Wednesday, July 18, 2012

Tight Oil could not Render OPEC Irrelevant

Steve Levine has a blog post discussing the idea that the "unfolding new age of fossil fuel abundance" will have profound effects on various things, including OPEC:
With prices dropping and competing supplies flowing from numerous new producers, OPEC will lose much relative influence, and may simply cease to be a pivotal economic player. "OPEC will descend into chaos as an organization," said John Hofmeister, former president of Shell USA. "They don't know now how much they are hated by the entire world. But they will find out as things unfold."
The key factor behind this kind of thinking is the rapid rise of production of oil from tight rocks like the Bakken in North Dakota and the Eagle Ford in Texas.  I haven't taken a strong position on what the limits of production are from these sources - it just isn't clear to me yet from the data that I have available.  But we could certainly place some limits on how much geopolitical impact this could have on OPEC.

Let's posit, for the sake of argument, that tight oil plays in the western world could eventually produce 20mpd of oil.  This is a much larger number than I've heard from any analyst, so should presumably allow us to explore maximal benefits from this type of play.  However, let's also posit that this 20mbd of potential supply is only profitable at oil prices better than $75 (since these plays are very input intensive and require a high oil price to work), and let's also posit that the individual wells decline rapidly - say 50% y-over-y - as this is also a characteristic of these plays; they require constant new fracking of new wells to squeeze oil out of rocks in which it won't naturally flow very far.

These numbers are not intended as particularly accurate - just a thought experiment to allow us to get at the essentials of the situation.  Now, what is implied by this picture?

Well, firstly, this cannot result in sustained oil prices much below $75.  A drilling boom could certainly overshoot and result in too much supply and collapse prices, but that oversupply could not last very long.  Since these wells decline rapidly, once oil prices go below $75, drilling will largely stop, and the available supply will quickly contract until prices can again be supported at or above $75.  This is in contrast to the situation in the 1980s when oversupply came from new sources in the North Sea and Alaska which were not resource plays: once a decent sized field was on plateau it would continue to produce for years unless oil prices fell very low indeed.

So, from this argument we see that what we would expect here is just enough of the 20mbd would be developed at any time to meet the demand of the global economy at an oil price of $75.  This amount of oil would increase over time, of course, as the world economy grew.  There might be price fluctuations to either side, but they could not be long-lived.

Now, let us ask: does Saudi Arabia, say, have less leverage over the world in this scenario?  Let's say the world is producing 100mbd (including 10mbd of new supplies from tight oil) and Saudi Arabia is also producing 10mbd of that 100mbd still.  Do we still care critically about the stability and good graces of the Saudi regime?  I think we do.  10mbd is still 9% of global supply in this scenario, and there is no reason to suppose that oil demand will suddenly become highly elastic, so it's still the case that if that Saudi 10mbd were to disappear, oil prices would increase by a large multiple.  True, that 10mbd might potentially be made up from the unexploited tight oil, but that is something that would take years to accomplish, and in the meantime, the global economy would suffer dreadfully.

In short, I don't see how this new source of oil supply can result in large amounts of spare capacity (at least for any length of time).  And without large amounts of spare capacity, the basic dynamic at play presently - oil demand is inelastic so that any large supplier going offline creates an economic crisis - will not change.  Therefore, OPEC will continue to be a highly influential body, and the world will continue to care critically about the stability of major oil producers.


rjs said...

KLR said...

I plotted ND rigs against Bakken output; interestingly enough when the price crashed in '08 rigs pulled out, production went down - for 3 months, then it was back on its upswing. Haven't quite figured out what dynamic was at work there; obviously there are plenty of lags for bringing rigs in, building infrastructure, finding manpower, etc. It's a study in of itself. I think you'd see more 1:1 in the Eagle Ford - which has been more productive YOY, for the simple reason of pipelines being to hand, more forgiving climate, etc.

I've thought much the same about spare cap if tight oil really begins to make itself felt. Incidentally they're on their way to doing that very thing, at least in theory; we also saw a very productive half decade in the GOM. I need to calc YTD for these resource plays and see how they're doing. None of this has budged prices in the slightest, of course; even ND Sweet is trending up, just at a $20 discount to WTI.

For NA if I were a driller I'd vacillate between oil and NG; overproduce latter, pull back, move into former, pay for NG wells with oil proceeds, stir well. Doesn't that make sense? NG being largely stranded you'll readily shoot yourself in the foot, but oil we just can't get enough of, the whole wide world round. Perhaps this is the strategy being employed, I haven't skimmed over any EOG etc .ppts to find out what they're all about.

Kenneth D. Worth said...

Thank you, Stuart. So much discussion of the oil industry is just wishful thinking or unjustifiable pessimism. Your rational analysis is a breath of fresh air.

And the recent white paper that is getting so much comment in the press assumes that there is no decline in conventional production that offsets the additional production from shale plays over the next 20 years.


Greg said...

Stuart -

I think there is room for doubt about the conclusion. The old saw of economists that high prices are their own cure might apply. Oil demand could start falling because of long-run elasticity effects and cross-price elasticities. The long-run own-price elasticity of oil is much higher (about 0.6) than the short-run elasticity.

After googling I came up with these numbers from the usual suspects (BP, the IEA, etc):-

* The number of vehicles is expected to grow by 3% per year. This prediction seems to date from about 2008.

* Vehicle efficiency is expected to improve by 1% to 1.5% per year.

If oil consumption is to fall, then one or another of the following needs to happen:

1. Efficiency grows more quickly than vehicle numbers.

2. Vehicle distance travelled per year falls.

3. Non-oil vehicles become significant.

Two of these (no.s 1 and 2) require behavioural changes, which are set in motion by persistent high prices (or reduced incomes): tastes change so that more efficient vehicles are preferred. People move closer to work, and vice versa, vehicle utilisation increases (trip combining, greater use of taxis and buses), slowing the growth in number of vehicles. Simply not travelling as much for entertainment, or using substitutes such as rail or bicycles, decreases total miles per year.

A high floor on oil prices makes no. 3 more likely also. If natural gas remains cheap compared to oil, more vehicle will use CNG (outside of North America, where rent-seeking by the oil industry prevents a switch to gas). If the price of LPG decouples from oil due to an abundance of NGPLs, more vehicles will use that.

If each of the above contributed a 1% share to reducing oil use, then total demand would reduce by 2% per year.

Technology may provide an assist. There is renewed interest in making vehicles more efficient; that might accelerate improvements. Some entrepreneur may yet figure out how to combine GPS and mobile phones to make ride-sharing a majority habit, increasing utilisation. Self-driving vehicles should make using taxis much cheaper (again, except where rent-seeking by taxi drivers prevents it) and more convenient - in large cities, more convenient than driving and parking your own car - again increasing utilisation. Internet shopping and teleworking may grow more quickly than expected. You never know - someone might get cellulosic ethanol working. It seems to me that there's potential for another 2% per year decline in oil consumption here.

Finally, I should note that the IEA predicts that transport's share of oil consumption will steadily rise up to 2030; i.e. total oil demand will grow less quickly than transport fuel. So if transport fuel demand declines, oil demand will decline more quickly.

Therefore it might be that Steve Levine is right for exactly the wrong reason. It is not the abundance of shale oil, but its scarcity (i.e. the high price floor needed to produce it) that might make OPEC irrelevant in the medium term.

Nick G said...

Greg is exactly right.

Historically there have been significant barriers to entry for EVs (including HEV/PHEV/EREV/EVs).

Well, the current high prices are allowing enormous investment into electric drivetrains. Eventually economies of scale and new battery tech will combine to push PHEV and EV total life cycle costs sharply below those of ICE vehicles, and the genie will be out of the bottle.

Then we'll see some creative destruction...