Kemp: Forecasts For Higher Oil Prices Misjudge The Shale Boom

Article title
"The world of energy may have changed forever," according to Professor James Hamilton of the University of California.

Reuters

John Kemp is a Reuters market analyst. The views expressed are his own

LONDON, July 28 (Reuters) - "The world of energy may have changed forever," according to Professor James Hamilton of the University of California. "Hundred dollar oil is here to stay."

Hamilton, who is one of the most respected economists writing about oil, made his bold prediction in a paper on "The Changing Face of World Oil Markets", published on July 20.

"Old hands in the oil patch may view recent developments as a continuation of the same old story, wondering if the high prices of the last decade will prove another transient cycle with which technological advances will eventually catch up," he wrote. "But there have been dramatic changes over the last decade that could mark a major turning point."

The shale revolution will turn out to be only a pause in the upward trend in prices, Hamilton argues, as growing demand from emerging economies and stagnant supplies from conventional oil fields push prices higher in the long term.

"Rather than a force pushing oil prices back to historical lows, it seems more accurate to view the emerging tight oil plays as a factor that can mitigate for a while what would otherwise be the tendency for prices to continue to rise."

Ignoring Shale

The problem with Hamilton's analysis is that it largely ignores the impact of the shale revolution on the economics of oil production and understates the tremendous variability in real oil prices in response to changes in technology.

The professor devotes just 400 words out of almost 4,000 to discussing the production of crude oil and gas from shale formations.

Most of that discussion focuses on the high cost of drilling and fracturing shale wells; the rapid decline in production; the alleged unprofitability of shale wells; and question of whether the conditions that produced the shale revolution in North American can be replicated in other parts of the world.

But this part of the paper is also the weakest, and it highlights the fundamental limitations with Hamilton's entire argument about the increasing difficulty and costs of producing crude oil.

Peaking Oil

Since 2008, the dramatic increase in oil and gas production from shale formations in North America, and the abundance of shale resources around the world, has discredited theories about peaking oil production.

The simple theory that supplies will run out has been reframed as a more sophisticated one about rising prices.

Peak oil supporters now point to the increasing cost of oil production, diminishing energy return on investment and the diminishing energy return on energy invested to claim that it is becoming harder and more expensive to sustain, let alone increase, crude output.

Prices must continue to rise in real terms, they say, to reflect the increasing cost of producing crude and to restrain demand. Price increases will prove to be just as disruptive as physically running out of the stuff.

Hamilton's paper lends influential support to this view. He notes that oil demand is now being driven by rising incomes in emerging markets, even as high prices restrain consumption in the advanced economies.

He also claims that much of the growth in oil production since 2005 has come in the form of he calls "lower quality" natural gas liquids, which have a much lower energy content and energy density than conventional crude.

Production of conventional crude oil has stagnated, despite surging prices and unprecedented spending on exploration and production activity.

"Depletion of older reservoirs and the high cost of developing new resources" explain why conventional oil output has not responded to climbing prices, Hamilton concludes.

Shale Skeptic

The paper is sceptical about whether shale oil can alter the supply outlook fundamentally because of its high production costs and the difficulty of replicating the boom outside the United States. But this is the least convincing part of Hamilton's argument.

The paper confuses the struggling economics of dry gas wells with the much more attractive economics of wet gas and oil plays.

If oil wells were not extremely profitable, North Dakota and Texas would not be experiencing a drilling boom, with demand for both rigs and petroleum engineers at the highest level for three decades.

In focusing on decline rates, Hamilton ignores the ultimate amount of oil and gas recovered from shale wells, which in many cases is higher than from conventional wells.

The second section of the paper suggests that much of the increase in oil output since 2005 has in fact been "low quality" natural gas liquids rather than true crude, but then the fifth section acknowledges production from shale has increased U.S. crude output by a net 2.3 million barrels per day.

In fact, statistics from the U.S. Energy Information Administration show the shale boom has produced a dramatic increase in both natural gas liquids and true crudes. It is simply not true to imply that the oil industry is finding only "low quality" hydrocarbons.

One of the biggest problems of the paper is that it confuses the period between 2005 and 2008, when output was struggling to meet demand, with the more recent period from 2009 through 2014, when output from shale has grown quite quickly and global oil demand growth has slowed.

Price Forecast

Even if shale continues to boost overall U.S. oil production, "it is abundantly clear that it would not return real oil prices to their values of a decade ago", Hamilton argues.

According to the BP Statistical Review of World Energy, the real price of crude oil, adjusting for inflation, has ranged from as much as $120 per barrel to as little as $10 since 1861. (http://link.reuters.com/myj52w)

The price is currently close to the top of its historical range, while in the 1990s and early 2000s it was near the bottom.

So oil prices could retreat from their current highs by $20, $30 or even $40 per barrel and still remain quite high in historical terms.

By comparing current exceptionally high prices with the very low ones that prevailed "a decade ago", Hamilton risks using a misleading baseline.

North American shale is currently the marginal source of supply in the world oil market, and most producers claim they can break even at $70 or even $60 per barrel.

Technology

Prices have varied enormously over the 155-year history of the oil industry, mostly in response to large discoveries and changes in technology.

The collapse in oil prices during the late 1920s and 1930s was largely due to the discovery and development of massive new fields in East Texas.

Low prices from the 1940s through the 1960s owed much to the massive discoveries in the Middle East around the Persian Gulf and in North Africa.

Massive new fields in Siberia and Alaska, as well as the development of deep offshore drilling in the North Sea, eventually contributed to price declines in the late 1980s and through the 1990s.

But the history of oil prices is as much about the history of technology as field discoveries.

In a very basic sense, production costs have been rising since the industry was born. As in all extractive industries, the easiest oil was developed first, and more expensive oil has been developed later. Hamilton's argument that costs are increasing could have been made at every stage in the oil industry's history.

The first wells in Pennsylvania tapped oil buried less than 100 feet below the surface. By the mid years of the 20th century, wells were being bored thousands of feet below ground. Then in the 1970s the industry turned to offshore drilling, which was even more tricky and expensive. Now it is mastering the art of drilling horizontally rather than vertically.

But productivity has also increased as companies have learned to target the highest yielding formations and drill faster and more accurately. Hamilton's paper is silent on all these matters, and that is ultimately what makes it unconvincing.

The paper is also silent about climate change, policies to restrict the consumption of fossil fuels, and the growing challenge to oil-based fuels from natural gas even in the transport market, all of which could depress real prices in the medium to long run.

So while Hamilton concludes that $100 oil is here to stay, in real terms, the outlook is far less certain. In fact, a betting man, looking at the price history, might conclude prices are currently abnormally high and due for a fall.

(editing by Jane Baird)

Copyright 2017 Thomson Reuters. Click for Restrictions.

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oilprice | Oct. 14, 2016
Pretty funny reading how confident Kopits was.

Todd | Aug. 4, 2014
The transport vehicle manufacturing industry and major operators of vehicle fleets are just now embracing the fuel-saving technologies available to them. It is already slowing global demand growth for liquid fuels, and soon it will cause demand to fall. This is what will keep crude oil prices from continuing their upward climb. There will be no signficiant new sources of easy, conventional, low-price crude coming to market ever again. All the new production will be difficult to produce, remote, risky, high-tech and very expensive. Shale oil will form an effective, historically high price floor below which crude will never fall again.

Philippe | Jul. 30, 2014
The business of producing oil, gas and NGL has changed and is changing. The majors used to pay royalties from their production. Majors used to have a free hand at managing their production. Today majors have been forced to enter JVs with local governments. In many cases the majors are minority within the JV. None the less the majors must provide the capital, up front. In some JVs the majors get paid by the initial production for a pre-determine period of time. After, let say, 5 years the majors are nothing more than the manager of the production and get paid for managing and maintaining the production infrastructure. The real owners set the production price, but this price is political based. OPEC is the best example, the price of Brent oil is as high as the world economies can bear. The threshold of too high price is when the price of oil causes a world economic recession. The price is further hedge on the price of gold, so any inflation is under controlled regardless of the currency used. So far this hedge is 12 barrels = 1 ounce of gold. The shale play has modified the capital required to entertain a profit faster. So far the shale play is onshore and do not require the billion dollar capital up front to show a profit. Drilling a horizontal well requires from $3 million to $5million depending on the depth, the number of stages and the length of the horizontal to be bored. Add several more million dollars for the infrastructure and the potential profit are present. The shale play requires the drilling of new wells, so as to cover the geological formation. The capex is sent over 5 to 10 years, not up front as with standard reservoir play and especially offshore project. Shale play permit the capex to be managed as profits develops over time. The risk management is absolutely controlled. This capex puts the investors in charge regardless of the government taxation or JVs internal business conditions. In many cases the government, majority player in the JVs will find resistance from the minority by scaling down the capex should the conditions become abusive? The majors will no longer be hostage to the upfront capital. The natural gas has conveniently been linked to the BTU of crude oil. The Henry Hub price is a standalone price not linked to oil. The world price of Natural Gas will be lower as the US Natural Gas as the LNG production comes on line. Already several contracts are based on Henry Hub price plus a fix percent. Overall the price of Oil or Gas will be more competitive world wide, more friendly to the end user. This does not mean that oil or gas will become cheap, the price variation will stay under control. The many potential sources will decrease OPEC control over the world price.

Steven Kopits | Jul. 29, 2014
Jim Hamiltons paper is correct in all material respects. Let me add just one comment: "North American shale is currently the marginal source of supply in the world oil market..." This is untrue. The marginal barrel is probably deepwater, Arctic or oil sands. Goldman Sachs estimates the free cash flow breakeven for the oil majors at $100-130 / barrel, thus the IOCs are the high cost producers and the marginal barrel. If Johns thinking is correct, then the IOCs will be squeezed off their projects as lower cost shales displace higher cost initiatives. Shales have not, however, materially reduced oil prices. In fact, Brent is largely unchanged for the last three years; and WTI is $4 higher than in 2011 or 2012. In the US, surging shale production has been associated with increasing domestic oil prices. And yet, the IOCs are still reducing capex, suggesting that they are unable to control costs. If Johns scenario is right, and prices collapse as well, then IOC oil production is set to implode, and its hard to see how the global oil supply can be maintained, much less expanded, under such circumstances. A collapsing oil supply is not consistent with low oil prices. As I stated back in January (and much earlier), shales are no threat to deepwater. Rising E&P costs are. [John - feel free to reach out to me. Im writing a book on supply-constrained oil markets analysis. You can reach me at steven.kopits@prienga.com]

Rusty | Jul. 29, 2014
This article seems to agree with, not refule, Hamilton. The only refutation is the unsupported statement, "most producers claim they can break even at $70 or even $60 per barrel."


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