74&W Exclusives: Tom Seng

74&W Exclusives

How did you first become interested in the oil space?
I started out as what’s known as a “pipeline controller.” I worked shift right out of college, shift work where you’re monitoring the flows across the system. I learned a great deal about where the supplies were coming in and where they were going. And eventually I was hired out of that role by a marketing company, and spent several years in a marketing role. Initially, physical commodity and later on financial. Later on, I began running an actual hedge book for a midstream oil and gas company. I was actually the director of a risk control group for a while. The last eight years of my career, I spent in a role with midstream companies where I was marketing oil and natural gas and natural gas liquids and condensate, and running a hedge book.

When did you start teaching?
I’ve been teaching since 2000. I had a friend who was running what was called an energy management program at the University of Oklahoma, and he wanted to have a course for his students to understand trading. And so I started teaching as an adjunct of OU back in 2000, did that for seven years. He brought the program up to the University of Tulsa. I stayed in the industry and continued to be an adjunct for eight years here. And then in July 2014, they offered me a full-time position, and I came in as an assistant professor. I was then asked to run our undergraduate program in Energy Management. And then just this past August, I was promoted to director of the School of Energy, where I’m running the undergraduate program in Energy Management, and we have an online Master’s in Energy Business. So I have over 30 years in the industry and have been teaching for a long time. 

Over the course of that 30 years, you’ve had several different angles from which to view the industry.
Right. Some people might say it was haphazard, but I intentionally did that to learn more. Not that I was thinking, “Oh, someday I’m going to be teaching, so wouldn’t it be great to know this?” I just always wanted to try different aspects of the industry, and now I’m glad that I can talk about things I did instead of going off theory. Right now, for example, I have my screen up and running, watching futures pricing. I’m still an information junky. That’s preferable to, “Gee, back when I was in the industry.” I had a textbook published back in July, and now I teach from it.

Commodities are generally interesting because they’re influenced by so many different economic forces. What do you find particularly fascinating about oil in that regard?
I think that’s just it -- all the different influences. If anything, we know the volatility of oil prices has increased. There’s record volume, as well, of course. With WTI [Ed note: West Texas Intermediate crude oil] futures contracts, astronomical volumes are trading. Part of that is related to high-frequency trading. I mean, the amount of volume that’s traded on certain days could simply not be done by a mass of human beings banging on keyboards trading electronically.  We knew there was high frequency trading in equity markets, but then we saw abnormal volumes trading in energy commodities. It’s been fairly well established by now that they're contributing volume, which adds to liquidity but also to volatility. When I’m talking to my students about hedging, I point out that without that type of liquidity, if you’re a hedger, you can't get a position out there. So the volume is impressive. More recently what has astounded me is that, while it’s hard to grasp what’s going on, there’s been a very fickle mindset, especially related to the US and China. Almost every day, it’s, “Oh, we’re making progress,” and so stocks increase and energy commodities go up. And then the next day the opposite happens. It’s been an incredible rollercoaster. Along with that, you have the Trump Tweets. That’s been incredible. In all my years of watching the markets, I’ve never seen anyone be able to influence the marketplace with a single Tweet the way that he does.

The volume that’s traded on certain days could simply not be done by a mass of human beings banging on keyboards.

Let’s cover some of the very basics with regard to oil production. First, we often hear the terms “upstream,” “midstream” and “downstream.” Can you just talk a bit about what those are?
Sure. Upstream is all the activity it takes to bring that oil to the surface. So you have all the initial land work, the exploratory work, seismic, logging. And then it’s, “Okay, we believe we have something down there,” so then there’s the drilling, which is separate from completion. And now we’re ready to produce oil. It then changes hands to the midstream segment. Midstream, for oil, is the transportation to a refinery. A lot of sites have tanks right there, with wells pumping oil into a field pipe system that goes to a large pipe that carries the oil to refineries. In some cases, though, a tanker truck actually does come and carry the oil to what we call a truck rack, where it’s offloaded into the pipeline. Then the refineries will refine into the various products. Even there at the refinery stage, we’re still midstream. Some of that product, of course, gets shipped to pipelines throughout the country and delivered to retail stations. All of those products have to be transported. So finally, we have downstream, which is the final consumption points. I’m talking about the retail pump. The refined products that make it to where they’ll be used, like jet fuel delivered to the airport.

And for each of those stages – upstream, midstream and downstream – are we talking about different companies, for the most part, or do any of these companies try to do it all?
Generally speaking, there are very few vertically integrated companies. Exxon does all of it except transportation. They don’t own these pipelines when they’re moving their product around the country. So, yeah, generally E&P [Ed. note: exploration and production] sticks to E&P.  

So when people talk about investing in “an oil company,” they’re probably referring to an upstream company, is that right?
That’s generally right, yes. 

What are some of the key considerations investors should keep in mind when they're looking at these companies?
Well, that changes over the years. Right now, I think it’s very important to look at the particular play that they’re in. Especially the shale. I mean, that’s the thing, the shale play. So, number one is the Permian Basin of West Texas and Southeast New Mexico. Then for oil you’ve got the Bakken Formation. Number three, the Eagle Ford in South Texas. Then in Oklahoma, the SCOOP and STACK. Back East, the Marcellus and Utica shale play. Although that’s mostly natural gas. But at any rate, if I went to the website of one of these companies or I was looking at their prospectus, I would be asking myself, “Are they in these key plays that have achieved success, where a lot of money is already being invested?” I mean, you can also check the numbers on government websites that are coming out of these various fields. And the next thing, to me, would be, “How is this company capitalized? What does their drilling activity look like? How many rigs are up and running?” And then I’d take a close look at their KPIs and their past histories. How successful have they been? How much acreage do they have under their control? Ten thousand acres sounds like a lot, but that’s actually a small player. What are they saying about the acreage that they own in terms of potential recoverable reserves? Because there are various tiers of reserves – there are probable reserves and proved reserves. When I personally look at oil and gas companies, I tend to look at their hedge programs. Because that’s a measure of risk. How much risk are they willing to take on? Are they just selling their oil and natural gas at whatever price the market bears? Or do they have a disciplined hedge program in place for when there’s an opportunity to achieve a certain level of earnings if they go out there and put some hedges on? So those are the things that I’d look at to see if they’re a good prospect.

The technology is just allowing us to produce more, which is why we’re now at 12 million barrels per day of oil.

When we spoke to Lobo Tiggre about precious metal extraction, he explained the Lassonde Curve, which follows the valuation of an exploration company through its life cycle. After a mine is up and running, according to the Lassonde Curve, the valuation becomes a question mark because the company will deplete its resource unless another discovery is made. It must be the same with oil exploration, right?
Very much so. And unfortunately, from an investor standpoint, it’s very hard to find information about depletion. Thanks to horizontal completions in shale formations, we’re now extracting as much as possible. So the reserves haven’t changed, but we’re draining those reserves faster. That’s why companies often talk about reserve replacement. If you go back five years or so ago, a lot of compensation for CEOs in the industry was about reserve replacement. At $70-100 per barrel, you wanted to get it out before competitors. But then you have the issue of sustainability and replacing reserves when you’re draining them a lot faster. The technology is just allowing us to produce more, which is why we’re now at 12 million barrels per day of oil.

Well, let’s pause here for a moment to talk about horizontal drilling and the so-called Shale Revolution. What are oil companies doing now that they weren’t doing before that allows them to get oil from the shale?
If you picture a pool of oil trapped under rock, the traditional way of extracting it was vertical, straight down, drilling down through the middle of the reservoir. Now, they drill down to one side or the other, and then laterally drill in across that formation.

And that’s an improvement because sucking out that oil is not like emptying a cup of soda, right, where it wouldn’t matter whether you stuck your straw straight down in the center of the cup or put a horizontal bend in it? Instead, to extract petroleum from shale, you’ve got to break the shale apart to free the petroleum, and if you only do that at one vertical point, you’ve only captured a little oil. You’d next have to drill another well beside the first one, go down to the shale, break it apart, get that oil, rinse and repeat. Is that right?
That’s exactly right. Instead of one pinpoint at a time, you're breaking up the rock in that entire long horizontal pay zone and extracting that oil that was trapped there. In a vertical completion, it could take 20 years to finally draw as much of what we consider to be producible oil. Horizontally, we’re pulling out so much more per year.  

The market mainly consists of humans making decisions, and panic can ensue because of course nobody wants to lose money.

Let’s talk about oil as a commodity. First, what are the key drivers of the price of oil?
I wish there was a short and simple answer. It’s so many things. So let’s touch on a few of the factors that can influence the price of crude on a given day. The first one is weather. The Northeast part of the US is the largest consumer of heating oil in the world, because there are still lots of homes with a boiler in the basement. Just this past winter, I know there was one plant in New England that was using fuel oil to generate electricity. Right now, we’re coming into winter, so we’re going to want to watch the weather in the Northeast. The other big weather impact is hurricane season. Just this week, we have reports of a tropical depression in the southern Gulf of Mexico. I’m looking at it right now: “Tropical Storm Olga likely to form in the Gulf, En Route to Louisiana.” That headline literally just popped up. So oil and gas platform operators on the Gulf of Mexico will have to be watching this. And what’ll happen is, if in fact there are any evacuations from the platforms, the Bureau of Ocean Energy Management will come out and estimate how much of the supply of oil and natural gas they think is going to be curtailed because you had to remove personnel from the platforms.

What about more purely economic forces and their effect on oil?
Yeah, I mean, really, you have just about any economic data. So you’re looking at the stock market every day. You’re looking at the health of China, which is the world’s largest consumer of oil. Generally, positive economic data infers future energy use, and negative economic news seen is seen as signaling a potential decline in future demand, so the market reacts in a bearish way.

And then of course you have geopolitical events.
Right. I mean, just look at the last month and a half and how chaotic things have been. By the way, I hope that we learned a lesson from the attack on the Saudi infrastructure. The end result was maybe a 25-cent jump in the price of gasoline, so that interruption did not have a major impact on the US. Partially, because we’re importing 20% less than we were a year ago. But the New York Mercantile Exchange didn’t open for hours after the attack, and you can just imagine the panic of traders who had open positions. Oil jumped to $68 per barrel that evening. The market mainly consists of humans making decisions, and panic can ensue because of course nobody wants to lose money. So things like that can result in dramatic moves in prices even when the long-term consequences aren’t that dire.

What about the impact of the US dollar on oil prices?
Well, crude oil trades in dollars. At any given time, investors are moving in and out of commodities, bonds, and the stock market. There’s a lot of wheeling around of the pool of investing funds. And what we see is that if the dollar strengthens, you’ve diminished the buying power of foreign currencies, and they leave the oil marketplace. And then there tends to be a higher influx when the dollar weakens. So there’s a fairly tight correlation between the two, and they're inversely related. We watch these things every single day, and we see patterns emerge: dollar up, crude down. Other days, of course, something will happen out of the blue, like a Trump Tweet, and the markets react to that.

Any other ingredients to the pricing matrix?
There is one other thing we look at. The Energy Information Administration, or EIA, is the government’s statistical gatherer of all things energy. If you go to their website, you can literally see tens of thousands of pieces. Every Wednesday morning, at 10:30 a.m. Central, they put out their Weekly Petroleum Status Report, which tells us how much crude the country as a whole added or took from inventory the prior week. It tells the percentage of our refining capacity that’s being utilized. It tells whether we had surplus gasoline or had to draw some out to meet demand. So that’s a very concrete supply-and-demand report that comes out every Wednesday. Now, the day before it comes out, the analysts – from the Wall Street Journal and lots of other places – will predict what that report is going to show. And when that report is released, forecast becomes perception, and crude traders begin trading on the difference between what analysts thought the report would show and what it actually shows. Like I said, that comes out every Wednesday at 10:30 a.m., so if you're on the website at 10:29 a.m., you’ll literally see nothing. You have to keep refreshing your browser until it comes out. Because you can imagine the magnitude of the advantage of knowing that information before anyone else in the market. 

Let’s talk about the players involved in oil futures contracts. People who hedge oil prices tend to be from companies that rely on a supply of oil for whatever reason, like transportation companies and so on?
Correct. 

We could not take another barrel of oil from the Middle East area and we would be just fine.

And they’re trying to protect themselves against the vagaries of the market and secure pricing for themselves into the future. That’s their reason for buying or selling oil futures contracts.
Exactly. Right. If you’re a producer of oil, you're selling in the market, and if you’re a consumer of oil, you buy from this market. 

But the vast majority of trading in oil futures is done by speculators, right?
Correct. Yeah, in fact, CME, the parent of the New York Mercantile Exchange, estimates that approximately 98% of the trading is speculative. 

Meaning that those traders have no intention of going out and actually buying oil on the date that the futures contract comes to fruition.
Right. When we’re talking specifically about the NYMEX futures contract, for West Texas Intermediate crude, the delivery point happens to be Cushing, Oklahoma, which is just about 50 miles down the road from me. And yet we know that with all these contracts trading, only about 2% of the contracts that change hands are actually going to result in a physical transfer of crude oil from one party to the other at Cushing, Oklahoma. Still, the underlying for all these futures contracts is actually a physical commodity. It’s actually WTI oil. The speculative traders, if they were to end a particular month -- if they “went off,” as we say -- long or short, they have an obligation then to purchase oil or provide oil at the Cushing hub here in Oklahoma. At the end of the day, these are contracts. If you’re still holding them, these are an obligation to either make or take delivery of oil at Cushing, Oklahoma. 

It takes two parties to execute one of these contracts, and it seems like most players in the market probably have access to similar information, and generally there tends to be a consensus view about what’s going to happen. So how do people find counterparts for these trades, especially if it’s not a contrarian play? In other words, if I’m thinking like everybody else is thinking about what the price is going to do, how can I find somebody to buy the other side of my trade?
Well, you’re exactly right. Without that contrarian view, you have no marketplace. It’s like this: I’m a producer of oil and I want to sell oil. Well, if there’s nobody willing to buy it, I’m stuck. I can’t do anything. I have a price in mind for my oil. So is there someone willing to pay me that price? I may have to lower my expectation in order to actually consummate a deal. And so a similar thing is going on if you take the speculative folks. It’s just a slant on the marketplace. It’s a zero-sum game. Every time there’s a trade out there, that essentially means that there were two parties who had a different perspective on the marketplace, one thinking the price would go up, one thinking prices would go back down. So without that, it doesn’t work.  

Only about 2% of the contracts that change hands are actually going to result in a physical transfer of oil.

Of course that makes sense. But it’s hard to wrap your head around the phenomenon of high-frequency trading, with all those algos out there firing these things back and forth. There doesn’t seem to be any human with a conviction about the oil market behind that. It’s not somebody who’s read a ton of research and decided, “This is what I think is going to happen in three months.”
Yeah. The algorithms don’t care that Trump sent a Tweet out or that the weekly government report says X, Y, or Z. They're just reacting to price movement, which to me is sort of an interesting thing. I mean, what if there were no longer any humans engaged in this marketplace? What would they trade off of? Just each other? Would you have a handful of supercomputers caught in these loops where they’re just continually buying and selling in reaction to one another? 

That’s kind of a mind-blowing thought.
Sometimes financial derivatives and trading and hedging can obviously be very heady stuff. So one of the things I always tell my students is, “Look. Take a deep breath. Step back. And what is it we’re talking about? At the end of the day, we’re talking about a physical commodity. We’re talking about crude.” So anything that happens above those levels can always come back to the physical commodity. So, yeah, algo traders, that’s nothing but reacting to the prices in the marketplace. And let’s say, for lack of a better word, that the “real price” is the human interaction prices, which are the result of the trades of human beings who either have a vested interest in the commodity, as on the commercial side, or the speculative noncommercial traders who are just looking for an opportunity to make some profit.  

The other part of this that makes the head swim a little bit is that the current price of oil is very much influenced by – or almost determined in – the futures market. Is that right?
Yes. That’s a great question. Because the only reason that hedging works is because there is a relationship that’s fairly constant between the physical marketplace for oil and the futures marketplace for oil. And there’s two terms we talk about. One is called “parallelism,” which means that the markets tend to move in sync with one another. So if futures go up today, then the so-called “spot market,” or physical market, for crude oil, also tends to go up, and then vice versa: they both decline in unison. However, something happens as you approach the final trading day for the futures contract. For instance, right now, what we call the “near” or “prompt” month for crude oil is the December 2019 contract. And it will expire somewhere around the 21st or 22nd of November. As you approach that day, the last day that you can buy and sell futures contracts for December 2019 crude oil, what we talk about is “convergence.” The physical and financial markets at that point essentially become one. They become the same price. That’s the only way that hedging can work. Because otherwise, if they were disparate, you couldn’t have any relationship between the two of them and there would be no point in selling futures or buying futures if there was not a corresponding movement in the physical spot market for crude oil. 

That makes even more interesting your hypothetical about, “What if there were no humans involved in this market and it was just these robots throwing these numbers back and forth?” Would that convergence ever happen?
Right. Exactly right. It’s just kind of funny because they are, again, reactive mode. They're not setting markets so much as they're reactive. And I just find that fascinating.  

The algorithms don’t care that Trump sent a Tweet out or that the weekly government report says X, Y, or Z. They're just reacting to price movement.

Let’s turn to the topic of renewables and the prospect of actually making the switch away from fossil fuels. The common wisdom is that it’s bound to happen at a certain point, but how far out do you think that is?
I agree that it will happen. I think, unfortunately, that the perception is that it’s going to happen much faster than it will. If you look at the government data, the EIA has some forecasts. I think that for us to see a significant decline in the use of oil, Americans are going to have to say either, “I don’t have to have a car,” or, “I’m going to go electric.” We’re heading in that direction, but I think it’s going to be much more incremental than the leaps and bounds that seems to be the general perception.

But whether it happens slowly or quickly, we’re talking about a significant drop in demand for oil.
Yes. And I think oil demand will potentially decline faster than natural gas. Right now, natural gas is replacing coal across the country, and we’re now shutting down nukes but we’re not replacing that generating capacity fast enough with green sources of energy like wind and solar. So I think you're going to see a sustained and growing usage of natural gas to produce electricity for the next few decades while these other technologies come into place. But I think the whole gasoline auto thing is the big question. How many people are going to be willing to buy an EV or buy an extremely high-MPG vehicle or a hybrid, something like that? I think if you told people, “Hey, if you do this, you’re going to save money and lower emissions and be greener,” I think most people would agree with that. But right now, when you put that cost in front of them, there isn’t a big incentive. People want somewhat of at least a payout that they can see down the road that was worth this additional investment. But you know, it’s growing.

But the right incentives still aren’t in place to get consumers to change their ways?
I think the keys to alternatives and renewables have to do with the costs of them. I think if you bring them down to where the average household can afford to have a decent amount of solar panels on their roof to supplement some of the power they get from the grid, we’ll see a lot of that. The EIA does have a forecast saying that 30 years from now -- so in the year 2050 -- only a third of electricity in the United States is going to come from all sources of alternatives and renewables. So that means we’re talking about all solar, all wind, all hydroelectric, all biomass, all biofuels. Those sources of electricity are only still going to represent a third of our needs from a power standpoint. So oil is very sparsely used in generating electricity, but natural gas is up to about 35%. So that’s where I think natural gas generation will increase. We’re going to see alternatives and renewables increase, it’s just that I think the pace is being exaggerated at the present time.

Which bodes well for natural gas producers. What about oil, though?
For the past several months, I’ve been touting that the future of the oil and gas industry in the United States is exports. I mean, it just is. The global transformation to cleaner fuels is going to be a lot slower, probably, than even here in the United States. And yet the global appetite for fossil fuels across the board is going to continue to increase. Right now, the United States is producing record amounts of hydrocarbons across the spectrum: oil, natural gas, refined products, natural gas liquids, petrochemical feed stocks. And we happen to be exporting record amounts of all of those as well. Unfortunately for the coal industry, as these coal plants are being retired, they're trying to sort of survive on exports. But the world in general is also turning away from coal. So I think the future of oil and gas is going to be that as domestic demand for fossil fuels in the form of oil and natural gas declines in the coming decades, the global marketplace will absorb our surplus. 

And you’ve been saying lately that the US is on the cusp of becoming a net exporter of oil, right?
Yes, that is correct. One of the things that’s interesting, too, is that again, when you talk about these conflicts that happen, when you talk about the attack on the Saudi infrastructure, when you talk about what’s going on in Syria, I think the general public still thinks that we import a lot of oil from that region. Forty percent of the imported oil that we do get comes from Canada. We are not reliant on that region of the world for oil supply. You know, we could not take another barrel of oil from the Middle East area and we would be just fine. But yet I think there’s a perception that we have key interests in the oil fields over in the Middle East. We don’t, really. We could literally turn our back on that area relative to oil and we’d be just fine.

Someone from OPEC recently said, “What the Americans export from the Persian Gulf is not so much the actual black liquid but its price.”
There you go. That’s right. That is exactly right. And you know, there’s a very strong semantic argument here. People think we will be energy-independent. Now, we can achieve energy self-sufficiency. But, as I mentioned, if the future of the oil and gas industry, as I see it, is going to rely on exportation, we’re in a global market for energy commodities. And right now, the global prices are extremely influenced by OPEC. By OPEC and Russia, I should say, what we’re now calling the “OPEC-plus” group. So they can tug on our economy by doing something like what they did back in 2014 [Ed. note: when the cartel effectively began a price war with US producers]. So we’re never going to be truly independent, but we can certainly be self-sufficient in terms of our ability to provide for our own needs.

The future of the oil and gas industry in the United States is exports. I mean, it just is.

How do you think the oil companies are doing in terms of preparing and positioning themselves for this inevitable transition toward renewables?
I don’t know the full incentives of the majors. Maybe they want to be on the right side of the change. I mean, when you're talking about the majors like BP, Shell, ExxonMobil, you name it, they also have thousands and thousands of shareholders. And it seems that more and more shareholders want to see the efforts that they're making relative to climate change and relative to themselves being invested in things like biofuels. And most of the majors are out there touting their development of biofuels and things. You can see it in their commercials. So I think that you see diversification. I mean, even the Saudis are trying to diversify the energy that the country itself produces for its own needs and not to be so dependent on oil and oil revenue. Now, if you drop down to the next tier, what we would call the middle tier of the oil and gas companies, I don’t know that they have the wherewithal to turn around and invest in the type of research and capital infrastructure to develop green portfolios. And certainly your smaller independent oil and gas companies don’t. They're not going to be thinking of green or looking at green. They're going to be trying to survive.

And one important way of surviving in the future you’ve just described is the export market. As a potential investor in upstream companies, I think I’d want to make sure they’re ready for that trend.
Yeah. Can you tie yourself to the export market in light of what we think is coming? And if that’s the true outlet for our surplus, as an oil and gas company, are you somehow involved in that? Are they selling to an exporter? Do they have transportation, for instance, on a pipeline that can deliver their oil to the Texas Gulf Coast where we’re doing most of the exporting? Are you getting your product to export points? I mean, there are producers in the Marcellus in western Pennsylvania that have entered into transportation agreements for natural gas. They are literally delivering natural gas to the Gulf Coast for exportation, and they're also taking it down the East Coast for exportation in places like Cove Point and Elba Island. So to me, it’s a matter of recognizing what’s coming and doing something about it, which means being highly engaged in that international marketplace.

UPDATE: In late April of 2020, oil crashed in an unprecedented way, even closing in negative territory at the end of one day. To help make sense of this, 74&WEST’s Derek Burnett got back on the phone with Mr. Seng. Check out this fascinating conversation and hear why Tom thinks it happened and what’s ahead for this particular commodity.

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Tom Seng is an Applied Assistant Professor of Energy Business and Director of the School of Energy at The University of Tulsa. Previously, he taught at The University of Oklahoma, Penn State University, and Texas Christian University. Mr. Seng has over 30 years of experience in the natural gas and natural gas liquids industry including: physical and financial commodity trading, risk management and hedging, pipeline and midstream operations, transportation & storage capacity marketing, and risk control. He is the author of Energy Trading & Hedging: A Nontechnical Guide (PennWell 2019).

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