06 May 2013 Shale Oil: A Turning Point for the Global Oil Market Edith Southammakosane, Director - Research research@etfsecurities.com Key points Global oil supply is rising rapidly as shale oil production has surged in the US and is expected to expand to Russia and the Middle-East, where output from conventional oil is declining. At the same time, major energy reporting agencies have reduced their estimates of global oil demand on a reduction in forecasts of US and China demand and a deterioration of demand conditions in Europe. The increase in supply from shale, together with an uncertain global growth outlook will likely keep oil prices trading in a relatively narrow range. Near-term oil price upside will likely be capped by concerns about the sustainability of the US and China economic recoveries, while downside barring a large growth scare should be limited to around US$80/bbl for WTI, as below that level production will start to become uneconomic for many shale producers. Executive summary According to the IEA, the US will overtake Saudi Arabia and Russia to become the largest oil producer in the world by 2020. US oil production increased by 790,000 barrels per day in, the largest annual increase since 1859, accounting for 97% of global oil supply growth in. Most of this output is from tight and shale oil formations. With OPEC supply expected to decline over the next decade, the new supply from US shale oil may just compensate for OPEC lower output. However, major reporting agencies have also recently reduced their forecast of global oil demand due to a lagging global economic recovery, energy consumers switching to cheaper substitutes such as natural gas, and government incentives to increase consumption of less-polluting fuels. Given the elevated costs of producing unconventional oil, this note looks at under what conditions shale oil production will continue to expand and the implications for the global energy markets. Brent and WTI prices at the bottom of their recent trading ranges 140 130 Global growth data improves Spain pulled into Sovereign crisis Cyprus near bankruptcy 120 110 Brent trading range: US$100 - US$125 100 90 80 Recent WTI trading range: US$85 - US$100 70 60 'Arab Spring' begins Iran embargo comes into force 50 Apr 09 Jun 09 Aug 09 Oct 09 Dec 09 Feb 10 Apr 10 Jun 10 Aug 10 Oct 10 Dec 10 Feb 11 Apr 11 Jun 11 Aug 11 Oct 11 Dec 11 Feb 12 Apr 12 Jun 12 Aug 12 Oct 12 Dec 12 Feb 13 Apr 13 Daily Data in USD from April 2009 to April 2013 Sources: ETF Securities, Bloomberg Brent Crude (USD/bbl) WTI Crude (USD/bbl) 1
Oil shale or shale oil? First it should be made clear that shale oil is different from oil shale. Oil shale is a sedimentary rock that contains organic compounds kerogen from which oil-like substance can be obtained by heating the rock to high temperatures and then be refined to produce a fuel. In the 1980 s, American oil companies abandoned oil shale plants on the ground that production was not economically viable and was creating high level of greenhouse gases due to the high level of heating necessary to extract the liquid. On the other hand, shale oil formations, also referred to as light tight oil, can be refined to produce fuels using a technology less harmful for the environment called hydraulic fracturing technology or fracking. The technology uses horizontal drilling rigs and creates fissures in deep shale formations by injecting water, sand and other additives under high pressure, releasing the trapped natural gas and oil. Water expands the fracture and delivers the sand allowing for the fractures to remain open so that natural gas and oil can flow into the wellbore and be collected at the surface. The extraction occurs thousands of feet below the aquifers level with the wells protected by multiple layers of steel casing surrounded by cement. Shale oil reservoirs allow for the production of medium to light oil and forms part of a group of called tight oil which also includes low-permeability sandstone and carbonate reservoirs. Medium to light oil Heavy oil Low-Permeability Reservoir Tight Oil Horizontal Drilling Stimulation Immature Oil "Oil Shale" Mining High-Permeability Reservoir Conventional Oil Vertical Drilling Heavy Oil Bitumen - Oil Sands Steam-assisted gravity drainage/mining Shale oil production in the US Hydraulic fracturing and horizontal drilling have been used since the 1940s and are used in nearly all natural gas wells drilled in the US today. Its application to shale oil plays has been developing at a fast pace over the past few years. The main shale plays are located in South West and North regions of the US, with Eagle Ford and Williston Bakken oil plays being the most successful one. In these regions, recoverable oil is estimated at more than 5 billion barrels per play. Some smaller plays located in Permian and Woodford basins contain recoverable reserves estimated at 0.4 to 2.1 billion barrels equivalent. New shale plays in California and Ohio are currently being assessed. Some preliminary estimates of the potential lie around 5 billion barrels per play which make them comparable to Eagle Ford and Bakken. Recoverable oil reserve from shale plays in the US is currently estimated at 30 billion barrels. US shale oil plays and estimated oil recoverable New Mexico/Texas/Oklahoma Shale oil (in bn barrels) Western Gulf basins 5.1 Austin Chalk Texas 2.7 Eagle Ford Texas 2.5 Permian basins 2.1 Bone Springs Texas/New Mexico 1.6 Spraberry Texas 0.5 Woodford basins 0.4 Anardarko West Oklahoma 0.4 Granite Wash Texas/Oklahoma Montana/North Dakota/Wyoming/Nebraska/Colorado Rocky Mountain basins 11.9 California Ohio Niobara 6.5 Williston Bakken 5.4 San Joaquin/Los Angeles basin 8.8 Monterey/Santos 8.8 Utica basin < 5.6 bn barrels TOTAL 33.93 Note: recoverable oil from shale oil resources from EIA July 2011 report 2
Jan-00 Jul-00 Jan-01 Jul-01 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2014 2016 2018 2020 2022 2024 2026 2028 2030 2032 2034 2036 2038 2040 02 May 2013 Is shale oil production sustainable? Before oil and gas can actually flow in the wellbore, there are a number of phases that oil and gas exploration and production companies (E&P) need to follow: 1. Identify the oil resource with the help of geological and seismic data; 2. Evaluate the reservoir with multiple vertical drilling to collect samples and assess the potential; 3. Build the plant and surrounding infrastructure necessary for the transportation of the oil to refineries; and 4. Invest in new wells to maintain productivity rates given that the initial productivity of a well declines by 70% to 90% in the first year after production starts. The cost to produce a barrel of oil from shale formations is therefore higher than the cost to produce a barrel of conventional oil and currently varies between US$50 and US$80 per barrel depending of the structure of the shale projects. The completion of a shale oil project is therefore highly dependent on a positive economic and investment environment. Although production costs are on average estimated to fall to US$30-40 per barrel after reaching 1 billion barrels per day, oil prices are expected to stay above US$80 per barrel for this technology to remain economically viable and for new projects to be considered given the revenue sensitivity to oil price levels during the first few years of a project. At the moment, hydraulic fracturing and horizontal drilling is only being applied to very low permeability formations where drilling yields are high. Technology improvements such as increasing the length of the horizontal laterals to handle larger production volume may help reduce the cost of production further and allow E&Ps to benefit from higher economies of scale. Implications for the US energy market US total oil output is forecast to rise 815,000 barrels per day from 6.3 million barrels per day in to 7.2 million barrels per day in 2013, a level not seen since the early 1990 s. The past few years have seen a sharp rise in US tight oil production to 2 million barrels per day in, reversing the previous 20 years of decline in US oil production. The EIA forecasts tight oil production will peak at 2.8 million barrels per day in 2020 before stabilising at 2 million barrels from 2035. In their latest Annual Energy Outlook report, the EIA revised up their growth estimates for tight oil from 0.72 to 2 million barrels per day, a revision that highlights the difficulty of providing accurate estimates of the shale oil market, particularly given that E&P research divisions continue developing new techniques to improve productivity rate. 8 7 6 5 4 3 2 1 0 U.S. domestic crude oil production by source 1990-2040 (million barrels per day) 1.6 1.4 1.2 1.0 0.8 0.6 0.4 0.2 0.0 Bakken Eagle Ford Spraberry Bone Spring Niobrara Granite Wash Austin Chalk Monterey Woodford Tight Oil Production Monthly data in million barrels per day, from Jan 00 to Jun 12 Tight oil Other onshore Offshore Alaska Source: EIA Annual Energy Outlook (Early Release) - December Sources: EIA - Annual Energy Report 5
This new supply from US shale oil may just compensate for the slowdown in OPEC oil supply. OPEC oil output in January was down 720,000 barrels per day year-on-year according to IEA and 100,000 barrels per day compared to previous month. The difference between OPEC and US supply levels is 2.5 million barrels per day with US oil supply expected to rise 1.2 million barrels per day by 2020. Assuming supply momentum continues, US oil production may exceed output from Saudi Arabia by 2020. The increase in US oil supply is likely to have an impact on US oil imports as both are historically negatively correlated. The decline in US oil supply, down 1.7 million barrels per day since the 90 s, has been compensated for by an increase in US oil imports from 6 to 9 million barrels per day. As the downtrend in oil production is reversing, US imports of oil are likely to fall over the medium-long term, affecting mostly Mexico and OPEC members in South America, the main countries the US imports oil from. 5.0 4.5 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0 Sep-07 Dec-07 Mar-08 Jun-08 12 10 8 6 4 2 0 1990 1991 Saudi Arabia High Production Level and OPEC Low Spare Capacity (Monthly data in mn bbl/d, from September 2007 to March 2013) 1992 Sep-08 Dec-08 Mar-09 Jun-09 Sep-09 Dec-09 Mar-10 Jun-10 OPEC Middle East Spare Capacity 1993 1994 1995 1996 1997 5 Year Average 1998 1999 2000 Sep-10 2001 Dec-10 2002 Mar-11 2003 Jun-11 Sep-11 Dec-11 Mar-12 Jun-12 Sep-12 Dec-12 Mar-13 EIA Forecast Jun-13 Sep-13 Saudi Arabia Production Level (RHS) US Oil Production and Imports since 1990 in million barrels per day Crude Oil Imports 2004 2005 2006 2007 2008 2009 Crude Oil Production 2010 2011 Dec-13 2013F 10.5 10.0 9.5 9.0 8.5 8.0 2014F The shale oil boom is also coming at a time when US demand for oil is likely to decrease. Auto sales in the US have slowed down over the past few years as new fuel-efficiency measures on cars and trucks make domestic consumption shift to less-polluting fuels such as natural gas. New vehicles are required to average 35.5 miles per US gallon between and 2016, from 10 miles per gallon currently and to 54.5 miles per gallon by 2025. Demand for oil is estimated to fall by around 1.8 billion barrels by 2016, the equivalent of one year oil supply in the US. 3.0 2.5 2.0 1.5 1.0 0.5 0.0 1994 1995 1996 US Consumption of Liquid Fuels per Fuel Type in million barrels per day 1997 1998 1999 2000 2001 2002 2003 Natural Gas Liquids and Others 2004 2005 2006 2007 2008 2009 2010 2011 2013F Finished Oil Liquid Fuels (RHS) 2014F 19.0 18.5 18.0 17.5 17.0 16.5 16.0 15.5 15.0 14.5 14.0 Although US auto sales recovered last year, the impact of government fuel-efficiency policy on gasoline retail sales is clear. Refiners sold two times less gasoline in than 2 years ago and US inventories of gasoline reached a 5-year low in October, indicating that refiners are also adjusting their production levels as demand for refined oil decreases. With the program covering more vehicle types, and fuel-efficient vehicles taking an increasing part of US auto sales, domestic demand for refined oil products is likely to decrease further, reducing in turn US demand for crude oil. 70,000 65,000 60,000 55,000 50,000 45,000 40,000 35,000 30,000 25,000 20,000 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec U.S. Total Gasoline Retail Sales by Refiners Monthly data in '000 gallons per day, From Jan 1986 to Dec 2001-2005 (Avg) 2006-2010 (Avg) 2011 1986-1990 (Avg) 1996-2000 (Avg) 1991-1995 (Avg) 4
Implications for the global oil market Even as the IEA, EIA and OPEC have revised down their estimates of global oil demand, the shale oil boom is starting to expand outside of the US. Russia has started applying hydraulic fracturing technology to Siberia s deposits of unconventional oil. The government s goal is to keep Russian oil production at 10 million barrels per day until 2020 to offset the decline in the country production of conventional oil. China s state-owned energy companies have also started to investigate shale oil with Sinopec taking a 50% stake in the Mississippi Lime oil and gas field at the end of February 2013. While the owner, Chesapeake Energy Corporation, has kept the operational management of the facilities, Sinopec has now access to the latest technologies in exploring shale formations, confirming China s interest in replicating the same techniques locally. To keep shale oil production economically viable, and avoid excess oil from dragging US oil prices down, the US will have to consider increasing either the number of permits to export oil, or the number of refineries capable of treating light and medium crude oil. Historically, US oil exports have been limited to Canadian refineries mainly, as they specialise in treating light sweet crude oil and shale oil. In exchange, US refiners receive oil from the heavy oil sands in Alberta thanks to the North American Free Trade Agreement. Although the US is unlikely to export oil to countries other than Canada, data from the EIA shows that February oil exports doubled compared to the same period last year to 3.5 million barrels, up 75% from January. 4,000 3,500 3,000 2,500 2,000 1,500 1,000 500 0 Feb-03 Jul-03 Dec-03 US Exports to Canada Monthly data in '000 barrels from February 2003 to February 2013 May-04 Oct-04 Mar-05 Aug-05 Jan-06 Jun-06 Nov-06 Apr-07 Sep-07 Feb-08 Jul-08 Dec-08 May-09 Oct-09 Mar-10 Aug-10 Jan-11 Jun-11 Nov-11 Apr-12 Sep-12 Feb-13 Outlook for 2013 The direction of oil prices in the near term will depend on the sustainability of the US and China economic recoveries. With WTI and Brent trading near the bottom of their recent trading ranges (see page 1) and assuming the recovery continues, there is potential upside for oil prices. However, any signs of recovery faltering would likely push prices down further, given the new US oil supply coming on-line. Ultimately, the downside for oil prices barring a major economic or financial shock should be limited to around US$80 per barrel for WTI, as below that level shale oil production will start to become uneconomic for a number of producers. The increase in US oil exports will also help release some of the downward pressure on the WTI price. Brent oil medium term downside should be limited to not far below Saudi Arabia s indicated target level of US$100 per barrel. Therefore, despite rising global supply and lower demand trends in the West, the price of oil is likely to remain within a relatively tight trading range for the foreseeable future. 5
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