Hail the Shale Revolution

With oil prices remaining very high over the past few years, it has become rather lucrative to search for alternatives on both the supply and demand side of energy. The substitution by other resources seems imminent. In this article I will dive deeper into the latest developments in the US’ shale gas and tight oil markets. In doing so I will try to expose the potential worldwide impact these developments could have.

High oil prices

As can be seen in exhibit 1 the spot price for oil peaked in July 2008. However, in July of this year another historic price level was reached. For the first time in over the 5 year rolling average for Brent crossed the $100/bbl. mark. Due to the high price level of oil over the past years, many developments have started on both the supply and the demand side of the oil/energy market. On the supply side these prices have made it fruitful to explore and extract new sources (shale, deep-water, oil sands). On the demand side, these prices levels have caused other developments. Think for example of fuel efficiency and fuel-substitution.

Exhibit 1: Brent Prices and 5-Year Average (2000-2014, $/bbl)

Geopolitics probably will remain bullish for oil, but this will only reinforce the incentive to look for alternatives. One of the developments in this field is shale oil and gas, which could put pressure on the demand for Brent oil. Especially the gas for oil substitution will potentially have an impact on future demand for oil. This “energy revolution” has played out slower than some have expected, but with oil prices stuck north of $100.bbl. this might start to accelerate.

The energy market

First it might be useful to look at the energy market in general, starting with capital expenditures. In the graphs below we first see the capital expenditures of the energy sector from the years 2000 to 2013. The second graph shows the capital expenditures per sector in 2013, and the third graph shows the capital expenditures of different sectors in the year 2000. We see that the higher energy prices have led to higher and higher levels of corporate outlay. However, until shale came along, this did not really result in a massive increase in supply. In North America supply is slowly responding and we can expect that other parts of the world will follow.

Looking at the past we have seen that, for example, the high levels of capex in the telecom sector did indeed result in a surge in supply and lower prices. This could also be the case for the energy market. However, history is not always a perfect guide.

Exhibit 2:  Energy Equity Capex vs. Payout ($ bn, 2000-13E)

Exhibit 3: Equity Capex vs. Payout ($ bn, 2013E)

Exhibit 4: Equity Capex vs. Payout ($ bn, 2000)

US shale oil

US shale oil resources have supported a true surge in supply over the past years, as seen in exhibit 5. This pace of production is expected to continue over the coming years although it probably will decelerate slowly. Bringing the US supply of crude oil to 12m b/d in from 8,5m b/d today, according to Citi’s outlook. This crude production boom combined with the increased exports natural gas liquids (NGL) and petroleum exports can make the US self-sufficient in crude products by 2020 (exhibit 6). However, the level at which shale might plateau remains subject to many factors.

Exhibit 5: US shale liquids production by major play (m b/d, 2007-14)

Exhibit 6: Volume share of total US petroleum supply.

One of the problems with shale wells is that they show a very high decline rate. This means that when the amount of wells increases, the combined decline rate of the existing wells increases as well. So if we want to see a growth in shale production, the new well production should exceed this decline rate.

The production of new wells fluctuates heavily, especially when the weather slows down drilling like we saw in the last harsh winter. During this winter the number of new wells dropped below the minimal requirement to keep production at a flat level. However, the lack of new wells rebounded quickly when conditions improved. The increase of wells could again contribute to production growth.

Rising US gas production

In the US there are plenty of gas reserves to meet the growing domestic demand. The reserve size has grown and new areas continue to be discovered. Furthermore, technological improvements continue to boost output per well(exhibit 8 and 9), increased oil and liquids drilling is raising associated natural gas production, and the existing pipeline network between the US and Canada should allow largely land-locked Canadian gas to enter the US market. All in all, domestic US production is expected to rise by 53% to 88-bcf/d between 2010 and 2020. To put this into perspective, this increase of 30.5-bcf/d is about the size of the current global LNG market.

Exhibit 7: First month oil/liquids and gas production per rig (2007-2013)