Frank Wolak: The End Of Expensive Oil?

Frank Wolak: The End Of Expensive Oil?

The End of Expensive Oil? by Frank Wolak, Stanford Institute for Economic Policy Research

1. The North American Shale Resource Bonanza

The shale oil and gas revolution in the United States (U.S.) has led to a more than 4 million barrels per day increase in domestic oil production since 2008. Combined with an almost 1 million barrel per day increase from the Alberta tar sands, the surge in North American oil production has significantly reduced the region’s demand for imported oil. Increased production of shale gas in North America and the significantly lower dollar per million British thermal unit (BTU) price of natural gas versus oil have caused a number of sectors of the U.S. economy to shift away from consuming oil to natural gas. Consequently, China, rather than the United States, is now the world’s largest oil importer, purchasing more than 7 million barrels per day from the global market. Figure 1 shows domestic production of oil in December of 2014 approaching the historical high of slightly more than 10 million barrels per day in November of 1970.

2. The Declining Role of OPEC

The increase in North American oil production and decline in U.S. oil consumption have also significantly reduced the share of global oil demand served by the OPEC countries. Recognizing this fact, Saudi Arabia, the largest OPEC producer, recently decided not to reduce its production in response to prices in the $50 to $40 per barrel range. One can make a strong case that Saudi Arabia concluded that reducing its output would not increase the global price enough to make this unilateral reduction in output profitable. One plausible reason is that Saudi Arabia inferred that other OPEC countries would not follow its lead in reducing output to the extent needed to achieve a jointly profitable (for all OPEC members) global oil price increase.

A number of factors point to stable or even higher output levels from the OPEC countries. Most OPEC countries are currently experiencing massive fiscal shortfalls because of low oil prices. The desire of these countries to avoid further domestic unrest makes oil output reductions unlikely because this would lead to even larger fiscal shortfalls unless these actions could be successfully coordinated among the OPEC countries to produce a significant increase in the global oil price. Slower demand growth in China and Europe makes unilateral output reductions by Saudi Arabia and other OPEC countries even less likely to increase global oil prices. Finally, over the past year, oil production has increased by almost 1 million barrels per day in Iraq and Libya.

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3. Increasing Standardization of Well Drilling

The share of global oil production from the OPEC countries should continue to fall as more countries adopt shale oil and gas production technology. The technology of shale oil and natural gas production is less than 10 years old, so there is still significant scope for cost reductions in exploration, drilling, and production activity, even in the U.S. According to the oilfield services firm Baker-Hughes, more than 37,000 wells were drilled in the U.S. in 2014. This volume of drilling activity has led to increasing standardization of the drilling and production activity. This so-called “factory drilling” process has reduced the time necessary to drill a well to less than 10 days. Historically, approximately 40 percent of the wells drilled are uneconomic in the sense that less oil and gas is recovered than it costs to drill the well. Consequently, there is considerable scope for improvement in well completion efficiency, which should increase the amount of oil or gas that can be recovered from a given well.

Another important trend likely to reduce both drilling and production costs and enhance productive efficiency is the greater integration between oil and gas service companies. Historically, drilling and production activities were undertaken by a range of suppliers. Recently, an increasing number of companies are offering one-stop shopping for all drilling and production activities, which can reduce production costs and increase well efficiency. A prominent example of this trend is the merger between Halliburton and Baker-Hughes, two of the largest oil and gas services companies. This merger is motivated by the desire for a single company that provides fully integrated services for all aspects of oil and natural gas drilling and production.

4. Natural Gas and Oil Interactions

One key driver of a reduced global demand for oil is the development of technologies that are able to exploit the differential between the dollar per MMBTU cost of oil and the dollar per MMBTU cost of natural gas. Even at $40/ barrel, the dollar per MMBTU price of oil is still substantially in excess of the dollar per MMBTU price of natural gas. Assuming the industry standard 5.8 MMBTU per barrel of oil conversion factor implies an $8.60 per MMBTU price of oil. The current dollar per MMBTU price of Henry Hub natural gas is less than half that amount, which implies further switching away from oil is likely to occur in North America, particularly in the heavy-vehicle transportation sector.

The production of associated gas from oil extraction is an additional driver of fuel switching from oil to natural gas. Roughly one-third of the growth in new U.S. natural gas supplies and approximately 10 percent of total domestic natural gas production are derived from the production of oil. Increases in the supply of associated natural gas are driven by the price of oil, but this increased supply of natural gas reduces the price of natural gas. Consequently, the production of associated natural gas increases the difference between the dollar per MMBTU price of oil and dollar per MMBTU price of natural gas, which leads to further switching from oil to natural gas for fossil fuel-based energy services.

5. Technologies that Reduce Oil versus Natural Gas Price Differential

An innovation limiting the amount of natural gas flaring (gas burned at the source without doing any useful work) that takes place in regions with significant shale oil production, such as North Dakota, is the CNG-in-a-Box technology recently developed by General Electric (GE). CNG-in-a-Box is a mobile technology that captures the natural gas that was formerly being flared off and compresses it to produce compressed natural gas (CNG) for use in vehicles serving the region and in drilling equipment, reducing the demand for diesel fuel in the region. This technology makes productive use of natural gas in regions without natural gas pipeline infrastructure.

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