In two previous reports, I had mentioned the changes occurring in the oil markets and explained how countries were affected differently by the drop in prices.
The second report went a bit deeper into explaining how companies drilling shale oil wells were doing, how consumers were benefiting, and how governments have the chance to reduce or cancel subsidies. In this report, full focus will be placed on historic US oil production and how it has changed from the 1970s to now.
The report will as well refer to two different methods of extraction, and explaining the financial feasibility of each in determining the operational costs of extracting shale oil. The report will conclude with the future prospects of the industry.
There have been many political arguments surrounding the reasons for the sudden — and up to now — consistent drop in oil prices. One of these was for shale oil wells to cease to exist, whether by stopping further wells from being drilled or additional drilling permits being obtained, or by forcing producers out of business.
This is supposed to result from the ongoing drop in oil prices. Away from any political aspect of the argument, the report will focus on the economic aspect as well as explore the financial feasibility of shale oil production.
The following figures are based on data from Energy Information Administration (EIA) to identify peak points for oil prices. The 1970s witnessed oil prices increasing from $3.18 a barrel in 1971 to $12.64 in 1979, $21.59 in 1980, and $31.77 in 1981 before it drops back to the $20s range until 1986, when it dropped below $20.
The price per barrel climbed back up to $26.72 in 2000, $36.77 in 2004, $50.28 in 2005, $66.52 in 2007, and $94.04 in 2008, where it maintained an upward projectile except for two troughs of $56.35 and $74.71 in 2009 and 2010 respectively. The drop in oil prices that started in 2014 has brought the price per barrel to below $60.
To summarise, there have been significant surges in oil prices from 1979 to 1981, then from 2000 onwards except for two relatively lower prices in 2009 and 2010. So what happened?
The oil embargo took place in 1973, which quadrupled the price of oil per barrel — whether directly by limiting the supply of oil or by Opec members demanding that foreign oil corporations increase prices to consequently increase oil revenues.
The US reliance on foreign oil was exploited, and President Nixon’s strategy was to increase local production. According to a research titled ‘Oil Shale Development in the United States’, part of Rand Corporation’s Monograph series, that was the first time when there was interest in shale oil and in developing its technology with interest eventually fading away as oil prices dropped to below $20 in 1986.
In the same paper, two different techniques of extracting shale oil have been explained. I will skip the technical details and rather focus on the commercial viability of each, which does not include the initial investment by shale oil producers.
The first extraction method is ‘Mining and Surface Retorting’, which can only be profitable if oil price per barrel was somewhere between $75 and $90. As previously stated, price of oil per barrel exceeded $70 in 2008, and total US production of oil increased from approximately 8.5 million barrels per day to 12.3 million per barrel, with the increase of around 3.8 million barrels consisting of 2.4 million barrels of crude oil production.
So where did the other 1.4 million barrels come from? Looking at this, proportionately, one would say that the increase in shale oil production is quite small. Though that argument can be undermined by the fact that each shale oil well can produce a maximum of around 550 barrels per day for three months before production starts declining, as stated by Edward Morse, global head of commodities at Citigroup, on CNBC.
The weighted average of shale oil well production is 334 barrels as indicated by EIA, with some wells having a daily production of as low as 24 barrels. This explains the need for too many wells to be drilled, and partly explains the increase in the number of rigs from 426 in November 2008 to 1,573 in November 2014.
The second extraction method is ‘in-situ retorting’, which can be profitable even if oil price was below $30 per barrel. When the Rand Corporation research findings were published in 2005, it pointed out that this method of extraction needed another six years of research before it becomes widely available.
In 2011, the number of rigs has more than doubled from their 2008 levels. As this method has much lower extraction costs per barrel than the first one, it is therefore safe to assume that this is why there have been various thoughts on what is the break even oil price per barrel for US oil production.
In an earlier op-ed in Bloomberg, the lowest break even price recorded for a US shale oil project was $43.01 a barrel. The second method of extraction might be in effect here with the increase in break even price being due to other cost factors computed in.
The main idea to be concluded here is that current oil prices wouldn’t necessarily push shale oil producers out of the market, especially those who already are heavily invested in the industry. However, the method of extraction being applied and other operational cost factors computed in would determine the exit date if one is to be set.
This will also be subject to that early entrants, preferably in 2011 onwards, might have already recovered a huge share of their initial capital investments making it only beneficial to stay in the industry until all wells have been fully utilised towards increasing profitability.
So will shale oil production cease to exist as many have been predicting? Or would production be at least lowered? No.
Despite the fact that low oil prices might push many to exit the industry, that’s not the entire story here. Other factors in action are, as mentioned too in the previous report, is how much debt is carried on the company’s balance sheet.
The total debt of American shale oil producers exceeding $260 billion has been made possible by financing at extremely low interest rates of 0-0.25 per cent.
The looming threat comes instead from two possible causes resulting in a debt bubble burst separately or dually: extremely low oil prices, at below $30, and the planned interest rate increase by the Federal Reserve.
For the former, the forcing of some companies out of the industry will lead to job losses that will only reverse the latest fall in US unemployment rate and push it north of 6-6.5 per cent. With the increase in interest rates, obtaining financing will be more costly which will result in recovering capital investments becoming relatively harder.
It will also result in an additional effect of strengthening the dollar which has been inclining in value since the Fed stopped its quantitative easing programme. It might be safe to assume here that oil producers who have their currencies pegged to the dollar might be gaining purchasing power that hedges part of the loss incurred from the drop in oil prices.
So, what’s next for the industry? Despite the fact that the largest deposits of shale oil are found in the Green River Formation covering Colorado, Utah, and Wyoming, Russia in fact has more technically recoverable shale oil than the US.
In the top 10 are also China, Argentina, Libya, Australia, Venezuela, Mexico, Pakistan, and Canada.
Drilling wells might not be financially feasible now, especially as countries lean towards interest hikes to preserve their currencies’ values against the dollar. However, shale oil technology has been progressing since 1973, and cheap debt is still available.
What needs to be stressed is that oil prices will not reach previous peaks even with or without production cuts, as the entry of new producers at periods of high prices will eventually lead to a drop in the long run, leaving worldwide demand as the sole future determinant.
The thought that I want to leave you with is: how will the millions of oil barrels being stored on storage tankers affect oil supply and demand curves in the near future?
The writer is a commercial consultant and a commentator on economic affairs. You can follow him on Twitter at www.twitter.com/aj_alshaali