The Saudis Hold the Line

The big news in the oil world last week was a do-nothing policy by OPEC, and especially by the Saudis, the swing producer of oil. By swing producer I mean that Saudi Arabia has the physical, political and financial capacity to adjust its oil output to suit its policy goals. OPEC met this last week and decided to leave its output at 30 million barrels a day, despite the abrupt drop in world oil prices. Crude oil closed Friday at $66, down from $110 not long ago.

You’d think that the Saudis would want to cut production to tighten supply and bring the price back up. By some accounts, they can’t meet their national fiscal goals unless the price of oil is above $90 a barrel. They aren’t losing money, even at $66, as their cost of production is the lowest in the world at $3-6 a barrel. However, oil being essentially their only source of income, their national budget is in deficit at present prices.

My guess, along with some other observers, is that they are playing the long game.

The rising production of shale oil in the U.S. is a big part of the problem for the Saudis. Although temporary, our production increase has pushed down our demand for oil on the international market. It’s an expensive process, though. A shale exploration company has to drill multiple boreholes that turn horizontally and follow the thin layer of oil containing shale. Then they have to force fluid and sand into the holes in order to fracture the shale and let the oil out. This is hydrofracturing, popularly known as fracking. The nature of these wells is that they produce large amounts of oil initially and then rapidly decline, sometimes within months. Then the driller has to pack up the equipment and repeat the process elsewhere.

There are a number of oil producing shale formations in the U.S., but only a small percentage of the total shale area is highly productive. Some of the shale exploration and production industry was losing money even at higher prices. The business plan for a number of companies seemed to consist of outlasting competitors and reaping the benefits of future high prices.

The expensive production cycle and money-burning nature of the industry requires a constant influx of money, both as investment and credit. That is what the Saudis are after.

By maintaining the world supply of oil at present levels OPEC can keep the price of oil below the breakeven price for many shale oil companies. Beyond that, a lower oil price means that drillers lose access to credit. Just as the resale value of your house backs your low-interest mortgage, the estimated value of a drilling company’s oil reserves serves as security for loans. When the price of oil drops they have to resort to higher interest unsecured loans and divert present income to exploration, all of which discourages both banks and investors.

 OPEC doesn’t have to drive all of them out of business. They can pick off the stragglers, the companies most overextended and possessing the least productive oil field leases. A string of bankruptcies in the shale oil industry would not only lower production, but also choke off investment and credit. That would hamper present production and slow the return of the shale oil industry when prices recover. The threat of repeated Saudi intervention would keep banks and investors at a distance.

The Saudis are willing to spend some sovereign wealth to clear the field of competition. With currency reserves over $700 billion, they can endure $66 oil for a while longer. Much longer, I’ll bet, than the U.S. shale industry.

High Prices Coming Down the Pipeline

 “Eventually, the politics of energy has to surrender to the physics of energy.” Randy Udall

Two pieces of news have come together in my mind recently. One is the Vermont Public Service Board approval of a new natural gas pipeline through Addison County. The other is a Wall Street Journal article about investments in shale gas production.

The PSB approval and pipeline story is straightforward. Vermont Gas, a subsidiary of Canadian Gaz Metro, is extending its pipeline from Chittenden County and the population center around Burlington southward through Addison County. Phase 2 of the project will have the pipeline cross the narrows of Lake Champlain and serve the Ticonderoga paper mill in New York. In theory, Phase 3 will bring natural gas to the city of Rutland around 2020.

There are objections to the pipeline by many residents of Addison County, generally on two grounds: First, that this will encourage the use of hydrofractured (“fracked”) gas, which is controversial due to its threat to ground water and the general environment near drilling sites. Second, that it will detour us from the pursuit of renewable energy and energy efficiency. A number of people simply don’t want a natural gas pipeline on or near their land.

The proponents of the pipeline argue that it will bring cheap energy to western Vermont, with the resulting economic benefits. Phase 2, they say, will bring far cleaner, cheaper energy to the Ticonderoga plant, with resulting environmental and economic benefits.

A sidebar on shale gas production:

So-called conventional oil and gas generally reside in underground sandstone formations, like sponges made of rock. The oil and gas are in the holes in the sponge (porosity) and the holes are connected to some extent (permeability) so that the oil and/or gas can flow through the sponge, much the same way that water can soak through from one end of a sponge to the other. These conventional deposits can be miles across and hundreds of feet thick.

Shale oil and shale gas deposits can be described the same way, but with different measurements. A shale deposit might have one one-thousandth the porosity and permeability of a sandstone deposit. A shale formation like the Bakken in the northern Midwest covers thousands of square miles but is only ten to maybe 150 feet thick. To imagine the scale, picture a layer of plastic wrap over a couple of football fields. This distribution means two things. One is that there is a lot less energy per horizontal acre in a shale field. The other is that the oil and gas won’t travel from one part of the field to another without a lot of help.

Horizontal drilling is the process of controlling the drill bit so that after going straight down it curves sideways and follows the thin shale formation. Drillers make a number of these horizontal boreholes out from a central drilling point in order to get access to a large area of shale.

Hydrofracturing is the process of injecting a mixture of water, chemicals, and then sand at extremely high pressures to blast open the cracks and pores in the shale. The sand is a “proppant”, keeping the blasted shale from collapsing back on itself. These two operations are an expensive proposition.

A horizontally drilled, hydrofractured well has a relatively short productive life. After a massive initial rush of production, output could drop by 40-50% in the first year. It might drop another 30-40% in the second year, and 20% or more in the third. The key to maintaining production levels is drilling intensity – quickly drilling more wells to replace declining ones. This is also an expensive proposition.

The Wall Street Journal Article (paywalled), as quoted in the ASPO-USA Peak Oil Review, casts doubt on the cheap energy claim by Vermont Gas. There has been a huge rush into shale gas drilling over the past decade. With that rush came a huge rush of natural gas, driving the price down to the historic lows of the past few years. Those low prices, bottoming out below $2 per thousand cubic feet (Mcf), were below the cost of production. Shale gas exploration companies lost tens of billions annually. As far as I can tell each company’s strategy was to hold on to the mineral leases and produce at a loss until their competitors went out of business. Then the remaining companies could clean up as supply declined and gas prices rose. The industry has been running on continued injections of investor cash.

Recently the investors have been getting cold feet. Here’s the key quotation from the WSJ article:

    “Since 2008, deep-pocketed foreign investors have subsidized the U.S. energy boom, as oil and gas companies spent far more money on leasing and drilling than they made selling crude and natural gas. But the rivers of foreign cash are running dry for U.S. drillers. In 2013, international companies spent $3.4 billion for stakes in U.S. shale-rock formations, less than half of what they invested in 2012 and a tenth of their spending in 2011, according to data from IHS Herold, a research and consulting firm. It is a sign of leaner times for the cash-hungry companies that have revived American energy output. The value of deals involving U.S. energy producers plunged 48% this year from 2012, to $47 billion, the first annual decline since 2008. So U.S. oil and gas producers have started to slash spending.”

                              -- (The Wall Street Journal, Jan 2)

Remember that the key to low prices is continued high production and the key to continued high production is drilling intensity. The key to drilling intensity is investment, and that is going away, dropping by a factor of ten in just two years. Investment will only come back when the price of natural gas rises enough to make shale production profitable. Industry analysts argue endlessly about what the breakeven price of shale gas is for various fields, but my general takeaway is that it could mean a doubling of wholesale prices.

Back in Vermont, the residents and businesses of Chittenden, Addison, and Rutland Counties are being promised a bounty of cheap natural gas. The geology of shale gas dictates the economics, and the economics, via investor flight, indicates that this is a false promise. Just about the time that consumers find themselves hooked up to the pipeline and paying for their new appliances the price will start heading for a profitable range. The politics of energy will surrender to the physics of energy before Rutland ever sees a cubic foot of natural gas.