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The Economics of Oil and Gas
The Economics of Oil and Gas
The Economics of Oil and Gas
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The Economics of Oil and Gas

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The availability of low-cost energy from fossil fuels – in particular oil – has been the driving force behind postwar global economic growth, such that the petroleum industry has some of the world’s largest companies. This book examines the economics of the oil and gas industry, from exploration, development and production, to transportation, refining and marketing. At each stage of the value chain, the key economic costs and considerations are presented in order to provide the reader with a comprehensive understanding of the workings of the industry.

The book examines some of the unique economic challenges the industry faces, including negotiating international contracts with host countries (to gain access to hydrocarbons), managing the risks of recovery, implementing cross-border pipelines, dealing with huge variations in the taxation of refined products, and reacting to the effect of price control and subsidization in the OPEC nations which can create massive volatility in pricing. The search for low-carbon fuels, the impact of shale gas, the prospect of finite reserves, and the global political realities of the competing demands of oil-importing and oil-exporting countries are shown to make the sector high risk, but the economic rewards can be huge.

Release dateDec 5, 2019
The Economics of Oil and Gas

Xiaoyi Mu

Xiaoyi Mu is Reader in Energy Economics in the Centre for Energy, Petroleum and Mineral Law and Policy at the University of Dundee. Prior to joining the Centre in 2008, he was a Senior Consultant at Global Energy Decisions (now ABB Ventyx) in California, and worked as an analyst at the headquarters of CNPC, China’s largest oil and gas producer.

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    The Economics of Oil and Gas - Xiaoyi Mu

    The Economics of Oil and Gas

    The Economics of Big Business

    This series of books provides short, accessible introductions to the economics of major business sectors. Each book focuses on one particular global industry and examines its business model, economic strategy, the determinants of profitability as well as the unique issues facing its economic future. More general cross-sector challenges, which may be ethical, technological or environmental, as well as wider questions raised by the concentration of economic power, are also explored. The series offers rigorous presentations of the fundamental economics underpinning key industries suitable for both course use and a professional readership.


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    The Economics of Music

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    The Economics of Oil and Gas

    Xiaoyi Mu

    The Economics of Oil and Gas

    Xiaoyi Mu

    © Xiaoyi Mu 2020

    This book is copyright under the Berne Convention.

    No reproduction without permission.

    All rights reserved.

    First edition published in 2020 by Agenda Publishing

    Agenda Publishing Limited

    The Core

    Bath Lane

    Newcastle Helix

    Newcastle upon Tyne

    NE4 5TF


    ISBN 978-1-911116-27-1 (hardcover)

    ISBN 978-1-911116-28-8 (paperback)

    British Library Cataloguing-in-Publication Data

    A catalogue record for this book is available from the British Library

    Typeset by Newgen Publishing UK

    Printed and bound in the UK by TJ International



    List of abbreviations


    2.Exploration, development and production

    3.Licensing and fiscal issues

    4.Petroleum transportation

    5.Refining and marketing

    6.Natural gas

    7.Oil prices and OPEC


    List of figures and tables



    This book has grown out of a course that I have been teaching since 2008 at the Centre for Energy, Petroleum and Mineral Law and Policy (CEPMLP) at the University of Dundee to postgraduate law, business and economics students. Although the interest in understanding the economics of oil and gas has never faded, there is a lack of an updated text covering the entire value chain of the petroleum industry. Partly for this reason, I agreed to write this book when the publisher approached me a couple of years ago.

    The book is primarily intended to provide students in business, economics, law, engineering and other related subjects with an introduction to the workings of the petroleum industry. It is also aimed at professionals who want a perspective and understanding on energy economics and policy, including such questions as these: are we running out of oil? What is the value of a petroleum find? How to monetize a gas discovery? Why is the oil price so volatile? Why is there a disparity between changes in crude oil price and gasoline prices at the pump? Can the shale gas revolution occur outside the United States? And why is it that countries with abundant natural resources do not always grow rapidly? These are important and exciting questions, and the interest in them is certainly not limited to those who might want a career in the petroleum industry or policy areas dealing with petroleum and energy issues.

    The emphasis of this book is the economics of the oil and gas industry, from upstream exploration and production to downstream refining and marketing. At each stage of the value chain we will present the economic theory and analytical tools, along with the technical and institutional knowledge necessary to understand the economic and policy issues. The gas industry is specifically discussed with an emphasis on ways of monetizing gas.

    The book begins with a chapter on why oil matters and the characteristics it has that make it difficult to be substituted by other fuels. We then move on to the relationship between oil price movements and macroeconomic performance, for both net oil-importing countries and net oil-exporting countries. This includes the nexus between oil price and economic growth rate, inflation and other macroeconomic indicators. For oil-exporting countries, the focus is on understanding the resource curse and Dutch disease.

    Chapter 2 starts with a layman’s introduction to the technical aspects of petroleum exploration, development and production. The bulk of the chapter focuses on the economic concepts and analytical tools used for business decision-making. For exploration, the emphasis is on the risks associated with the uncertain outcomes and methods of managing these risks. The calculation of expected monetary value and the decision tree as analytical tools for managing the exploration risks are illustrated. For development, we introduce development planning, rate sensitivity, the common pool problem and unitization. For production, the focus is on production modelling with the introduction of different recovery methods. The optimal allocation of production over time is also discussed.

    In most countries other than the United States, the mineral rights of underground resources belong to the state. Consequently, the upstream petroleum industry has developed a system of rather unusual contracts. This is the focus of Chapter 3. We first provide an overview of the main international petroleum agreements, namely the concession system, production-sharing contracts and risk service contracts, before moving on to the economic analysis. Financial modelling under different fiscal systems is illustrated with a few examples.

    Transportation connects the upstream and downstream industries. To stay focused, Chapter 4 considers only maritime transport and pipelines. In the section on tankers, we reiterate the concept of economies of scale in transportation and provide information on tanker jargon. For pipelines, we discuss the implications of the economies of scale, including the natural monopoly, the regulation of tariffs and third-party access. As there is an increasing demand for cross-border pipelines, the political economy and key challenges of cross-border pipelines are also discussed.

    Chapter 5 deals with the downstream side of the petroleum industry value chain, namely refining and marketing. The chapter starts with the technical background of the refining process, noting the global trend of tightening specifications for refined petroleum products. The economics of refinery operations again features significant economies of scale. The chapter presents estimates of the relationship between the investment required for a refining unit and its capacity. Countries that recently discovered oil may consider whether and where to build a refinery. Refinery location – whether a refinery is better located near markets or the source of crude oil supply – is also addressed. For marketing, we first present an overview of the marketing channels of international oil companies (IOCs) and highlight the rationale for changes. We then discuss the pricing issues of refined petroleum products. In developed countries, refined products are heavily taxed. Arguments for taxing petroleum products are presented. In developing countries, particularly the oil-producing countries, the price is often controlled and subsidized; the effect of price control and subsidization is therefore analysed.

    As the upstream side of natural gas is covered in Chapter 2, Chapter 6 focuses on the monetization of natural gas and covers five topics. First, a brief introduction to the physical characteristics of natural gas, particularly the environmental attributes, and a general overview of natural gas consumption by sector are given. We then take a closer look at liquefied natural gas (LNG), including the evolution of the LNG industry, the cost structure, the traditional business model and the emergence of spot and short-term markets. The third section provides an overview of gas-to-liquids (GTL) technology, noting its opportunities and challenges. The fourth section discusses gas pricing in the world. Finally, the chapter concludes with a review of shale gas development in the United States.

    Given the vital role of oil price to both the petroleum industry and the wider economy, Chapter 7 focuses on the understanding of oil prices. It begins with a history of oil prices going back to the birth of the modern oil industry in 1859, when the first commercially successful well was drilled in Titusville, Pennsylvania. This is followed by an economic analysis of oil price determination. The pricing policies of the Organization of the Petroleum Exporting Countries (OPEC) are discussed in light of a dominant firm model, as well as the recent empirical literature on OPEC behaviour. To help us understand the long- and short-run dynamics of oil prices, we introduce a widely used two-factor model and a trend-cycle model in the next section and discuss the insight gained from these models. In addition, a detailed account of the price formation mechanism in physical markets is also given. The chapter ends with an introduction to energy derivatives, particularly futures market.

    In writing this book, I seek to explain economic concepts and theories in simple terms with the occasional aid of graphical presentations. Most of the content of the book is accessible to people with non-mathematical backgrounds. At the same time, I also include some model derivations for those who would appreciate a more rigorous treatment of the analytical tools, and provide references for further reading.

    The book was born out of the course notes on petroleum economics and policy that was first developed by Professor Paul Stevens, who taught this course until 2007. I am extremely grateful to Paul for his kindness in allowing me to use the notes in the first instance. An earlier draft of the book was critically reviewed by two anonymous reviewers, whose comments and suggestions have helped improve the quality of the book. I am also thankful to colleagues at CEPMLP who have encouraged me in one way or another during this journey, to Hanchen Xiao and Dilip Jena for very able assistance and to Steven Gerrard at Agenda for his patience and flexibility in publishing this book. Of course, I am the only one responsible for any remaining errors and omissions.

    List of abbreviations



    Oil has become so central to modern civilization that language strains to convey its importance; the common metaphors for its role – linchpin, lifeblood, prize – seem tired and inadequate.¹

    Why petroleum matters

    Oil and gas are used in almost every aspect of modern life – in our homes, in businesses, in industry and for travelling. Oil not only fuels the cars and trucks that we drive and aeroplanes that we fly but also provides plastics and chemicals, as well as many lubricants, solvents, waxes, tars and asphalts. Nearly all pesticides and many fertilizers are made from oil or oil by-products. Similarly, gas is one of the most important fuels for generating electricity. It can also be directly burnt for cooking, and for heating houses, buildings and water. It is an important fuel for powering many industrial operations, including iron and steel foundries, aluminium or nickel smelters and many manufacturing industries. Both oil and gas are important petrochemical feedstocks for producing fertilizers and a wide range of industrial and consumer goods, including plastics and polymers, textiles and paints, detergents and perfumes.

    Box 1.1 What is crude oil and what are petroleum products?

    Petroleum is a mixture of hydrocarbons and was formed from the remains of animals and plants (diatoms) that lived millions of years ago in a marine environment before the existence of dinosaurs. Heat and pressure from these layers turned the remains into what we now call petroleum. The word petroleum means rock oil or oil from the earth. Crude oil is the hydrocarbon mixtures produced from underground reservoirs that are liquid at normal atmospheric pressure and temperature. Natural gas is the hydrocarbon mixtures that are gaseous at normal atmospheric pressure and temperature; the gas mixtures consist largely of methane – the smallest natural hydrocarbon molecule (CH4). Petroleum products are fuels made from crude oil and other hydrocarbons contained in natural gas. Petroleum products can also be made from coal, natural gas and biomass.

    Source: www.eia.gov.

    Partly because of its wide usage, oil becomes the largest single item in international trade, measured in value terms.² It is also the most actively traded commodity in centralized exchanges such as the New York Mercantile Exchange (NYMEX) and the Intercontinental Exchange (ICE).³ The significance of oil and gas as energy resources is best demonstrated by their shares in world total primary energy supply (TPES). As shown in Figure 1.1, even with the boost of renewables in recent years, oil and gas together still provided more than 50 per cent of world primary energy supply as of 2016.⁴

    For statistical purposes, the use of oil and gas is usually categorized into energy use and non-energy use. When they are burnt to produce energy or transformed as another fuel, it is referred to as energy use. Energy use can be further divided into four sectors: residential, commercial, industry and transportation. Non-energy use includes those used as raw materials in the different sectors – that is, not consumed as a fuel or transformed into another fuel. For example, most lubricants and bitumen are used for non-energy purposes. Similarly, natural gas can be used as a raw material for the petrochemical industry, etc.

    Figure 1.1 World total primary energy supply by fuel (Mtoe), 1990–2016

    Source: IEA (2018a).

    Residential use of energy includes heating, cooking, lighting, air-conditioning, home appliances such as refrigerators and washing machines, and electronics in our homes. The ways we use energy in homes vary substantially over time and across countries. Figure 1.2 depicts the share of energy use in homes in the United States. Space heating has the largest share of residential energy consumption, which is followed by lighting and other appliances. As income increases, refrigerators, cooking equipment such as gas hobs and microwaves, and washing machines become ever more popular. It is increasingly common for homes to use multiple televisions and computers. Additionally, as the home electronics market is constantly innovating, new products such as digital video recorders, game systems and rechargeable electronic devices are becoming integral to our modern lifestyle. As a result of these changes, appliances and electronics now account for nearly one-third of all energy used in US homes. In general, households use more energy as income grows and living standard improves. As can be seen in Figure 1.3, there is a clear, positive correlation between per capita energy consumption and per capita gross domestic product (GDP), an indicator of income, among countries in the world.

    Figure 1.2 Share of households’ energy consumption (United States), 2015

    Source: Energy Information Administration, Table CE3.1, Annual household site end-use consumption in the U.S. – totals and averages, 2015; available at: www.eia.gov/consumption/residential/data/2015/c&e/pdf/ce3.1.pdf.

    Commercial use of energy mainly refers to the heating, lighting and – to a lesser extent – cooking in commercial buildings. Examples of commercial buildings include but are not limited to the following: offices, hospitals,schools, police stations, churches, warehouses, hotels, libraries and shopping malls. In the industry (manufacturing) sector, there are many different uses of energy sources. One main use is as boiler fuel, which means producing heat that is transferred to the boiler to generate steam or hot water. Another use is as process heating and involves using energy to directly raise the temperature of products in the manufacturing process; examples are separating components of crude oil in petroleum refining, drying paint in automobile manufacturing and cooking packaged foods. A list of energy-intensive industries would include iron and steel, basic metals, mining, construction and the energy use in the chemical industry.

    Transportation use of energy includes energy used by cars, trucks, aeroplanes, ships, railways and tractors in farms.

    Figure 1.4 shows the world oil consumption by sector in 1973 and 2016. Clearly, the transportation use of world oil consumption has expanded quite significantly (more than doubled) during the past 45 years, while all other factors have remained largely flat. In 2016 the transportation sector, including road transportation, aviation, rail and navigation, accounted for 65 per cent of the total final consumption of oil.

    Figure 1.3 Energy use per capita versus GDP per capita, 2013

    Notes: The figure shows the correlation between per capita energy consumption and GDP in 2013; the size of each bubble represents the total GDP of the country. The international dollar is a hypothetical currency unit used by economists and international organizations to compare the value of different currencies. An international dollar has the same purchasing power as the US dollar has in the United States at a given point in time.

    Source: Our World in Data, Energy production and changing energy sources, available at: https://ourworldindata.org/energy-production-and-changing-energy-sources.

    Figure 1.4 World oil consumption by sector (Mtoe), 1973 & 2016

    Note: Other includes agriculture, commercial and public services, pipeline and non-specified transport and industry.

    Source: IEA (2018b).

    Physical characteristics of oil

    Out of the primary energy sources, oil has certain key advantages because of its physical characteristics: its fluidity and its energy content. The fact that oil is a liquid attracts considerable economies of scale. The capital cost – in particular, the material of a storage tank – is largely determined by its surface area. However, the output of the tank is determined by the volume, and there exists an exponential relationship between the two. For example, the volume of a circular tank is the product of the square of its radius multiplied by pi (π) and the height, whereas the surface area is the product of the circumference and the height. Although the surface area is linear in the radius, the volume is squared.⁵ The point is illustrated in Figure 1.5. When the size of the tank doubles, the surface area increases by four times but the volume increases by eight times. As a result, the unit cost of the materials used in the storage tank halves. The example is illustrated using a storage tank. It works equally well for other stages of the petroleum industry such as pipelines, refinery towers and ocean-going tankers.

    Figure 1.5 Comparison of unit storage costs between a big tank and a small tank

    Note: Because the materials cost of making the tanks is roughly proportional to the surface area of the tanks, doubling the size of the tanks reduces the average cost by 50 per cent.

    In addition, relative to other fuels, oil has a high energy density. Figures 1.6a and 1.6b make the comparison. Compared to coal, oil contains twice as much energy as coal on the same weight bases. Hence a ton of oil contains some 50 per cent more energy than a ton of bituminous coal. Compared to gas, oil contains 1,000 times more energy than the same volume of gas. As can be seen, gas in its natural state has virtually no energy content. The low energy content of gas in its natural state implies serious constraints for transporting gas, a point that will be discussed in great detail in later chapters.

    Figure 1.6a Heat content of oil and different types of coal by weight

    Figure 1.6b Heat content of oil and gas by volume (at standard temperature and pressure)

    These two physical characteristics of oil provide two distinctive advantages for oil as a primary energy resource. First, because of the large economies of scale and high energy density, oil can be conveniently transported and stored, which greatly reduces the average transportation and storage cost. The low average transportation cost makes the market for crude oil a truly international market. This can be seen from Figure 1.7. Crude oil prices tend to be uniform throughout the world, in the sense that prices in different regions tend to move together and any price differential, adjusted for quality, will disappear quickly through arbitrage.⁶ In other words, the law of one price (LOOP) applies in the crude oil market.

    Figure 1.7 World crude oil prices, 1992–2016

    Second, the high energy content and fluidity offer flexibility and convenience of use, making it difficult for oil products to be substituted for certain usage. For example, in the transportation sector, oil is still the dominant fuel even in advanced economies. Figure 1.8 shows the share of energy consumption by sources for the transportation sector in the United States in 2017. Petroleum products provided about 92 per cent of the total energy the US transportation sector used. Biofuels, such as ethanol and biodiesel, contributed about 5 per cent and natural gas contributed about 3 per cent. Despite the impressive increase in electric vehicle sales, electricity provided less than 0.3 per cent of the total energy used in transportation.

    Figure 1.8 Energy consumption in US transportation sector by sources, 2017

    Notes: The data are based on energy content. Gasoline includes motor gasoline and aviation gasoline, excluding ethanol. Others includes electricity, liquefied petroleum gas, lubricants, residual fuel oil and propane.

    The macroeconomic and political influence of oil

    As an important energy source, oil also matters in the broader economic and political sphere. Changes in oil prices have been shown to have significant effects on the macroeconomy, although the effect differs between oil importers and oil exporters.

    Channels of oil influencing the economies of importing countries

    For oil importers, oil importation often represents a major drain on the balance of payments and has a positive correlation with the inflation rate. It also raises important concerns over import dependence and supply security. Oil price shocks can affect the economy through several channels, including consumer demand, the supply of goods and services (production) and physical product rationing.

    Box 1.2 Balance of payments

    The balance of payments is a record of accounts reflecting a country’s economic transactions with the rest of the world. It has two components: the current account and the capital account. The current account consists of the balance of trade (the physical movement of goods) and the trade in services such as banking, insurance, tourism and other intangibles. The capital account consists of long-run and short-run capital movements. There then has to be a balance through changes in foreign exchange reserves. A payment for the importation of oil is clearly a debit item to the current account.

    Because the demand for petroleum products is inelastic, especially in the short run, the share of expenditures by consumers and firms on petroleum goes up when the oil price increases.⁷ If the oil shock is known to be temporary, consumers may make minimal adjustments to the rest of their spending and temporarily finance the additional oil consumption through savings. However, in practice, consumers do not know the duration of a price hike, and many or most would instead reduce their spending on other goods and services to pay for the more expensive fuel needed for daily life. Because expenditures on oil imports go abroad and not to the domestic economy, they do not count towards GDP, so the immediate effect of an increase in the price of an imported good, such

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