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The Future For Oil Supply And Prices After The 'Amazon Effect' Stimulates Shale 2.0

A phalanx of forecasters now expect the American shale revolution to peter out, but what happens when, not if, the digital revolution comes to the oil and gas industry? Will we see a repeat of the ‘Amazon effect’?

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The Energy Information Administration (EIA) went out on a limb this past summer and forecast what is already happening: U.S. crude oil production is on track to reach historic highs. This week U.S. crude exports hit a record too, now rivaling those of Kuwait. (Savor the word “exports” after decades of hand-wringing over oil imports.) And in related news: last month Citi issued a forecast predicting U.S. shale oil production will double in five years,

Set aside whether Citi is overly enthusiastic. Even the status quo is worrisome for stressed oil producers, especially OPEC, as well as for eager alternative energy proponents, the two constituencies that hope for lower U.S. output and higher prices.

The oil business has always been about a Goldilocks price: Too low, and producers can’t make profits and will bail out, sometimes permanently. Too high, and you get the twin-edged sword of demand destruction as markets revolt while escalated prices stimulate production from all kinds of otherwise non-viable players. There are a lot of reasons the world yo-yos between these two ends of the price spectrum, not least the semi-chaotic behaviors of consumers, credit markets, and oligarchs.

But over the long haul technology is at the core of this cycle of “creative destruction.”

While access to cheap capital matters, as do government permits, impediments and subsidies, it’s technology that creates supply (and demand too, but that’s another story, covered elsewhere). The world would not be awash in oil if we were still using the drilling technology of 1917. History’s long rise in oil production is traceable through technology progress from the Hughes drill bit to seismic imaging to deepwater rigs, and now of course shale tech.

So the hot topic amongst shale pundits these days is whether there is anything really new on the horizon, or whether shale, the latest entrant on the world petroleum stage, is on the glide-slope of the law of diminishing returns.

When it comes to petroleum prognosticators, it’s worth considering the record. Wind the clock back a handful of years and no forecaster saw America adding so much new production so rapidly. The addition of five million more barrels per day to global supply practically overnight – at these scales a half-dozen years is overnight – wreaked havoc. Shale put an unwanted 5% more supply into global markets that see prices soar or plummet from a mere 1% mismatch between supply and demand.

Then when prices collapsed a few years ago, pundits eagerly forecast the demise of the shale boom. They missed the astonishing increase in shale drilling productivity that continued and even accelerated, minimizing the carnage from rock-bottom prices and positioning the industry for today’s recovery. Note we’re talking about productivity in engineering terms, barrels per rig, and not costs per se since the latter can also come from squeezing service providers in a down marke t, which (while valuable) is always evanescent.

The narrative now is that productivity gains are nearly maxed out. It makes sense that this new industry would follow the standard progression seen in the advent of all new mechanical tools and techniques wherein there’s a learning curve in the early days leading to rapid improvements, then things slow down. Recent data certainly supports that possibility. A slow-down is visible now for the key mechanical and operational features that have driven per-rig productivity gains thus far: longer lateral lengths, more frac stages, and more sand and water per well. And while there is still headroom for more gains in all of those, limits are in sight.

Thus the question: does shale production now follow the pattern of previous discoveries and new mechanical techniques like, say, deepwater production?

The development, two decades ago, of tools and techniques to drill in ultra deep waters lead to a 500 percent rise in deepwater rig production in its first ten years, but then growth flattened out. Two decades earlier yet, the same pattern played out, rapid-growth-to-flattening over a ten-year span, with the Saudi’s monster Ghawar field. Now a new MIT study claims that half of the gains in shale productivity arise not from better technology but from choosing sweet spots, better locations to drill, and that the latter will dominate going forward.

Or is there another wild card? Despite years of hype and over-promises for digital oil fields (one example, a 2008 Booz paper), is there finally a digital disruption on the frontier? Consider a thought experiment apropos technology disruptions:

It’s 1994 and the nation has seen a decade of explosive growth in the consumer PC market, and the number of Internet hosts has jumped 1000x. That year Amazon was founded to sell books taking advantage of those twin revolutions. Did any of the retail pundits or investment wizards at that time anticipate the unraveling of Sears and shopping malls just one decade later?

It’s old news that e-commerce and Amazon have disrupted retail. And now, grabbing a mere 1.6% share of the U.S. grocery business via the Whole Foods acquisition, the creative-destruction expands into the low-margin grocery business. Call this the Amazon effect.

Once investors recognized the market power and inevitability of the Amazon effect, they began changing investment decisions which triggered the de-capitalization of the rest of the market laggards (not just Sears), first in retail and then in groceries.

Keep in mind that the Amazon effect is not the elimination of the underlying goods or services: the same physical goods are still produced, stored, shipped and consumed. (Ditto for Uber, or AirBnB, etc.) The Amazon effect is, in simplest terms, using information platforms to radically improve the efficacy of all that, in ways that traditional players failed to do. Importantly, the original Amazon effect initially involved a whole host of other lesser online e-commerce companies. And market disruption began well before e-commerce captured 2 percent of all retail sales.

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