Energy market a windfall for tube, pipe producers in 2019 and beyond

Few commodities capture our attention like petroleum. In the U.S., nearly everyone relies on it for transportation in the form of gasoline or diesel fuel, and the current price is posted prominently on every gas station from coast to coast. Beyond the two most common transportation fuels, which make up more than 70 percent of its use, it’s also used in jet fuel (9 percent), lubricants, fuel oil, and asphalt (a total of 8 percent), and as the feedstock for making chemicals, plastics, and other synthetic materials (11 percent).

While it’s tempting to discuss petroleum as a single entity, it’s not. The international petroleum industry—and by extension, the natural gas industry—is the sum of many dissimilar parts.

First, while crude oil is considered to be a commodity, the quality varies considerably, as do the processes and costs associated with extracting and refining it. Pumping oil out of a conventional oil deposit onshore, one surrounded by modern infrastructure, has little in common with pulling oil from under an ocean floor, removing it from oil sand, or extracting it from a shale formation. In other words, two barrels of oil sold at the same price might have markedly different production costs.

Second, varying economic structures play into the complexities of the energy business. Throughout the Persian Gulf region and South America, many of the producers enjoy monopoly power, and several are mere extensions of the governments that protect them. In Russia the energy sector is an oligopoly, a market dominated by a few large producers, again with strong ties to the government. These companies often are at odds with oil producers elsewhere that work in competitive markets.

Third, the market is distorted by cartel behavior on the part of the Organization for the Petroleum Exporting Countries (OPEC), which for decades advocated production restrictions that artificially inflated the crude oil price. It does so to this day, but its influence is less thorough now than it was in the past.

Fourth, the petroleum market is further complicated when a substantial oil producer is hemmed in by its own gross ineptitude. Iran is home to the world’s third largest oil reserves, yet for decades it has had to import gasoline because its refineries are too few, too decrepit, and too inefficient. The hardline socialist government in Venezuela squanders the country’s oil revenue by essentially giving away gasoline to its citizens—the domestic price is about five cents per gallon—while pursuing wacky economic policies that cause a hyperinflation that has been known to run 100 percent per month.

This combination of factors doesn’t mean that the worldwide energy market is impenetrable, but it does mean that even the most careful analyses and forecasts are challenging, especially in the last several years as new dynamics have come into play, regarding both demand and supply. A solid assessment goes far beyond oil and natural gas, providing insights for the short- and long-term prospects of many related industries, including tube and pipe.

On the demand side, the global poverty rate has been falling for decades; as prosperity spreads, so does the demand for energy. Meanwhile, many nations that have long benefited from prosperity face new problems as they grapple with curbing emissions, especially carbon dioxide, which means reducing fossil fuel consumption.

On the supply side, OPEC hasn’t been knocked off its perch, but its grip is increasingly tenuous. Technology disruptions and a key U.S. policy change have provided an unexpected amount of leverage to non-OPEC producers, who have rushed to disrupt the worldwide energy market. How much leverage do they have? It’s too soon to tell, but often just a bit of leverage can go a long way. In the words of Archimedes, “Give me a lever and a place to stand and I will move the Earth.”

Trends in Supply

Most industries are a little like fashion: Trends come and trends go, and if you wait long enough, some trends come around again. The commodity markets are like that and often are dominated by two main supply trends: stability and volatility. When left to itself and governed by free market forces, a commodity market is somewhat self-regulating as the laws of supply and demand interact with each other. A rising commodity price encourages greater supply—more suppliers enter the market, and existing suppliers ramp up production—which can result in a supply glut that causes the price to drop; as suppliers cut back production, the surplus dries up and becomes a shortage, which causes prices to rise, and the cycle repeats. If these trends develop gradually, the market is relatively stable and predictable.

Shocks to the system lead to periods of volatility. In agriculture, a typical shock is a late frost or a period of drought; in livestock, a contagious disease; in international trade, it can be an unexpected currency fluctuation or a sudden round of tariffs. While the international petroleum market has been disrupted by its fair share of shocks (the 1973 oil embargo, the 1979 revolution in Iran, and the unbridled speculation in 2008), in normal times it doesn’t function like a normal commodity market, and it hasn’t done so since the early 1970s.

The Rise of the Cartel. Throughout the early part of the 20th century, the U.S. was the largest oil producer in the world. Domestic supply exceeded domestic demand, and the U.S. business environment—free-market capitalism fortified with antitrust laws—fostered competition and innovation, keeping the oil price low. As the U.S. economy expanded and its appetite for oil grew, its productive capacity couldn’t keep up, and by midcentury the country was supplementing its domestic supply with foreign oil.

In 1960 several other oil-producing nations—Iran, Iraq, Kuwait, Saudi Arabia, and Venezuela—saw an opportunity to solidify their disparate positions and formed a single unit, the OPEC cartel. The cartel’s first chance to flex its muscle arrived in 1973 after the Yom Kippur war; OPEC retaliated by cutting off petroleum shipments to every country that had supported Israel: Canada, Japan, Netherlands, Portugal, Rhodesia, South Africa, the U.K., and the U.S. The crude price quadrupled and shortages ensued. Although OPEC ended the embargo about a year later, the organization didn’t stop using its cartel power. Since then it has used its influence to restrict output to create an environment of artificial scarcity that has kept the crude oil price artificially high.

Same Game, New Rules. The global heavyweight has long been OPEC founding member Saudi Arabia, a country that sits atop proven reserves of 250,000 billion barrels of oil. The country also benefits from low costs of production; its light, sweet crude, pumped from conventional onshore deposits, needs less refining than oil from many other regions of the world.

As the de facto leader, Saudi Arabia has long led the way in establishing output targets (restrictions) for OPEC members. While effective at restricting supply and driving up the price, the targets were never permanent. Routine cheating on the output restrictions by small cartel members, along with increased output from non-cartel producers, would increase the worldwide supply and cause the price to erode. Eventually OPEC would trot out a fresh round of production restrictions to restore the price, and thus the cycle would repeat.

These cycles dominated the petroleum industry for at least 30 years, but everything changed when horizontal drilling and hydraulic fracturing activity opened up shale resources in North America in the 2000s. The North American petroleum industry grew quickly and eventually was large enough to challenge Saudi authority. The turning point came in the middle of 2011, when U.S. field production was about 5.4 million barrels per day; three years later, it was up to 3 million more barrels per day. OPEC took notice and changed its game plan 180 degrees. Rather than restrict the oil supply to increase the oil price, its new mode was to increase the supply, drive the oil price down, and force more than a few U.S. producers out of the market. Its efforts to reduce the price worked. In July 2014, the spot price of benchmark crude oil, West Texas Intermediate, was $104 per barrel. Just 18 months later, during February 2016, it fetched a mere $30 per barrel.

At that time Saudi Arabia claimed that it could turn a profit at $20 per barrel. That statement might have had a bit of truth to it, but the devil is in the details.

Several key OPEC members in the Persian Gulf area are nations with relatively small populations governed by kingdoms propped up by petroleum revenue. In the case of Saudi Arabia, when times are good petroleum makes up about 80 percent of the government’s income. The royal family uses petrodollars to subsidize education, energy, housing, and other benefits. It’s understood that the royal family’s hold on power is funded and secured, more or less directly, by oil fetching around $90 per barrel. Kingdoms such as Qatar, United Arab Emirates, and Kuwait are likewise supported by high oil prices.

The main problem with this strategy is that OPEC isn’t a monolith. While several of its members are wealthy kingdoms that support small populations, many are less well-to-do and support large populations. The latter countries rely much more on oil revenue from day to day and don’t have the wherewithal to withstand long periods of low prices. The second problem is that even the wealthy OPEC members found that the long period of decreased revenue stressed their cash reserves. Third, when OPEC finally changed direction and resumed production cuts, it learned the hard way that it had underestimated the scope and resilience of the U.S. market. By November 2017, U.S. field production exceeded 10 million barrels per day; by August 2018, it was up to 11 million per day.

“For decades, OPEC didn’t have to worry much about losing market share, so it focused on price,” said Chris Kuehl, co-founder and managing director of Armada Corporate Intelligence and economic analyst for the Fabricators & Manufacturers Association Intl. OPEC thought its share of the international market was secure because it didn’t foresee how the newfound ability to pull oil out of shale formations at a profit would play out. In other words, OPEC was under the impression that the U.S.’s domestic production capacity would never change much. The shale boom put an end to that notion.

Eventually OPEC resumed production cuts, but the market had changed. U.S. producers were ready to supply more oil to the market, which prevented the price from rising much.

“OPEC lost quite a bit of market share and much of its ability to influence the price,” Kuehl said.

In the middle of 2018 the U.S. was exporting 3 million barrels per day. Among OPEC members, just two—Saudi Arabia and Iraq—can extract that much in a day. This additional 3 million barrels on the international market put the brakes on the rising price. During much of 2018, West Texas Intermediate grade petroleum traded a little more than $60 per barrel. Two factors were the quantity produced by U.S. companies and the time it took them to get this oil to market.

“When OPEC cuts production, U.S. producers can increase production quickly,” said Michael Strand, sales manager for tube and pipe mill manufacturer T & H Lemont. When $100-per-barrel oil was discussed a while ago, Strand was skeptical at best. The price was rising, but he doubted it would rise that much.

“U.S. producers responded and got a better price for their oil,” he said. One thing led to another, and the U.S. passed a critical milestone in the first week of December 2018.

“The U.S. is now a net exporter,” Strand said. After the oil embargo ended in 1974, Congress made crude oil exports illegal, he explained. U.S. producers were allowed to export refined products and have long had a position in selling in international markets, but the U.S. wasn’t as significant in exports as it could have been. A reversal of this position during the Obama administration changed the dynamics considerably, and the U.S. now has a substantial part of the international crude oil market, Strand said.

“OPEC is no longer the end-all and be-all supplier,” he said.

The increase in U.S. production can be seen in the increased port activity near refineries, Strand said.

“The Port of Houston is a principal export hub now,” Strand said, adding that a new terminal is under construction at the Port of Corpus Christi, prompted in part by the need to move more petroleum.

The result of all this additional activity also shows up in demand for energy-related tube and pipe products.

“Each well uses about 50,000 pounds of steel per month,” Strand said. Multiply that by the rig count, and you get a substantial uptick in activity from iron ore mining to steel processing to tube and pipe manufacturing. The rig count was at a recent low in May 2016, when the number of oil rigs in operation was just 316. It climbed more or less steadily since then and, as of December 2018, reached 873.

A key point is that U.S. producers didn’t wait for $60-per-barrel oil to act.

“We’ve seen more inquiries in the North American energy market for a couple of years,” said John Hillis, president and general manager for T & H Lemont. Oil- and gas-oriented customers have been inquiring about essentially everything—replacement tooling, new tooling to make additional pipe sizes, equipment upgrades, and entire mill systems, he said.

“We consider this to be a strong, active market right now,” he said.

A key point in U.S. activity in this market is Section 232 of the Trade Expansion Act of 1962, which grants the executive branch of the government the authority to establish tariffs or quotas to adjust imports. Tariffs of 25 percent on imported steel and 10 percent on imported aluminum went into effect in March 2018. Some nations later received exemptions; others negotiated quotas.

“Some Korean producers stopped production entirely,” said Donald Gibeaut, global tubular products manager for AjaxTocco Magnethermic. “Others hit their quota midsummer,” he said.

The tariffs and voluntary quotas have been a boon to U.S. manufacturers, Gibeaut said.

“We’ve received orders for three major heat-treat, quench, and temper lines in 2018, making this our busiest year in several decades,” he said, referring specifically to the company’s tubular products. He expects 2019 to be better still. “Our backlog is the highest that it has been in a long time,” he said. “Business in Houston is going gangbusters and, based on current order activity, there’s no slowdown in sight. Many customers are demanding orders to be released in early 2019—in the first quarter of the year, our sales will exceed all of 2018,” he said.

While the oil price isn’t very high—it never got to $70 in all of 2018, and toward the end of the year it dropped below $60—a key component in the market is the outlook, and the outlook is solid.

“I think people in this industry are getting more confidence,” said Dean Isbell, business development manager for Magnetic Analysis Corp. (MAC), a manufacturer of nondestructive testing (NDT) equipment for tube, pipe, and bar applications. “Many big projects have been doing well,” he said.

Although small projects have been slow in developing, he has seen a pickup in these recently. He doesn’t see the recent fall in the crude oil price as a problem.

“We’re getting more leads, but at this time of year we’re in for a seasonal slowdown,” he said, referring to the late December timeframe. He expects that to end in early January.

An abiding problem until recently, for companies that provide any equipment or software for tube and pipe mills certified to make API products, is the amount of pipe inventory.

“When activity first picked up, we saw a glut of pipe, especially in imports,” he said, and some of that inventory remains. “You could see yards and yards and more yards full of pipe inventory in southern Texas.”

According to Gibeaut, that glut of old inventory is coming to an end. A telltale sign is the corrosion that accumulates on steel products stored outdoors.

“Trucks have been leaving pipe yards six or seven days a week, hauling out old inventory until November or so,” he said. Since then, Gibeaut has seen much less of that and more truckloads of new inventory. This is the turning point that domestic mills and equipment makers have been waiting for.

While the bulk of the recent activity has been in the U.S., both homegrown and foreign investment, Gibeaut said that companies in Canada and Mexico also are making substantial investments.

“They’re investing in quality technology, especially high-end finishing equipment,” Gibeaut said. Testing technology is another area of interest, of course. MAC’s Echomac® FD-6 illustrates how advances in electronic technology have helped the industry move forward.

Designed to meet API, ASTM, and EN standards for ultrasonic testing technology, it has 32 independent channels. Upstream of the weld box, it can be used to measure the strip to verify the width; after welding, it can detect weld flaws and take further measurements, for example to determine the ID, OD, ovality, and eccentricity. It interfaces with rotary, spin, squirter, and bubbler equipment.

“It has a better signal-to-noise ratio than its predecessor, and better linearity,” Isbell said.

Trends in Demand

Throughout the industrialized world, energy demand is likely to continue to be strong and stable, with little in the way of big changes. In the U.S., consumption has been steady at 19.7 million barrels per day for the last 20 years or so, in a range between 18.0 and 21.8 million barrels per day. This is good news for the petroleum industry in the U.S. and its mill and pipe suppliers. The better news, of course, comes from the international market, now that U.S. producers are allowed to export crude oil.

The Energy Information Administration’s (EIA’s) latest issue of International Energy Outlook, published in July 2018, is optimistic about the world’s energy demand for the foreseeable future. While the EIA’s research doesn’t provide a conventional forecast, it uses a method in which it analyzes current trends, applies these to an economic model, and creates likely scenarios that lead to possible outcomes. For example, the economy of China is known to be supported by a heavy reliance on manufacturing for export. If the economy of China transitions away from a manufacturing-heavy, export-oriented market and becomes more service-oriented and focused on domestic consumption, the EIA’s research suggests that its energy needs are likely to increase by 20 percent by 2040. If the economy doesn’t go through such a transformation, continuing to focus on manufacturing, its energy needs will grow faster, likely consuming 25 percent more energy over the next 20 years or so.

In 2015 India’s economy was the third largest in the world, and its energy consumption likewise was the third largest. Based on current growth rates, the country’s population is expected to move from the second spot to become the most populous nation in the world. Its demographic makeup is unusual in that it has a relatively young population, which is expected to make India’s economy the fastest-growing economy over the projection period. The EIA’s overview considers that economic growth will be led by one of three factors over the next 20 years: increased consumption, increased investment, or increased exports. If the economy grows mainly by increased consumption, energy use is likely to increase 26 percent; if exports lead the way, energy consumption is predicted to grow 33 percent; and if investment is the primary driver, the result is forecasted to be near the middle at 29 percent.

Although OPEC might not be the heavyweight it once was, it still has extensive market knowledge. A recent publication, World Oil Outlook 2040, issued by OPEC in 2018, cited many reasons for optimism in the energy market over the next 20 years. From the report:

• “… with almost one billion people still without access to electricity and three billion lacking access to clean fuels and efficient technologies for cooking, energy demand is anticipated to increase by around 33 percent between 2015 and 2040.”
• “Oil is presumed to remain the fuel with the largest share in the energy mix over the forecast period, led by demand from transportation and petrochemicals. Combined, oil and gas are still expected to make up more than 50 percent of the global energy mix by 2040.”
• “Long-term oil demand is expected to increase by 14.5 million barrels per day to reach 111.7 million barrels per day 2040.”

“For supply, total non-OPEC liquid supply is projected to expand significantly, with the majority of the growth over the next decade coming from U.S. tight oil. Global tight oil supply is projected to expand to 16 million barrels per day by the late 2020s, making up almost 25 percent of non-OPEC supply by then.”

Such a strong demand forecast might lead some to think that energy prices are going to skyrocket, but this isn’t likely, according to Kuehl. In his view, the crude oil price will likely remain between $70 and $90 per barrel for the foreseeable future. If the price gets much below $70 per barrel, some of the marginal operations will become unprofitable and will cease production temporarily, reducing the supply and putting upward pressure on the price. If it gets near $90 per barrel, producers worldwide will have an incentive to increase production, send more petroleum into the market, and prevent the price from climbing much higher.

While it’s certain to be a lucrative market over the next two decades or so, tube and pipe producers who have an interest but are unfamiliar with oil- and gas-related products should proceed with caution, Hillis warned.

“This market isn’t for everybody,” he said. Because the manufacturing standards are more stringent for oil and gas products than for other categories of tube and pipe, becoming a supplier in this market requires specific mills and quite a bit of specialized expertise in making these products. Achieving and maintaining the necessary certification isn’t an easy task, Strand said.

Those who have taken these steps, or are willing to do so, are in the right place at the right time. According to World Oil Outlook 2040, the industry will have to invest nearly $11 trillion over the next two decades to keep up with growing energy demand.

Ajax Tocco, www.ajaxtocco.com

Armada Corporate Intelligence, www.armada-intel.com

Magnetic Analysis Corp., www.mac-ndt.com

T & H Lemont, thlemont.com