ParisTech Review

Since the beginning of 2010, the so-called North American unconventional oils have added between 5 to 6 million barrels approximately to the daily crude production (oil and condensates), bringing the global oil production (non-OPEC) from 52 to 57.5 million barrels per day between 2010 and 2015. These amounts add to the 6.3 million barrels (oil equivalent) of gas produced by the same unconventional techniques. Over the same period, global oil consumption increased from 88 to 92 million barrels per day.

Until autumn 2014, this additional production had no impact on crude prices and demand and supply remained more or less balanced until then. However, since the beginning of 2014, production exceeds by far consumption. Consumption remained less vigorous than expected and forecasts has been constantly revised downwards while the average annual rate of production was rising steadily.

Over a longer period, this kind of imbalance has already occured. According to the EIA’s forecast, the return to balance is not expected to happen before 2017.

To get an idea of the possible impact of this production increase in the United States, one could also remark that these five to six million additional barrels were produced in the United States and consumed locally, hence removed from international trade. They account for a significant fraction of the 56 million barrels per day traded in the world.

Given these circumstances, legitimate questions may be raised as to whether the North American production of unconventional oil is bound to continue or stop for lack of sufficient return on investment. To answer the question, let’s have a look at the positioning of Amercian unconventional oils in the global supply and its possible developments.

How prices are determined
According to economic theory, in a market where supply is equal to demand, the price of a commodity is the price of the most expensive resource available to meet the additional demand. Therefore, theoretically speaking, prices can be represented and provided by a curve that shows the various possible sources of supply in an order of increasing cost price. This curve is fairly well represented below.

Cost price of a barrel of crude oil by source of supply. Source: Advancy Consulting, EIA, Imerys Analysis. These are long-term costs. They represent the price of crude needed to trigger investment decisions.

Reading this graph is simple: the cheapest 25 million barrels are produced in the Middle East, at a cost ranging between 5 and 25 dollars per barrel. The following 15 are produced by other conventional deposits. Then come Arctic extractions, enhanced oil (EOR) and Russia. American unconventional oils fall in the next category, which ranges from deep offshore to North Sea oils. Canadian oil sands, considered the most expensive resource at this day, come last.

Production costs are indicative. The bottom rectangles show fields with the best costs and the top rectangles, the fields with the worst costs in the area. The numbers correspond roughly to the situation that prevailed until 2014. The blue dots represent the average of the area. Some production costs have been adapted by the industry. This is especially the case for American unconventional oils.

The merit of this presentation is to determine the range of production price and the average price. American unconventional oils are comprised between 50 and 75 USD per barrel, with an average of 62.

The cost price of the most expensive resource needed to meet global supply is between 80 and 100 dollars per barrel. As long as the system was balanced (ie as long as the cheapest producers adapted their production to balance the market and keep prices, role played by OPEC up to mid-2014), the oil price was somewhere within this range, with slight variations related to stock movements. Assuming that global consumption of oil will continue to rise slowly as during the last several years, the long-term price necessary to maintain long-term supplies is expected to stand around 90 dollars.

American unconventional oils are in the third quartile of the cheapest resources to produce. In other words, they become uncompetitive after a quarter to a third of the world resources have become uncompetitive. Under these conditions, investment in American unconventional oils and all associated industries seemed reasonable to oil companies, oil-related sectors and lending banks. Hence the success and growth of production recorded in the United States.

The new context
What happened in 2014? Consumption increased slightly more than expected. OPEC and non-OPEC countries increased their production throughout the year. The non-OPEC world increased its production barely above the increase of American production. At the same time, Saudi Arabia ceased to play its role of shock absorber and consequently, OPEC countries increased their production.

These two phenomena have produced a strong rise in stocks since the beginning of January 2014, after a period of decreasing trend.

As a result, at the current price of oil, approximately 40% of the world production is not profitable: unconventional oils, but also some Russian oils, a large portion of North Sea oils, etc.

This suggests that the current price is simply not sustainable on the long term. Even truer if the prices needed to balance the budgets of OPEC countries instead of production costs are examined: Kuwait needs a minimum price per barrel of 60 USD, while the average is around 100 USD. Maintaining the current price level is not possible over a long period.

Price necessary for OPEC countries to balance their budgets

The International Energy Agency forecasts are rising slowly and crude prices should reach 60 USD in 2017. At this price, investments in unconventional oils become attractive once again.

In the short term, direct costs excluding depreciation need to be taken into account. This is why production levels are maintained. But, as we shall see, unconventional productions will fall faster than conventional ones.

The drilling activity dropped sharply as a consequence of falling prices, as shown by the curve of evolution of the number of active platforms in the United States.

Active drilling rigs in the United States. Source: Baker Hughes

In 2011, the price drop had a major impact on the number of active drilling rigs in gas wells. This fall had been compensated by an almost simultaneous increase of the number of wells drilled for the extraction of oil and liquid hydrocarbons.

In 2012, several phenomena mitigated the impact of gas prices on the decrease of the activity.

First of all, the drilling of gas wells stopped. Secondly, drilling for the extraction of liquid hydrocarbons increased at very high speed. Furthermore, liquid hydrocarbon extraction often produces some amount of associated gas (gas production often generates liquid products or condensates). These additional gas byproducts continued to support the growth of production. Finally, it should be noted that Quantitative Easing from the Fed, allowed access to very cheap financing.

Today, these amortization mechanisms are no longer available for drilling. There are no clear replacement solutions to the drilling of oilwells in an environment where the price of gas and oil are both falling. Operators who seek high returns on investment focus on the most economic fields and drill very little new wells.

The decline in production has begun
In the short term, producing wells will remain active. In other words, during a certain time, unconventional oils are produced at near zero cost (excluding amortization). This is why production volumes decline so slowly. The decrease started in the middle of 2015, at a rate close to 1 million barrels/day per year. The effects of the decline in drilling began showing from mid-2015 onwards, approximately.

One of the parameters to take into account is the decline curve of the different oilfields. The decline rate of unconventional wells is usually higher than conventional wells. Based on decline curves, one can estimate future production and the number of additional drilling required to maintain production in 2016.

Let’s take an example from the Bakken field. Needless to say that since wells don’t all have the same decrease rate, this calculation is an approximation that indicates an order of magnitude.

First of all, there’s a significant difference between the production curve of conventional deposits and that of unconventional fields. While the production of conventional wells rises during the first three years before declining gradually, the peak of production from a Bakken well is reached immediately. However, the daily production quickly decreases after that: 65% the first year, 35% the second, 15% the third and 10% per year after that.

Using this curve and the information available on the age of the wells, depending on the number of wells drilled in 2015, the decrease of production in that area can be accurately modeled.

In the table below, production indices are calculated by applying to a production of 100 (production of year 1) a rate of decline per year, depending on the age of the wells.

Based on these calculations, a model for the expected decline of production in 2015 in the Bakken field can be built, depending on the number of drilled wells.

Source: Imerys estimate

In other words, in this specific field, for the production at the end of 2015 to stay the same as in 2014, 1,800 drilled wells would be enough, against 2,200 in 2014. In fact, the decline was much higher, around 50%, which leaves us closer to the left of the curve.

Overall, if we look at all the oil basins, in 2014, the number of platforms at work has fallen by an average of 50%. This simple model allows to “predict” a drop of one million barrels per day of unconventional oil production day in 2015 compared to 2014. The real figure was slightly lower. According to this same model, based on the same number of drilled wells than during 2015, the production in 2016 will decline by 20%.

The goal isn’t to understand the arithmetic of decline but to propose a forecasting model. Oil companies have designed much more accurate and sophisticated models.

The effect of price evolution
The much faster decline rate of unconventional wells has one major effect. Whereas the production of unconventional wells will drop by 80% over two years, this time is much longer for conventional and offshore wells. Consequently, the impact of prices on production is much harsher.

Can we get an idea of the evolution of prices on the short-medium term? We can try. Our goal isn’t to predict price trends but simply to describe some of the factors that come into play.

First factor: industrial growth in the United States as consequence of the impact of low gas prices. Ethylene crackers are currently being built, along with the associated industry of chemistry of plastics. Many manufacturing sites than had been delocated in China during a long time will be relocated in America. This growth not only concerns gas but also the consumption of liquid hydrocarbons.

Second factor, the ongoing decline of oil production over the next couple of years. The production shortfall of several million barrels per day could cause a shortage.

Third factor: until last autumn, the gas consumption was supported by byproducts of oil exploration. However, the drop in oil production on the medium term could increase the pressure on gas prices and trigger new drillings, thereby generating more oil and condensate byproducts. To date, this phenomenon hasn’t occurred yet. Conversely, a rebound in US production would produce a surplus and lead to lower prices.

Obviously, the attitude of OPEC, and more particularly of Saudi Arabia, will be a determining factor in price formation. But unless the Organization reclaims its regulatory role, the United States and their unconventional hydrocarbons will need to assume the role of amortization and market regulation that the OPEC refuses to play.

Forecasting becomes difficult because marginal costs and short-term direct costs are much harder to assess than the full costs discussed above.

The US industry can adapt
One question is to know whether a well is competitive in the long term, ie if the expected income over the life of the well will justify the investment; another, whether production is economically viable for a previously drilled well.

Due to their faster decline in production, unconventional wells require greater expenditure to maintain or increase production over one or two years. In case of a sudden price drop, when conventional producers continue to produce at very low cost from previously drilled wells, unconventional producers will be forced to invest again, fairly quickly. Depending on the price level, they can choose not to do so, if the return on investment is insufficient. In other words, when oil prices drop, US production will decrease faster than any other conventional production. Hence, this outlines the role the US industry could play in regulating global demand i.e. the industry is exposed to a high degree of variability. Inevitably, the industry will need to adapt, both in terms of capabilities and competitiveness.

The US industry has already adapted its capabilities. The number of active platforms is a good illustration. For now, it’s more about cocooning. The industry is ready to restart quickly.

Moreover, if the new rule is that the wells should give 10% of return on investment for a barrel between 50 and 60 dollars, the industry will adjust and reduce costs. This is exactly how the oil industry has dealt with crisis situations for over a century.

Possibilities of decrease in costs are related to the competitiveness of the oil services industry. Drilling, fracturing and support technologies constantly evolve and the drilling of unconventional oilwells is still in its infancy. Horizontal drilling is no more than four or five years old.

A number of measures could be implemented for cost reduction. First, fewer mistakes, “dry holes” or low-producing wells. A better geological knowledge of bedrocks and deposits will help improve the selection of operational areas. Non-producing wells account for an important part of the extraction costs of unconventional oils. Reducing their number will automatically reduce costs.

Second factor: the (temporary) decrease in the price of well services (drilling, completion, etc.) linked to a lower demand.

Third factor: the development of information processing and micro-seismic analysis allows an increasingly precise assessment of oil reserves. Not only will it increase the drilling efficiency, but also improve well operations.

Other factors, such as the increase in the number of stages in fracturing wells, the quality improvements of hydraulic fracturing proppants, the development of optimization formulas by service companies and, more broadly, the improvement of productivity, as in any industrial sector, will continuously improve the performance of drilling.

Faced with the challenge of the new economic situation and oil environment, quick changes are already underway and continuing at full speed.

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The oil price drop is good news for most world economies. Market movements related to current low prices can be read as symptoms and not as the cause of a sluggish global economy that keeps prices low. It poses a new challenge to the US oil industry, especially regarding the extraction of unconventional oils. Various factors suggest that the current price level is unsustainable over the long term, but that the situation can last a few years. Meanwhile, in the absence of a rebound of prices, US production will decline slowly. This drop in production may itself have an influence on the rise of prices, forcing the United States to preserve market balance, a role that OPEC refuses to play for the time being. Unprecedented industrial adjustments are taking place, beyond any doubt.

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