  international oil companies (IOC) because the IOC
  business model maximizes revenue by producing oil
  as long as the price of selling the oil is higher
  than the cost of supplying an additional barrel
  of oil to market. OPEC spare capacity provides an
  indicator of the world oil market's ability to
  respond to real and potential disruptions in
  world oil supplies.

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Causes of world crude oil prices and supply
disruptions

• Geopolitical events and severe weather that
  disrupt the supply of crude oil and petroleum
  products to market can affect crude oil and
  petroleum product prices. These events may create
  uncertainty about future supply or demand, which
  can lead to higher volatility in prices.
• Most of the crude oil reserves in the world are
  located in regions that have been prone to
  political upheaval or in regions that have had
  oil production disruptions because of political
  events. Several major oil price shocks have
  occurred at the same time that political events
  caused supply disruptions, most notably the Arab
  Oil Embargo in 197374, the Iranian revolution,
  the Iran-Iraq war in the 1980s, and the Persian
  Gulf War in 199091. In recent years, conflicts
  and political events in the Middle East, the
  Persian Gulf, Libya, and Venezuela have
  contributed to world oil supply disruptions and
  increases in oil prices.

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• Given the history of oil supply disruptions
  caused by political events, market participants
  constantly assess the possibility of future
  disruptions. In addition to the size and duration
  of a potential disruption, market participants
  also consider the availability of crude oil
  stocks and the ability of other producers to
  offset a potential supply loss. When spare
  capacity and inventories are low, a potential
  supply disruption may have a greater impact on
  prices than might be expected if only current
  demand and supply were considered.
• Weather also plays a significant role in the
  supply of crude oil. Hurricanes in the Gulf of
  Mexico can affect oil production and refinery
  operations in the Gulf region. As a result, U.S.
  petroleum product prices may increase sharply as
  supplies from the Gulf to other regions drop.
  Severe cold weather can also strain product
  markets as producers attempt to supply enough
  product, such as heating oil, to consumers in a
  short amount of time. This seasonal demand can
  also result in higher prices.
• Other events such as refinery outages or pipeline
  problems can also restrict the flow of crude oil
  and petroleum products to market. These events
  can lead to a temporary supply disruption that
  could increase prices.
• The influence of any of these factors on crude
  oil prices tends to be relatively short lived.
  Once the supply disruption subsides, oil and
  product supply chains adjust, and prices usually
  return to their previous levels.

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Factors Affecting Pricing in the Downstream

• Apart from a price of a petroleum product on the
  world market, a number of factors affect end-user
  prices net of tax.
• Some are under the control of the government to
  varying degrees others are outside the control
  of the government and, in some situations,
  outside the control of any actor in the country.
• Market size is an important determinant and
  affects end-user prices through various channels.
  Large markets can enjoy economies of scale in
  procurement and supply infrastructure, and
  accommodate enough large actors to create healthy
  and effective competition

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Market Size algorithm
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Economy of Scale

• Economies of scale are particularly important for
  refining. Product demand has been increasingly
  moving away from fuel oil (heavy fuel oil, marine
  fuel (MFO), bunker fuel, furnence oil gas oil
  heating oils, diesel fuel etc) to gasoline,
  kerosene, and diesel, requiring cracking of
  residual fuel oil to white products. At the same
  time, fuel specifications are being tightened
  progressively, in particular requiring so-called
  sulfur-free gasoline and diesel in developed
  countries.
• Producing white products meeting tight fuel
  specifications requires processing units that
  enjoy large economies of scale.
• As a basic rule of thumb, a refinery needs to
  have a processing capacity of at least 100,000
  barrels a day (or 5 million tonnes a year) to be
  economic in a liberalized market.
• This is because it is disproportionately
  expensive to install small cracking units, small
  refineries tend to be hydroskimming
  refinerieshydroskimming refineries have no
  ability to convert residual fuel oil to white
  products and have only the units that raise the
  octane.

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• If domestic demand for petroleum products is
  small and much less than the production capacity
  of an economic-scale refinery, as in many
  countries in Sub-Saharan Africa, then a refiner
  is faced with two options build a
  sub-economic-scale refinery to serve primarily
  the domestic market, or build an economic-scale
  refinery and export some or even the bulk of the
  products.
• A sub-economic-scale refinery is unlikely to be
  able to compete with product imports from large
  and efficiently run refineries. A world-scale
  export refinery can take advantage of economies
  of scale, but will face full international
  competition.
• If a refinery is processing domestic crude oil,
  it has a potential cost advantage because it does
  not incur the cost of shipping crude or refined
  products. Similarly, a refinery may have access
  to relatively low-cost crude oil if, for example,
  it is a transit country for a crude oil pipeline.
  
• However, such cost advantage can be easily offset
  by higher refining costs if the refinery is small.

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Competition

• It is not easy to have effective competition in a
  small market, again
• because of economies of scale in establishing and
  managing supply
• assets and in fuel procurement. A large market
  can accommodate several actors, all enjoying
  requisite economies of scale, but a small market
• not necessarily so. This is particularly true for
  product import, refining,
• and wholesale. The larger the marine tanker
  carrying petroleum products, the lower is the
  unit cost of shipping. This requires two
  conditions first, the volume to be purchased be
  sufficiently large to fill an
• economic-size tanker, and second, the port be
  capable of handling large
• tankers. Some small markets have used joint bulk
  import with varying
• degrees of success. Refining and pipeline
  transport effectively become
• natural monopolies in small markets. Provided
  minimal scale requirements are metthe requisite
  scale economy is not achieved in many
• markets in the regionand infrastructure is well
  maintained for longdistance transport over land,
  pipelines offer the lowest-cost option, followed
  by rail, and then road. But pipelines, like
  refineries, require
• large upfront investment, regular maintenance,
  and a reliable source
• of power.
• International experience points to the importance
  of establishing
• fair, healthy, and transparent competition in the
  downstream petroleum
• sector. An effective and well-regulated
  competitive market imposes
• relentless pressure on participants to improve
  efficiency andequally

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• importantlyto share the gains with customers. A
  competitive market also reduces opportunities for
  corruption and provides a sound basis for
  attracting new private investment without
  creating contingent liabilities for government. A
  monopoly supplier by definition is not competing,
  although small markets may have natural
  monopolies. Where effective competition is not
  possible, economic regulation is needed.
  Protection provided to domestic refineries
  through import tariffs increases government
  revenue in the short run but, by increasing
  petroleum product prices throughout the economy,
  could hurt economic growth and lower long-term
  government revenue.

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THE END !