Q&A With Author Peter Zeihan: How Shale Is Reshaping America And The World

We recently met with geopolitical strategist Peter Zeihan to discuss world events since the American election and his new book, “The Absent Superpower,” released last month. In the book, Peter credits energy and resource innovations with reshaping the global geopolitical environment. He predicts by 2019, US oil production costs could drop to $25 per barrel, making US shale producers potentially the lowest cost oil producers on the planet. America’s move into energy independence he says, will reshape global dynamics for at least the next three decades.

We’ve also been thinking hard about America’s newfound energy independence, but from an investment opportunities angle: we’re keenly interested in capturing the innovation going on in the resources sector. We see large-scale productivity increases all over the resources sector and are tracking the companies in a new Knowledge Leaders Resources Index.

We covered so much ground in our visit with Peter, we’ll publish two reports. In this first one, we address the broad impact of the Shale Revolution, which he calls, “the greatest evolution of the American industrial space since 1970.” We hope you enjoy the discussion.

Q&A With Author Peter Zeihan: How the Shale Revolution is Reshaping America and the World

Part 1: Productivity & Innovation in the Resources Sector

GAVEKAL CAPITAL: In the book, you write that innovations in the resources sector have given rise to an American Shale Revolution that is “reshaping the energy politics and energy economy of the United States, and in turn the global system.” What happened to cause this shift?

Peter Zeihan:Shale was supposed to be on the brink of demise when oil prices crashed in November 2014, but due to a confluence of events, the industry has matured far faster and more holistically than I could have expected. During the past two years, the shale sector has evolved in dozens of ways, for the most part in a desperate effort to survive. The resulting changes have transformed the American shale patch from a critical piece of the American energy system to a globe-changing revolution. Understand those changes and you can understand just how transformative shale is about to become.

The best place to start is probably about what’s changed in the shale oil industry. The general technology, fracking, where you drill down, then go laterally, and then put in water and sand at high pressure and crack it apart … that’s nothing new. Everybody talks about the horizontal drilling and the pressurized fracking as what made it possible. And I don’t mean to suggest that that is not true, but what really allows shale to be something more than a big boondoggle is seismic technology. Now, seismic has been around in the industry since the late 1970s. It’s not new, either. But the old seismic is a radically different creature from what we have today. It’s like comparing a Toyota hybrid to an 18-wheeler from the 1950s. Yes, technically, they’re of the same technological tree, but they’re so radically different. With the old seismic you have these giant bulbs of oil-saturated rock that didn’t require much of a sonar cross-section to show up when you would do your seismic. The new ones can pick up deposits about the size of a 500 ml water bottle.

GC: How is this different from traditional drilling techniques?

Peter Zeihan: When the oil forms, it forms in a source rock, and then it tends to migrate through to different types of rock until it hits something that it can’t pass through, a “cap rock” in the lexicon. There, it will continue to build and form up more pressure but not necessarily more heat. The heat is in the source rock. That doesn’t mean that your cap rock can’t be warm, however. Sometimes, the cap rock is hotter than the source material. But if it’s too hot, it will quickly go from kerogen to oil to natural gas to nothing. So, if you have the storage area, for lack of a better phrase, and it’s really hot, you have to drill it at the right geological moment or the oil is going to be gone. That’s why conventional oil has always been seen as a terminal window because there’s only so much of that. And you can drill deeper and you can make money off of smaller deposits, but at the end of the day, there’re only so many places where you have that perfect mix of geology to create the oil, capture the oil and then hold it in a condition for more than a few eons.

GC:Does most oil sit in such an environment, under a cap rock?

Peter Zeihan:No. It’s easier to think of it as a pool of liquid, but it’s not actually a big chasm full of liquid. It’s porous rock that happens to have a lot of oil saturated through it. The difference about shale rock is it’s not as porous to the same degree that the conventional reservoirs are. So, if you have a high-porous rock, the liquid, the oil, the gas can migrate through it until it hits a barrier that it can’t pass through. At this point it builds up pressure and when you tap those, you get a gusher. Shale is porous at the micro level but not the macro level, so the oil can form in it but then it can’t get out. If you have a shale rock versus another oil-bearing rock, the shale rock is much heavier. It’s super-dense, and you can’t squeeze it; you have to shatter it. With the conventional reservoir, you drill down into it and you don’t even have to crack it. The water, which would be the liquid, will seep out on its own in most circumstances. With shale, you have to beat the hell out of it to get it to give up the crude. Micro-seismic allows you to get a more accurate picture of all of that, and micro-seismic is so new it did not exist 30 months ago. More than four-fifths of the petroleum in North America is trapped within the source rock, and most of those source rock are shales. The shale industry is all about developing technologies that make it possible to access the oil that isn’t perfectly packaged. The only way to get shale rock to give up appreciable amounts of petroleum is to turn conventional drilling techniques on their ear –literally. Instead of drilling vertically down through the formation, you instead drill horizontally along the formation. Total reservoir contact between the wellshaftand the shale layer would be but a few dozen feet per well with vertical drilling, but by going horizontally you can now establish over two miles of contact.

GC:Are technologies like micro-seismic allowing drillers to access this trapped oil that was inaccessible before?

Peter Zeihan:Right. Seismic technology has been around for a while and that’s gotten better and better, and we would’ve never had the shale revolution without it, but micro-seismic has changed the approach by sending a series of geophones down an existing well shaft and detecting noise across the entire cross-section. Then, as people are doing other drilling around it, it’s listening to how those much smaller sound vibrations, ergo micro, are bouncing around within the formation. They can now map out the formation as they’re doing other drilling. And there’s dozens of variations on this that are still coalescing around whatever the new tool is going to be, and each company excels at a different piece of this. It’s disseminating far more rapidly than any other technology in the energy sector ever has. The geophone is basically a big wire that has dozens of sensors going all the way down to the bottom of the well shaft, and they leave that in place as long as they’re doing operations. Now that we’re getting into things like re-fracking and going back to fields for the second, third, and fourth time, you basically can leave that installed. So, in places like the Permian, where we’ve been doing conventional operations for decades, they’ll go into a depleted area where the conventional oil’s gone, they’ll run the geophones down an old well, and then they’ll frack in new wells all around it. The more layers you have, the thicker the petroleum bearing layer is, the more economically viable it is. It is a massively disruptive technology that alone can lower the break-even price by at least $15 a barrel. Remember, it’s an emerging technology and the pace it is moving is lightning fast. You could say that some bits of this book are already out of date, because it’s moving so fast and we are at a stage that not everybody is even using it yet. I would say it was probably used in just 5% to 10% of the wells that were drilled last month (December 2016). A year before that, it was probably only used in 1% to 2% of the wells. Now that oil prices have rebounded a little bit, and you’ve got a broader array of companies that can make profit at this margin, you might not see that percentage creep up very quickly because there’s a little bit more breathing space in terms of breakeven costs. But the companies that know how to do it are the ones that are going to grow the fastest.

GC: What else is going on in the shale industry?

Peter Zeihan:Other advances are more linear than logarithmic. Liquid pits are now a thing of the past; it’s all water tanks. So, you don’t have to worry about site set up, you don’t have to worry about site breakdown, you don’t have to worry about land reclamation or rehabilitation. The water is all in a tank. Operators recycle it as they go and mix the frack fluid on site. The footprint of a well is 5% of what it was two years ago. You also need a lot fewer rigs. Instead of going down a mile and over 6,000 feet, down a mile, over 6,000 feet, now you hit the same well but at every vertical layer. By hitting the next layer again and again, you’re getting up to 50 miles of horizontal contact out of one well. That’s why I ignore the rig count now and view it as basically a meaningless number.

GC:You’ve also seen a 60% jump in rig count off the bottom too.

Peter Zeihan:That’s some of the older rigs that are coming back. I would not read into that too much because last year most of the rigs that were in operation were the multilateral rigs. Now that prices have come up, some of the older single spike rigs are coming back. They can work at $50 per barrel, but they can’t work at $40 or $30. So, I would caution you that a lot of the companies that might be seeing really big growth right now will not be able to sustain it. If you take these technologies and you compress them down to a nice little package, the companies that can do that are going be able to ride out any price shock, and the companies that can’t do that will make money only when the prices are higher.

The only area where the volume of inputs has not dropped is sand. Everything else has become more efficient. They are actually using more sand per foot of well stage. The general areas where efficiency has improved is with stronger pumps and cramming more sand to create bigger fractures. The good news is sand is cheap and they’ve also discovered that the fancy designer sands that are made out of artificial materials really don’t do much for you. You could just buy the absolute cheapest brown sand that Texas puts together and you’re good. So, we’ve seen a bit of a sand recession, if that’s even a thing, in Wisconsin. It wasn’t as bad as what happened in the rest of the energy sector because everybody still needs some sand, but then they started experimenting with cheaper and cheaper sand, and they discovered it didn’t make much of a difference. So, all the good sand out of Wisconsin is kind of falling by the way side, now they’re just using that for glass. Instead they are using cheap sand from wherever you can dig it up. And they’re using two, three, sometimes even five times as much per foot of well stage. The length of the fracks is much shorter now. It’s now 20 to 80 feet; an 80-foot one is really a long one.

They’ve gotten good enough with the precision application that the industry is now fracking stage-by-stage. Those cracks might technically go a couple hundred feet, but they are so tiny that the sand only goes a quarter of that distance and the water maybe half. The cracks are so thin you don’t have to worry about seepage nearly as much as you used to so that problem has gone away, and the Obama administration even signed off on it. The EPA report on water quality finally came out in 2016, and it basically said, “Yeah, fracking, don’t worry about it.” There have been instances of contamination, but they’re not statistically significant –and that’s according to the Obama administration’s EPA.

GC:You said operators are now seeing up to 40 miles of horizontal access per vertical well. Is that a significant increase?

Peter Zeihan:Back in 2004, it was 600 feet. In 2007, it was about 6,000 feet. We’re talking about a 10-fold increase since 2007, and that’s all with one horizontal. Now, remember pad drilling? Pad drilling’s going away. With pad drilling, you’d go down vertically and then go over a mile. And then you’d have another vertical shaft and then go over a mile, and then another vertical shaft. And you could do up to 20 of those on one pad. They’ve done away with all these vertical shafts. Now there’s just one. The apparatus turns around in the main shaft and goes out again and again, so they are using half the steel. Multilateral drilling is another linear advance, although a pretty steep one. They use much less water, and that’s huge on the environmental side of things. Micro-seismic is the logarithmic advance. Gathering infrastructure required absolutely no changes with what they were doing, but when you have 20,000-30,000 barrels coming out of one vertical well, because of all that horizontal connections, you need a bigger pipe, and you need fewer of them. So, you’re using less steel on the surface, less right of way, less royalties, less transit fees for the same collection capacity. And now, they’ve figured out how to go into areas that have already been fracked and using micro-seismic, for example, to look for new places and use exactly the same well and exactly the same gathering infrastructure, but do a completely fresh approach. The next big breakthrough will be doing that on pre-existing wells which is called refracking. They’re still working out the kinks of that, because once you’ve already fracked a zone, you already have a lot of cracks in the area, and keeping the pressure different from stage to stage is difficult because with the older wells the cracks intermingle. So, if you put a lot of pressure into one stage, you might actually be fracking the next stage. But if they can figure out a way around that, and there’s a few technologies that Halliburton is working on for that, something called the “sliding sleeve”, then everything we’ve done before, we can come back and do it again and get three times the oil out of it. So just in additional induced recovery, that could be another six million barrels per day.

GC: With all the new techniques, productivity and cost savings, where do you see production going? Do you see a repeat of almost a doubling of production over five years?

Peter Zeihan: I think that a million barrels per day added in calendar year 2017 is just baked in now, and that even assumes a certain price giveback from where we are at right now. The break-even price in the big four fields is now $40. And what you’re seeing now is this initial spike from relatively new players coming in with relatively old technology because the numbers make sense and they don’t have the debt overburden. It’s easy to get a little bit of money to start something fresh right now. It’s when the players who survived this get their fresh funding which is happening right now, that probably by the end of the first quarter that output will really increase. So one million barrels per day of new output I think is a very conservative estimate, but a very safe one. Two million is possible.

GC: You describe an environment of consolidation from June 2014 to June 2016, during which experimental technologies were shared much like tech’s open source culture, driving output rates higher even while they drove per-barrel product costs lower. Was this a result of the Saudi price war?

Peter Zeihan:Exactly. Saudi Arabia’s price war inadvertently created a dream scenario for American innovation. What’s happening now is a leaner, meaner, greener set of technologies that is allowing shale to tackle what detractors rightly see as its greatest Achilles’ heel: high upfront production costs. Such tech advances comprise the bulk of shales recent price advantage. In 2012, before any of those technologies had been operationalized full-cycle costs were about $90/barrel. In November 2014, when the Saudi’s launched their price war, the full-cycle break-even cost across the shale patch was probably about $75 … by August 2015 that figure had plunged to $50 in the Big4 fields. As operators started to redesign wells with the entire lifecycle of production in mind, that per-barrel production cost for new wells dipped to the vicinity of $40 in November 2016. North American shale already is more cost-competitive than the global average. As these technologies continue to mature and play off on another, a price structure of around $25 sometime in 2019 seems within reach.

Your average well involves inputs from more than 100 companies from start to finish. With the technology that exists now, each well now likely can be relied upon to at least triple its long-term output compared to 2014 norms for on average less than a 50-percent increase in cost, with less surface infrastructure. By my math, all in, North America is less than 0.8M barrels per day from being a net energy exporter.

Article by Gavekal Capital Blog

See the full PDF below.