Sunset to Sunrise: Fundamentals & Trends

Industry consensus is that the increase to United States oil production volume in 2012 will exceed growth in world oil demand for the first time in half a century. The increase in the rate of US production is expected to continue for the foreseeable future. The success in development of new natural gas reserves is comparably staggering. The change from the US requiring ever-increasing oil and natural gas imports to possible North America energy self-sufficiency, or even energy exports, is one of the greatest reversals of expectation in industrial history.

North American production of oil and natural gas has increased by 18% in the last five years. This follows decades of constantly declining production rates and reserves. Over the next several decades, proved US crude oil and natural gas liquid reserves are expected to grow five times, from twenty billion barrels to one hundred billion barrels. The US natural gas reserve life is expected to increase from a twelve year supply to a one hundred year supply.

This reversal of fortune is due to the development of new drilling and completion technology that allows for economically viable production of oil and natural gas from shale and low permeability conventional reservoirs. Advances in information technology and materials science that occurred during the oil and gas depression of the 1980s and 1990s have now been applied to the oil and gas industry. These have contributed to the development of three dimensional seismic surveys, horizontal drilling and the ability to perform multi-stage hydraulic fracturing on horizontal wellbores, making this seventy year old stimulation technique exponentially more effective.

These new and improved recovery technologies have increased the cost of drilling and completing new wells. The average well cost in the US has increased three fold, from an average of $1.7 million in 2005 to over $5.7 million today. Recoverable reserves per well have increased proportionately or more. It is estimated that the increased cost of development and expansion of the new opportunities in the US will translate to new capital needs of $35 billion per year for the oil and gas industry. This is over and above the reinvestment of retained earnings and use of the increased borrowing capacity created by the expanding reserve base.

The growth in production is also spurring a boom in required infrastructure. This is referred to as “midstream” in the industry. Midstream includes everything in the “middle of the stream” of the commodity “flow” between the wellhead and the refinery. Production volumes in most parts of the US have outgrown existing infrastructure. In new areas the infrastructure does not exist at all. It is estimated that new investment required to deal with the growing production volumes is about $10 billion per year (including Canada) for natural gas transmission, storage, gathering and processing; oil pipelines; and natural gas liquids pipelines. This is quite a boom in high skill, high wage manufacturing!

The increase in natural gas consumption has had a greater impact on emissions than all of the subsidized investments in renewables combined. Most of the increase in natural gas consumption has been used to generate electricity. Much of the electricity generated with natural gas is replacing the older high emission coal plants. Natural gas emits 45% less carbon per energy unit. CO2 emissions in the US are at the lowest level in twenty years.

Little of this decline in emissions is due to “alternatives.” It is estimated that the shift from coal to natural gas has reduced US emissions by 400-500 megatons of CO2 per year. Wind turbines account for a reduction of about one-tenth of that amount, biofuels 2.5% and solar panels less than 1%. Some experts calculate that the conversion to natural gas has reduced emissions more than required in the Kyoto Protocol.  Further development of natural gas as our core asset, particularly in fueling vehicles, can have additional economically efficient impact on further reducing emissions in an economically productive way.

The risk profile of oil and gas investing has changed with the improvement in development and recovery technology. In the 1985 – 2005 period, our primary risk focus was on individual project (unsystematic) risk. With oil averaging well below replacement cost at $20 per barrel, we were not nearly as concerned with price risk. New technology and the type of reserves being developed have materially reduced the risk of failure of an individual project. For example, we have participated in twenty-two Bakken oil wells in North Dakota in our production partnerships, drilled on acreage positions we own from production purchases made in the 1990s. All of these wells are calculated to be economic successes. Today, with oil over $80 per barrel and replacement cost in the $40 – $50+ range, we are much more focused on oil and gas price (systematic) risk. That is why we continue to lock in current high prices with hedges, and are making some of our new oil investments using mezzanine structures, so that we are in a priority position if oil prices decline in the near term.

Energy imports account for about one half of the US balance of payments deficit. Reducing or eliminating this deficit would have a highly stimulative impact on our national income equation. Much of our military budget is spent in an attempt to maintain stability in the Middle East. If we eliminate the stranglehold of OPEC on the industrialized west, US military expenditures and foreign policy can be greatly modified.

Leave a Reply

Your email address will not be published. Required fields are marked *