Sunday, March 15, 2015

Lipstick on a pig: America as the world's swing producer of oil

Most people have heard the old saying: "You can put lipstick on a pig. But it's still a pig." That's sort of what is happening in the American oil patch as producers try to put a positive gloss on the devastation that low oil prices are visiting on the industry.

Perhaps the most inventive redefinition is as follows: The part of the U.S. oil industry devoted to extracting tight oil from deep shale reservoirs in places such as North Dakota and Texas has made the United States the world's "swing producer." A swing producer is a country or territory that has large production in relation to the total market, substantial excess capacity and the ability to turn its capacity on and off quickly in response to market conditions.

The term makes the U.S. oil industry sound powerful and important. And, while the U.S. industry remains an important player in the world--third in production behind Russia and Saudi Arabia--it is most definitely not powerful in the sense that the moniker "swing producer" would imply.

To understand why this is so, we need only examine the history of the world's other two swing producers. Prior to 1970, Texas was the world's swing producer. Starting in the 1930s the state of Texas began regulating the amount of oil that an oil company could produce from its wells. It did this when overproduction drove the price of oil down to a mere 13 cents a barrel. (That's not a typo.) No one was making any money. Well owners were then forced to abide by a system called "proration" in which each well was allowed to produce at a percentage of its capacity.

The Texas Railroad Commission was given the responsibility to manage this percentage in order to insure that oil prices--and this meant world oil prices--would provide a fair return for oil producers. It would raise the percentage when supplies were tight and this would bring prices down. It would lower the percentage when supplies were too great and this would bring prices up.

By 1970 the world needed all the oil that Texas could pump and so the commission announced 100 percent "proration."* The commission essentially stopped regulating oil well output based on market demand. The inability of Texas to maintain significant excess capacity while supplying the market with adequate amounts of petroleum meant that the days of Texas as the swing producer were over.

The tightness of the world oil market set the stage for the Arab oil embargo and the success of OPEC. Neither would have been able to raise oil prices if Texas had been able to maintain significant excess production capacity. The ensuing price hikes led Saudi Arabia to build significant additional production capacity that it believed would allow the country to take advantage of rising world oil demand. When demand subsided in the early 1980s, the kingdom was stuck with substantial excess capacity and inadvertently became the world's swing producer.

Saudi Arabia had very large production, the largest in the world at the time. It had (and still has) oil that was cheap and easy to produce just as Texas had had when it first became the world's swing producer. And, the Saudis had the will to exercise discipline in raising and lowering production to moderate price declines and spikes.

The logic behind this role is that large oil producers neither wish to flood the market and make oil unprofitable, nor restrict production so much that high prices make substitutes for oil more attractive. In addition, prices that are too high are liable to crash the world economy, leading to a rapid fall in demand and thus prices. Swing producers prefer a "Goldilocks" world in which the price of oil is not too high and not too low, but just right to allow both producers and consumers of oil to prosper without making alternatives too attractive. It's a tough needle to thread.

Saudi Arabia has played this role (sometimes well, sometimes poorly) since the 1980s. Some say the country relinquished this role recently since it refused to reduce its production in the face of falling world demand and rising U.S. and Canadian production. But actually, the Saudis are merely doing what a swing producer has to do occasionally to discipline market participants who overproduce. They are punishing profligate producers now centered in the United States and Canada by allowing prices to drop precipitously in the face of excess supply.

The kingdom has declared that it is up to other producers to cut. This seems like an abdication of its role. But, in fact, the Saudis have punished other producers previously for overproduction in the mid-1980s by flooding the market with Saudi oil.

Still, many contend that this makes the American tight oil fields the world's swing producer by default. Let's see if the definition fits.

The production from American tight oil fields is significant, approaching 4 million barrels per day (mbpd). But is that production sufficiently flexible to qualify it as a swing producer? In the past when Texas was the world's swing producer, the Texas Railroad Commission merely adjusted the allowed percentage of the maximum "efficient" flow rate for wells already producing. That's pretty flexible.

Today, the Saudis claim that they can add or shut down production "immediately" in order to respond to changes in global demand. This flexibility also comes from having existing well production which can be adjusted up or down quickly. Almost certainly there are some wells not currently producing which can be called upon if necessary to boost production. How much is this spare production cushion? The Saudis say it is 2.5 mbpd. Not all agree, and no one knows for sure. But the Saudis and their close allies, the United Arab Emirates (UAE) and Kuwait, do appear to have substantial unused capacity estimated to be at least 3.3 mbpd.

The fact that the Saudis and their fellow OPEC members refused to reduce production in the face of weakening global oil demand does not necessarily disqualify Saudi Arabia from swing producer status. Sometimes swing producers allow excess production in order to discipline other market participants as I suggested above.

In light of this Saudi strategy, can we now say that America's tight oil plays are the world's new swing producer? It's true that America's tight oil fields have many existing wells pumping high-quality crude to the surface. But, we must ask: Can these wells simply be shut in or production reduced until the current oil glut abates? The answer is that most of them cannot.

Most of these wells have been drilled by public corporations using money from outside investors (through drilling partnerships) and from lenders such as banks and bondholders. Shutting in or throttling wells would reduce revenue and make it difficult to pay investors and lenders. In some cases, companies would violate debt covenants even though it might make sense for all parties to forbear until prices rebound.

Next, can production from the existing wells be increased in a short time? Because of the way these wells have been financed, they generally run at 100 percent of production capacity so that revenues can be realized as quickly as possible. The only way to increase production of tight oil in the United States substantially is to drill more wells, something that will be difficult to do under current circumstances. Lenders and investors will be reluctant to throw more money at an enterprise that has lost them great gobs of it even when prices rise again substantially. They will fear another Saudi-led assault on prices (which is exactly what the Saudis are counting on.)

This problem does not plague Saudi Arabia or its allies, the UAE and Kuwait. State control of oil resources means these countries can take a very long-term view toward current investment. They can drill and produce not subject to the lending and investment climate.

But perhaps the most salient difference between the oil produced by Saudi Arabia and that produced from tight oil plays in the United States is the cost of getting the oil out. The all-in cost of producing most tight oil is around $80 per barrel. But nobody wants to invest in something to break even, so $90 per barrel is a better estimate of what will attract investment capital.

Saudi Arabia claims that its extraction cost is around $4 to $5 per barrel. Even if this estimate is low by a factor of 10, Saudi Arabia is still in a position to withstand today's low prices.

The lesson is that the swing producer must also be a low-cost producer in order to have effective control of prices.

U.S. tight oil plays fail to meet the definition of a swing producer. Producers in these plays do not have the flexibility to lower and raise production quickly from existing wells in response to market conditions. In fact, U.S. production continued to grow through December in the face of declining prices, much of that growth coming from tight oil wells still to be completed and even some new drilling in prime spots. Many of these producers are on a one-way treadmill that requires them to drill faster and faster to satisfy lenders and investors. In addition, these producers are high-cost operators. Most are independents and cannot weather a sustained period of low prices without threatening the viability of their enterprises. For this reason operators are unable to make long-term commitments to build the significant excess capacity needed to play the role of the world's swing producer.

Moreover, there is no federal regulatory body comparable to the Texas Railroad Commission that can coordinate production throughout the United States.

So, while U.S. domestic oil drillers will continue to be an important factor in oil markets, they can best be characterized as marginal producers of oil. They produce the marginal barrels of oil for the market when the oil price gets high enough to make it profitable to drill their high-cost deposits as was the case before the recent drop in oil prices.

Naturally, nobody likes to be called marginal. So, the spinmeisters in the investment sales community and the industry are afoot reinventing the tight oil drillers as "swing producers." Investors and policymakers would be wise to stop staring at the glossy lipstick now being applied to the carcass of the U.S. industry. At least a pig with lipstick brings hope of a pork dinner at some point. All the industry has to offer now are shattered dreams and negative cash flows.

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*This refers to "prorated wells" and should not be confused with "proration unit" which is defined by the Schumberger Oilfield Glossary as: "The amount of acreage, determined by governmental authority that can be efficiently and economically drained by a well at a particular depth or horizon."

Kurt Cobb is an author, speaker, and columnist focusing on energy and the environment. He is a regular contributor to the Energy Voices section of The Christian Science Monitor and author of the peak-oil-themed novel Prelude. In addition, he has written columns for the Paris-based science news site Scitizen, and his work has been featured on Energy Bulletin (now Resilience.org), The Oil Drum, OilPrice.com, Econ Matters, Peak Oil Review, 321energy, Common Dreams, Le Monde Diplomatique and many other sites. He maintains a blog called Resource Insights and can be contacted at kurtcobb2001@yahoo.com.

4 comments:

  1. Don't forget that the price rise of the first oil shock was also wished for/pushed by the US/the west (and mainly the consequence of US1970 peak and 71 exit of Bretton Woods/associated $ devaluation)

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  2. A bit more detailed summary for the first oil shock :
    A summary :

    - end 1970 : US production peak, the energy crisis starts from there, with some heating fuel shortages for instance (some articles can be found on NYT archive on that), or :
    http://upload.wikimedia.org/wikipedia/commons/c/c5/US_Oil_Production_and_Imports_1920_to_2005.png
    - Nixon name James Akins to go check what is going on.
    - Akins goes around all US producers, saying this won't be communicated to the media, but needs to be known, national security question
    - The results are bad : no additional capacity at all, production will only go down, the results are also presented to the OECD
    - The reserves of Alaska, North Sea, Gulf of Mexico, are known at that time, but to be developed the barrel price needs to be higher
    - In parallel this is also the period of "rebalance" between oil majors and countries on each barrel revenues (Ghadaffi being the first to push 55/50 for instance), and creation of national oil companies.
    - there is also the dropping of B Woods in 71 and associated $ devaluation, also putting a "bullish" pressure on oil price.
    - So to be able to start Alaska, GOM, North Sea, and have some "outside OPEC" market share, the barrel price needs to go up (always good for oil majors anyway) and this is also US diplomacy strategy
    - For instance Akins, then US ambassador in Saudi Arabia, is the one talking about $4 or $5 a barrel in an OAPEC meeting in Algiers in 1972
    - Yom Kippur starts during an OPEC meeting in Vienna, which was about barrel revenus percentages, and barrel price rise.
    - The declaration of the embargo pushes the barrel up on the spots markets (that just have been set up)
    - But the embargo remains quite limited (not from Iran, not from Iraq, only towards a few countries)
    - It remains fictive from Saudi Arabia towards the US : tankers kept on going from KSA, through Bahrain to make it more discrete, towards the US Army in Vietnam in particular.
    - Akins is very clear about that in below documentary interviews (which unfortunately only exists in French and German to my knowledge, and interviews are voiced over) :
    http://www.youtube.com/watch?feature=player_embedded&v=fQJ-0jAr3LQ
    For instance after 24:10, where he says that two senators were starting having rather "strong voices" about "doing something", he asked the permission to tell them what was going on, got it, told them, they shat up and there was never any leak. The first oil shock "episode" starts at 18:00
    The "embargo story" was in fact very "practical", both for the US to "cover up" US peak towards US public opinion or western one in general, but also for major Arab producers to show "the Arab street" that they were doing something for the Palestinians.

    In the end, clearly a wake up call that has been missed, especially at a time when we are around global peak and the omerta about it is almost complete.

    Note : About Akins, see for instance :
    http://www.washingtonpost.com/wp-dyn/content/article/2010/07/26/AR2010072605298.html

    And his famous foreign affair article :
    http://www-personal.umich.edu/~twod/oil-ns/articles/for_aff_aikins_oil_crisis_apr1973.pdf

    His report to Nixon in 71 or 72 is still classified to my knowledge though, would be interesting to know if it can be declassified now.

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  3. Extract of a Nixon speech of the time (pre "embargo") :
    "
    "195 - Special Message to the Congress on Energy Resources.
    June 4, 1971

    1971


    To the Congress of the United States:

    For most of our history, a plentiful supply of energy is something the American people have taken very much for granted. In the past twenty years alone, we have been able to double our consumption of energy without exhausting the supply. But the assumption that sufficient energy will always be readily available has been brought sharply into question within the last year. The brownouts that have affected some areas of our country, the possible shortages of fuel that were threatened last fall, the sharp increases in certain fuel prices and our growing awareness of the environmental consequences of energy production have all demonstrated that we cannot take our energy supply for granted any longer.
    ...
    "

    http://www.presidency.ucsb.edu/ws/index.php?pid=3038&st=oil&st1=

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  4. PAaron9:31 AM

    Yes, in a way the proration system Texas once used to keep the oil price up now looks quite attractive. It won't be brought back, of course, because it smacks too much of government interference in the economy. Instead, each drilling company will act to maximize its own financial return, and in doing so will minimize the profitability of the entire industry. The good news is that this will prevent the rapid depletion of America's oil reserves, and will also, by keeping prices low, help the rest of the economy.

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