By Steve Andrews
The ongoing 50+% decline in world oil prices over the last six months grabbed attention back to our energy landscape, especially oil’s role. It highlights a key point about oil over the last decades, summarized by industry analyst Douglas Westwood: “there is one recurring theme—the lack of preparedness of nations, both producers and consumers alike, for the major changes in the availability and price of energy.” What follows are 10 quick background points about our current and long-term situation with oil supply.
1. The U.S. was never going to be “oil independent.” The U.S. Energy Information Administration generally supports this view in their annual reports (e.g., projects 30% of U.S. oil from imports in 2040; AEO 2014, reference case), yet industry analysts and the media have misinterpreted data and phrases like “oil exports” to mean the U.S. will become not only oil self-sufficient but also a net oil exporter. This is almost certainly not true, and ignores current U.S. imports of 33%, yet it has been one of the most frequently printed and talked-about stories since the shale oil boom got serious in 2012. This growing independence myth has potentially major impacts on U.S. energy policies.
2. The U.S. shale oil boom has been historic, but it’s not sustainable. The increase in U.S. crude oil production since 2012 has been staggering; it appears to be the largest three-year oil production increase by any nation in history. But shale oil is more expensive than conventional oil and has required several hundred billion in debt financing that can’t be continued at today’s low prices. Further, the Fed’s artificially low interest rates pushed a lot of investment towards the oil sector, distorting the abilities of companies chasing the boom to borrow unsustainably.
Apart from today’s price war, shale oil has two other limiting factors. First, the highly productive areas (“sweet spots”) represent only a modest portion of large shale oil fields; when they are drilled out, production will decline as even the optimistic US EIA acknowledges. Second, the rate at which oil production from individual shale wells declines is many times faster than normal, averaging over 70% during the first year alone. Just to keep production flat requires drilling ever more wells: in North Dakota’s Bakken, it took 1,470 wells drilled last year, 1,700 this year, and eventually 3,500 once the sweet spots are drilled out and are replaced by lower quality wells.
3. At today’s crashed oil prices, the drilling boom is already slowing. News stories tend to focus on the benefits to consumers of today’s $2 gasoline, but the oil industry is getting clobbered. Net cash flows for most shale oil drillers were actually negative before the oil price drop started last June. For the last few months, every week has brought new announcements of reductions in 2015 capital budgets. Rigs are slowly being laid down across the country, with layoffs in the thousands each week.
4. Banks recent support of oil boom waning. Loans to independent oil companies have been the lifeblood of the shale oil boom. Banks profited handsomely from providing the steady stream of liquidity required by the ever-increasing number of expensive wells ($5 to $12 million a pop) necessary to keep production growing. Yet the free-falling price of oil over the last few months has turned loans that seemed safe at the time into risky assets. Smaller players that carry very large debt appear to be the ones which won’t get the financial support they’ll need from bankers to outlast the price crash. Defaults are likely, contributing turmoil and dashing hopes for continuing annual oil production increases.
5. U.S. production likely to repeak, sooner than expected. Despite the oil price crash, U.S. oil production should continue growing for another few months for several reasons: a portion of this year’s output has already been hedged at higher than current prices; drilling rig contracts, which last for months at a time, can sometimes make it nearly as expensive to cancel the contracts as to drill; and hundreds of wells have already been drilled but not completed and hooked up to distribution systems. But this carryover ends within months. Eventually U.S. production will repeak, plateau for some “bumpy period,” then decline.
6. “Oil pyramid” means shale oil costs more money and energy to produce. Imagine all the world’s oil resources fit within a pyramid. The top sections are the easiest and cheapest (conventional oil) to drill; the remaining “top” is also among the smallest sections. As you descend, some of the slices (offshore oil, Arctic oil) are more expensive and challenging to produce. Then unconventional oil (shale oil, tar sands) is the next layer down; there’s more of it but it’s yet more expensive and energy intensive to extract. The lowest layer—so-called oil shale—isn’t actually a liquid; the waxy substance has to be melted out of rock. While technology has allowed us to drill lower into the oil pyramid, economies are strained by the more expensive oil. It’s legitimate to question whether producing the oil resource from lower levels of the pyramid is inspiration or desperation.
7. Alternatives to oil cost more money and energy to produce. Oil is our most versatile and dense form of liquid energy. It powers the world’s transportation system. No gaseous or liquid alternatives, especially U.S.-produced biofuels, compete at scale and on a level playing field with oil, despite decades of effort to support them.
8. Outside North America, world oil production is flat. The world’s largest oil producer (Russia) and fourth largest (China) appear to have hit production plateaus. Exports from some large and small producers are curtailed due to either geopolitics (Iran), politics (Venezuela), or violence (Nigeria, Libya, Yemen, Sudan, Syria). Some are declining due to geologic limits (Indonesia, Norway, the UK—now an importer again). These curtailments and declines offset the increases elsewhere (Iraq, Brazil). Bottom line: production outside North America has been flat, even declining slightly since 2012.
9. Outside North America, a shale oil boom is much less likely. While major shale oil deposits have been identified in Argentina, China, Russia, Australia, etc., none appears poised to become a major producer within the next five years. For a host of reasons (different incentives, less infrastructure, geology), barriers to fast growth loom large.
10. Oil demand is more volatile than expected, hurting long-term oil projects. Higher oil prices started cutting demand for oil in OECD countries back in 2005-07; more cutbacks appear likely (except in the U.S., in the short term, where recent demand is surging). China’s long-running large annual increases in oil consumption appear to have hit their first speedbump. Economic slowdowns and the price crash make it tougher for oil large companies to move ahead with 6+-year major investments to increase world supply.
Bottom line: These 10 factors, and others, make it likely that world oil production will reach a peak-and-plateau in production between 2015 and 2017. No guarantee here, just prudent concern.