Reason 5: “Shale Revolution” – A Purely North-American Phenomenon
Porter argues that a global shale oil revolution could push production volumes way up and prices way down, but this argument assumes the world has the infrastructure to power such a revolution. That is simply wrong.
It is not easy to drill an economic shale well, whether for oil or gas. To get the most out of a shale formation, an operator often needs to use a high-power – over 25,000 horsepower – frac drill set. He has to drill horizontally, which is far more technical and challenging than drilling vertically, and then has to complete multiple fracs to get the well flowing.
North America has more energy infrastructure than anywhere else in the world, resulting from years of conventional oil and gas development and production. In North America it is relatively easy to find drilling companies armed with these high-power frac sets, but such is definitely not the case in most other parts of the world. Europe, for example, is home to fewer than one-tenth the number of drilling and fracking sets as there are in North America. That means any shale revolution in Europe would take a very long time to develop –the equipment and expertise just aren’t there.
Yes, shale gas production ramped up quickly in North America, but we had the infrastructure in place and just needed to adapt it to a new kind of geology. The head start means North America is now more than a decade ahead in a sector that Europe has just begun to understand, and one that Russia still refuses to believe.
It is safe to say that it will take a very long time for the shale revolution to have a major impact in Europe and elsewhere. In the best-case scenario, we believe Europe will only have a small amount of shale production of any type twelve months from now.
Reason 6: The Easy Oil Is Gone and Shale Oil Wells Decline in a Big Way
The IEA estimates it costs between $4 and $6 to produce each barrel of oil from the conventional fields in Saudi Arabia and Iraq, including capital expenditures. Algerian, Iranian, Libyan, and Qatari fields cost slightly more, at about $10 to $15 per barrel. These countries produce most of their oil from relatively easy, straightforward, conventional deposits.
My perspective on energy resources revolves around the fact that there are no more of these big, easy deposits to be found. The deposits of tomorrow are harder to find and more complicated, expensive, and risky to develop. Companies now have to manage the litany of challenges inherent in getting oil out of places like the oil sands, sub-salt deposits, and ultra-deep offshore reservoirs.
With increased difficulty comes higher production costs. This also means that if oil prices fall too low, costs will overwhelm revenues and production will shut down altogether.
The Canadian oil sands are a perfect example. Producing projects in the oil sands need an oil price of at least $60 per barrel to remain economic – and that assumes capital costs have already been repaid. To build a new oil sands project, a producer needs to believe prices will remain high enough to cover not only his basic production costs but also to repay his huge capital outlay. As such, new oil sands projects are uneconomic to develop without an oil price of at least $85 per barrel.
The oil sands are by no means the only important oil region with high production costs. To access most of the world’s unconventional oil resources, companies need to drill horizontally, which costs much more than drilling vertically. After drilling horizontally, producers have to frac the well in many stages to achieve commercial production. This means each well costs many million dollars, an expenditure that is not going to be economic at $40 oil.
What is more, these wells decline much more rapidly than conventional wells. Production from any well falls with each passing year, but with unconventional wells the decline can be dramatic. In fact, shale wells typically decline by more than 50% after their very first year. To maintain production, companies need to be constantly drilling and commissioning wells, a treadmill process that increases the production costs significantly.
In the world of unconventional production, companies are faced with a double whammy: they need to drill more wells than a conventional field would require; and each well is much more expensive. Companies are not going to bother with this challenge if low prices make it a money-losing endeavor. Once production begins to shut down, the world will panic and the price of oil will turn upward once again.
Reason 7: The World Is Always Hungry for Oil – and Oil Deposits
The world is not awash in oil. On the contrary – we produce only just enough oil to meet global demand. With the world’s population growing every day demand continues to rise, making the balance ever tighter. Even the threat of major production cuts of the sort we just discussed – which would surface the moment the oil price fell to $85 per barrel – would be enough to send tremors through the global oil machine and push the price of oil back up.
It is not only traders who will react to push prices back up. Countries will jump at the chance to secure oil supplies on the cheap. You see, for the oil-needy nations of the world, having to constantly walk this supply-demand tightrope is far from ideal. Far preferable would be to control of enough oil deposits, at home and around the world, to meet national needs. With nation after nation coming to this realization, the race is on to secure energy supplies.
China is the biggest player in this arena. Armed with a massive bank account, the Chinese are seizing every chance they get to buy major deposits. If the price of oil starts to slide, as Porter suggests it will, the value of major oil projects will decline as well and the Chinese will act, buying up any reduced-price oil deposit they can find. Acquisition activity like that will push prices back up again, if for no reason other than that people will remember the finite and declining nature of our world’s oil reserves.
I also think the starting gun has already gone off in the global race for uranium, but that’s a story for another day.
Reason 8: A Falling Oil Price Means Big Chunks of Global Reserves Uneconomic
If exploration drills find an oil deposit, data from those drills are used to calculate a “resource estimate,” which is a geologic best-guess of how much oil the formation holds. However, oil in the ground is not necessarily oil that will ever see the light of day. That’s where the “reserve estimate” comes in. Reserves are an estimate of the amount of oil within a deposit that can be extracted economically.
Let’s look at both of those words: “extracted” and “economically.” Whether oil from a deposit can be extracted depends on the geologic parameters of the deposit and the technical abilities of today, which combine to determine how much of the deposit is “technically recoverable.” Then the “economically” part of the description comes into play. Oil is only “economically recoverable” if the cost of production is less than the price of oil – put simply, the producer has to be able to make a profit.
Remember, my outlook on energy resources is based on the premise that most of the easy deposits are gone. In general, only the hard-to-find and expensive-and-complicated-to-produce deposits remain. Producers cannot make money from these challenging deposits if oil is cheap, which means reserves will revert to being uneconomic resources.
Examples abound. It costs far more to produce a barrel of oil from the deepwater Gulf of Mexico, Canada’s oil sands, Russia’s Arctic waters, Estonia’s oil shales, or Brazil’s deepwater sub-salt deposits than from the big, conventional oil fields of yesterday, like those in Texas or Saudi Arabia. Oil reserves in these places will evaporate if oil prices fall and render them uneconomic to develop. The world’s oil resource count will remain the same, but resources are useless if we can’t get them out of the ground.
The world uses a lot of oil. All of that oil has to come from our finite pool of oil reserves. A falling oil price would gradually eliminate that pool, because the cheap oil is gone. And that simply doesn’t stand up to supply-demand logic.
Reason 9: Between the Lines – By-products
One reason that North-American gas producers continue to drill select wells is because certain shale reservoirs contain lots of Natural Gas Liquids (NGLs). These liquids, comprised of bigger carbon molecules than the methane that is natural gas, trade at a significant premium to natural gas. Furthermore, these NGL-rich natural gas wells often also produce some oil.
The presence of these bonus products means producers in NGL-rich areas can continue to operate because revenues from the sales of by-product NGLs and oil compensate for rock-bottom natural gas prices. The result is upside-down – for these operators natural gas is still the primary product by volume but is the least-important product by value – and ironic, because by continuing to add to the natural-gas supply glut in North America their gas output is actually perpetuating the gas pricing problem. But the point is that the price of gas doesn’t matter: as long as the NGLs and oil continue to flow out of these wells, the operator will remain profitable.
A similar paradigm does not exist in an oil well with natural gas as a by-product, because of course gas is worth far less than oil. If the price of oil began to fall dramatically, companies would simply stop drilling and there would be no upside-down by-product incentive to continue.
Reason 10: Black-Swan Events – The Fragile Supply-Demand Balance
A “black-swan” event is a rare but highly significant event with dramatic impact. The collapse of Lehman Brothers, the Arab Spring, and the Fukushima nuclear disaster are all examples of black-swan events.
These events tend to tilt more in favor of a rising oil price. Consider this: the loss of oil production from Libya – which represented just a small fraction of the world’s production – caused the price of oil to move 25% in just two months.
As we have mentioned before, the world produces barely enough to satisfy global demand at the moment. That is precisely why any significant impact on the supply side generally shocks the market disproportionally.
And there are a good number of possibilities that could quite easily occur that would send the price of oil much higher: a war with Iran; OPEC reducing production levels; terrorist attacks in Nigeria; renewed social unrest in the Middle East… the list goes on. The point is: if something goes wrong geopolitically in the world, it is more likely than not that oil will begin shooting up.
And there you have it – ten reasons why the price of oil will not hit $40 a barrel in the next 12 months.
Porter, I respect your opinions and consider you a friend but, just like I took your money in our poker game, I look forward to laying my hands on your 100 ounces of silver, should you accept my challenge.
[Porter gave his shocking analysis of the oil market at the Casey Research Recovery Reality Check Summit in Florida last weekend. It was one of a host of eye-opening presentations attendees heard over three days from 31 financial luminaries, including former director of the US Office of Budget and Management David Stockton, famous contrarian investor Doug Casey, and resource investing legend Rick Rule. And even if you weren’t able to attend, you can hear every recorded presentation and every piece of actionable investment advice in the Summit Audio Recordings.]
