It is impossible to understand where I am coming from on this blog it without grasping the implications of the graph above (also used here). The graph from the Federal Reserve Bank of Dallas earlier this year highlights the level at which it is profitable for E&P companies to drill new wells. Clearly this is well below the current oil price. The price signal is strong: drill more wells.
Shale oil production is not resource constrained. There is no shortage of rocks to frac or sand to feed the beast. Pioneer estimate there is in excess of 250 years supply in the Permian basin alone at significantly higher production rates than today. There might be a shortage of rocks to frac at an economically efficient price but that answers a different question. The limiting factor on shale is not resource availability but the technical and organisational constraints associated with its growth. The constraints shale faces in the US are organisational: raising capital, training people, building pipelines and new rigs, all the challenges of maximising a known process. Over time no economy in the world is more adept at solving these challenges than the US economy. Chandler called it The Visible Hand and he was right.
This is a massive change from the recent era of offshore domination. Shale is a mass production process where unit costs are constantly being driven down. Offshore was a custom process: each field development was a one-off, each rig and vessel (largely) were one-off’s, each tender was a one-off. The whole chain was geared to custom solutions and while it was efficient at high volumes it is not a deflationary process. The Brazilian pre-salt finds while enormous in size led to a cost explosion throughout the industry and not one it has fully recovered from. The Harsh Environment UDW rigs while significantly more capable than jack-ups did not reduce per barrel costs they just helped us access a scarce resource that we didn’t think we could get from anywhere else. We were happy to pay the price.
It is a very different world now. It is all well and good for the $FT to claim “Shell hails bounceback towards deepwater drilling” but the story carries a more modest message:
“Deepwater can compete if not demonstrate higher returns because of fundamental cost reduction,” he said. “Break-even prices in deepwater — we are now talking $30 per barrel.”…
“It’s great to have both in the portfolio and we are growing our shales business . . . but in terms of sheer cash flow delivery our deepwater has significantly more cash flow potential,” said Mr Brown.
We are into deepwater at $30 a barrel Shell are saying, but we like the competitive tension of shale and we will keep our options open. The upside is in other words capped.
I think the price of oil is therefore capped in the long-run, and I stress that because an industry run with minimal stocks and a highly interconnected supply chain is always going to have short-run volatility, at the rate at which the US shale industry can organise and finance itself and supply marginal production. Eventually the oil price will be capped at what these producers can profitably supply to the market because over time they will continue to grow production significantly. This is an industry with very low barriers to entry and a wealth of subcontractors who can supply kit, and while the offshore rig count has had a fairly minimal improvement globally over the last year there is an almost .9 correlation to the oil price and the US land rig count:
There is a good article here as well about how in the long-run refineries can process various types of sweet/sour and light/heavy. Again there will be a short-run transition for some refineries who cannot handle light sweet crude but the processes are known and it is simply a cost-optmisation exercise between cheaper light-sweet crude versus more expensive heavy-Brent (for example).
This is clearly a long transition but it strikes me as an inevitable one. US shale production will over time increase as the capital intensity and investment deepens. The huge capital and organisational requirements this will entail ensures this is not an overnight process, but it is a continuous process and one where the inertia now seems unstoppable. This is why I strongly believe that the offshore industry demand curve has lost its correlation with the oil price and a far more complex demand line needs to be plotted for companies.
Offshore’s golden age post 2000 simply didn’t have this competitive supply source, and certainly not one with a major deflationary bias, to compete with. Every strong recovery in global demand led to a straight linear investment in offshore as the only marginal source of supply… ‘there is no easy oil’ people used to say as cost inflation took hold of the offshore industry. But now there is and not only that it appears to be getting cheaper to access it as well.