Is the US Tight Oil Market 'Too Robust to Bust'?
The current crude oil price environment – in the vicinity of $100 per barrel (bbl) – comfortably exceeds the break-even economics of U.S. Light Tight Oil (LTO) production from the Bakken, Eagle Ford and other shale formations. But what proportion of LTO reserves would remain economic at, say, $75/bbl? According to Wood Mackenzie, the answer is a significant majority – at least 70 percent.
"There is not much U.S. producers can do to influence global oil prices," Harold York, Wood Mackenzie's principal downstream research analyst, said in a late-March communique from the consultancy. "Supply and demand fundamentals and non-market dynamics around the globe keep the price environment well above the break-even economics levels of several U.S. tight oil plays."
"With Brent crude oil pricing in the late-2013 range of $108 per barrel of oil … in early 2014, almost all tight oil proven reserves are commercially viable, even if global oil prices fell toward $75/bbl, over 70 percent of U.S. tight oil reserves would remain economic," York continued.
Wood Mackenzie's conclusion about what effect $75 oil would have on the economics of LTO reserves places more weight on logistical considerations rather than global oil prices. Sustainable break-even prices are largely a factor of how much it costs to get oil from the wellsite to the pricing point such as Cushing, Okla., or St. James, La., York asserted during a presentation at the American Fuel & Petrochemical Manufacturers annual conference in Orlando, Fla., in March.
"A single play can have multiple refining values and transportation costs, therefore a producer may realize a higher netback by selling their crude oil in to a refining center with higher transportation costs," he said in March.
Interestingly, however, York does not expect varying costs of shipping oil from a single LTO play to have a major dampening effect on the play's economics. To learn more about his insights on this and other aspects of Wood Mackenzie's stance that the U.S. LTO market is, in the words of the consulting firm, "too robust to bust," read on.
Rigzone: You assert that North America tight oil is too robust to go bust, but boom-and-bust cycles have existed throughout the history of the modern oil and gas industry. Is it your belief that the U.S. oil sector is moving beyond a boom-and-bust era? Why or why not?
York: There is always a "life-cycle" to virtually all commodity volumes and prices, not just oil. Typically the peaks and troughs are driven by external shocks to the existing system, such as rapid growth in demand that surges faster than supply can respond (price peaks) or rapid uptake of a new technology that puts downward pressure on the commodity price. The focus of our paper on tight oil not going bust is Wood Mackenzie's perspective on recent chatter the industry has seen the best that tight oil can offer and the production profile is on the verge of decline. Recent monthly production gains continue to defy that assertion. Our paper posits four of the larger risks we could see to growing tight oil and offers our analysis that the likelihood each of the risks materializes is rather small. Of course we do not offer a guarantee any of these risks (or a "Black Swan") will not appear.
Rigzone: What are some of the key "supply and demand fundamentals and non-market dynamics around the globe" – a quote from your March press release – that are keeping oil prices above break-even for U.S. LTO plays?
York: The key supply/demand fundamental that keeps global oil prices above LTO break-even is the need for marginal global oil supply from developments, other than tight oil, requiring a break-even price above $90/bbl, which is higher than most U.S. tight oil opportunities. There also is the loss of volume from production interruptions (both planned and unplanned), which can move from region to region, but impacts supply on a regular basis.
The "non-market dynamics" are factors such as market psychology that drives the price away from marginal cost of production economics. The best current example is the Ukraine crisis which can drive oil prices, either up or down, several dollars per day.
Rigzone: Wood Mackenzie contends that more than 70 percent of U.S. LTO reserves would remain economic at prices approaching $75/bbl. Looking at this in a historical context, how significant is 70 percent-plus at such a pricing level? Is 70 percent an extraordinarily high percentage, and how does the scenario change below $75/bbl?
York: It's difficult to make a comparison to history because it would require going back to what the industry thought break-even costs were for some other giant opportunity (e.g., Alaska, North Sea) and compare those historical break-evens and market prices (adjusted for inflation) to LTO. What can be said is that monthly oil prices have averaged more than $75/bbl for over 4 years and about 75 percent of the time since 2007, including the Financial Crisis. Anecdotally, the industry does talk about LTO with an enthusiasm I've only seen once or twice in my 20-plus years in the industry.
Rigzone: How is the shale revolution changing the refining community's long-held assumptions about the oil market, and how are these evolving assumptions changing how refiners operate?
York: Light-ends handling in the crude distillation (CDU) and fluid catalytic cracking (FCC) unit tend to be the bottlenecks we hear most. There also is some concern that tight oil can be "too sweet" in that it would unload sulfur plants to below minimum operating rates. A number of refiners have announced a variety of projects to improve light ends handling, including the ability to process more LTO through additional CDU capacity or even on-site condensate splitters. All told, we see about 350,000 barrels per day of distillation capacity coming to the market in the next few years.
Most refiners see the discount of U.S. crudes from international refining value as providing sufficient margin to keep run-rates very high. With flatish oil demand in North America, coastal refiners increasingly look to export markets to place product barrels coming from the increased refining capacity.
Rigzone: How are North American logistics constraints influencing the break-even prices of LTO ?
York: Logistic constraints do not impact break-even prices for LTO. Break-evens are set by production costs (capital recovery plus operating) at the wellhead. Logistic constraints do put downward pressure on wellhead realizations (as logistics constraints raise the cost of transportation away from the wellhead). The impact on LTO production growth is if wellhead realizations drop below production costs. Wood Mackenzie does not foresee transportation costs having a material negative impact on LTO wellhead realizations.
Rigzone: What are some key developments to watch to relieve the logistical constraints, and what effect might they have on LTO break-even prices?
York: Easing of logistics constraints is really about reducing the cost of transportation out of a play. That cost reduction would typically be the addition of pipeline evacuation capacity from a play. However, producers in some of the key plays (e.g., Bakken) are becoming more commercially savvy and thus looking to maximize wellhead realizations rather than minimizing transportation costs. That wellhead realization might require incurring a higher transportation cost (e.g., rail versus pipeline) in order to reach a market that puts a higher relative value on LTO (e.g., Pacifica Northwest versus U.S. Gulf Coast).
Rigzone: In regard to relaxing U.S. curbs on exporting crude oil, what impacts would you anticipate, both upstream and downstream, should this become a reality? Also, is there a "middle ground" in this contentious issue that both exploration and production companies and refiners could live with?
York: Wood Mackenzie expects there to be continued debate on the crude oil export policy in 2014, but maintain our reference case assumption that the current policy remains in place.
Wood Mackenzie does not think the lifting of the ban would have an impact on the Brent price because the global supply/demand balance for oil would remain the same in any case. An easing of U.S. crude oil export restrictions could change the trade flows of crude oil, but not total supply. We would expect an impact on crude oil price differentials in conjunction with these changing trade flows. There could be some narrowing of Brent-WTI, but the magnitude of the narrowing could be a function of which barrels would be exported. One hypothesis is that Eagle Ford versus Bakken barrels could have a different impact on differentials due to their quality differences.
Any narrowing of differentials between U.S. produced and internationally priced crude would benefit U.S. producers, but U.S. refiners would still be better off relative to the rest of the world. If the quality of the crude oil export barrel impacts the degree of narrowing, that might lead to some producers benefiting more than others. Producers in the play that exports the barrel could see wellhead realizations rise more than the differential narrows as a whole.
Rigzone: What are the major variables that could undermine your basic assertion that U.S. LTO is "too robust to bust"?
York: The two big risks to LTO would be a global drop in oil prices or a significantly widening of price differentials between the global price (e.g., Brent) and U.S. inland crude prices (e.g., WTI). However, we do not foresee either of these risks materially impacting the wellhead economics of LTO.
The combination of growing oil demand and the market needing non-tight oil with higher break-evens than LTO combining to keep global oil prices high enough to keep LTO opportunities attractive. Certainly there will be volatility around oil prices, but producers have the ability to mitigate that impact through hedging. Brent-WTI (which proxies the discount of U.S. inland crude prices to its global refining value) is expected to be wide enough to support rail movements to North America's east and west coasts. However, we also expect the differential to remain narrow enough to not threaten tight oil wellhead economics.
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