Cyclical Oil Prices – Is it a Necessary Condition to Balance Global Oil Supply/Demand?

Dr. Salman Ghouri[1] and Mian Aneesuddin[2]

During the past 50 years global oil demand increased from 30.8 million barrels per day (MMBD) in  1965 to 92.03 MMBD in 2014 – an increase of 61.28 MMBD. In contrast, global oil production increased by 56.87 MMBD during the same period (BP-Statistical Energy Review June 2015). That is on an average annual growth in demand and supply of 1.22 and 1.15 MMBD respectively. Energy Information Administration (EIA) predicts global oil demand to increase to 113.1 MMBD in 2035. Likewise global natural gas demand is projected to increase to 4760 BCM in 2035 as compared to 3394 BCM in 2014[3].

In order to meet the projected demand for global oil, natural gas and other sources of energy, International Energy Agency (IEA) estimated that during 2012-2035 the world would be needing cumulative investment of $48 trillion during now and 2035, consisting of around $40 trillion in energy supply and the remainder in energy efficiency. The main components of energy supply investment are the $23 trillion in fossil fuel extraction, transport and oil refining; almost $10 trillion in power generation, of which low-carbon technologies – renewables ($6 trillion) and nuclear ($1 trillion)¹ – account for almost three-quarters, and a further $7 trillion in transmission and distribution. Less than half of the $40 trillion investment in energy supply goes to meet growth in demand, the larger share is required to offset declining production from existing oil and gas fields and to replace power plants and other assets that reach the end of their productive life. Compensating for output declines absorbs more than 80% of upstream oil and gas spending. The fundamental question is how and from where the oil and gas industry will generate this level of investment year after year especially during the regime of lower oil prices?

Market Fundamentals

History has taught us that sustained higher oil prices negatively affect the demand, but encourages supply side (assuming other factors remain constant). The most important determinant of the level of exploration activity by international oil companies (IOCs) is the current and most recent past oil prices. The initial response of the industry to increase in oil prices may not immediately lead to an upsurge in exploration activity, but possibly a reappraisal of discoveries made in mature regions deemed uneconomic under lower price scenarios. Therefore, exploration activities in new acreage especially high-risk-high-cost basins are expected to increase after a year or two in response to higher oil prices especially if IOC’s strongly view that pattern of high oil price will continue in the future. Higher oil prices improves profitability of oil and gas industry and therefore they   are willing to invest in high cost unexplored basins (new frontier - deep offshore) in search of sizeable oil fields. In addition high oil prices also induces investments in energy efficiency, conservation, backstop fuel supplies from unconventional crude oil from tar/tight sands, oil shale, gas to liquid (GTL), coal to liquid (CTL)^[4], and other renewable sources of energy – thus reducing the pressure on oil demand in the long run. For example, recently, the sustained higher oil prices substantially encouraged shale oil/gas development, particularly in the USA, which is complemented by innovative technological advancements in horizontal drilling and hydraulic fracturing. Likewise, the world has also witnessed rapid growth in renewable sources of energy; however, it is not a threat to fossil fuels due to its marginal share in total energy mix. Persistent higher oil prices also adversely affected the global economy – slowing down oil demand. Therefore, eventually market fundamentals push the oil prices downward. The recent memories of 2007/2008 and later during 2011-2014 a period of higher oil prices followed by plunging oil prices during 2^nd half of 2008 and 2014/2015 are still afresh.

In contrast to higher oil price regime, lower oil price environment reduces the oil and gas industry profitability and therefore, they immediately take cost cutting measures including cutting back exploration activities. Recently, we have witnessed that it is difficult for most of the OPEC members to balance their budget given the low oil prices, and are forced to deplete sovereign funds (or foreign exchange reserves). That is, in the regime of  softer oil price environment it will be even difficult for the industry to sustain current level of oil production that requires continuous investment in work over, side-tracking, recompletion of wells in different formation, secondary recovery, and EOR and what to speak of new investment in finding and developing new reserves. A sustained lower oil price environment reduce profitability, cutting back in exploration activities, however, increases oil demand, depleting oil inventories and therefore eventually market fundamental will push the oil prices and converge to its long-term equilibrium. 

Implications of sustained higher or lower oil prices

The sustained higher oil prices always encourage exploration activities with some lags. Figure-1 & 2 illustrate the historical relationship between US rig counts onshore/offshore against oil prices. The visual inspection clearly demonstrates that there is indeed a positive correlation between drilling activities and oil prices though drilling activities increase/decrease with some lags. To test this relationship, we have used January 1974 to March 2015 monthly data. Number of rig count onshore and offshore are separately run against the oil prices. The models were suffering from serious autocorrelation and therefore we have used autoregressive moving average (ARMA) of order one. The onshore rig count is more responsive to changes in oil prices than the offshore.  As expected the initial response to changes in oil prices was marginal, however with the passage of each month the response got stronger and stronger. It took 24 months for onshore when a full impact is realized with 0.86 percent increase/decrease in exploration activities in response to one percent increase/decrease in oil prices. For offshore, the response to changes in oil prices for the first five months were negative and statistically insignificant. Thereafter the response was positive but remain statistically insignificant. It took 17 months before we got statistically significant response to changes in oil prices. However, after passage of 24 months the full impact was less than half that of onshore 0.41 percent increase/decrease in drilling activities as a result of one percent increase/decrease in oil prices. The difference between the responses to onshore and offshore drilling is due to magnitude of investment, difficulty, and time required to mobilization/demobilization of drilling rigs. Offshore requires huge capital investment as compared to onshore and therefore more time is required for planning and analyzing before making final investment decision. In case of US shale oil drilling, the response to changes in oil prices is shorter duration of about 5-6 months.    

The lag for example could be due to initially revisiting resources that were deem uneconomic during the regime of lower oil prices or a lag is involved in acquiring new lease/concessions, carrying out seismic surveys etc. Higher anticipated prices will encourage exploration activities, however, it is not like turning the switch on or off rather it requires a number of years before the full impact is fully realized. In a similar manner when oil prices plunge, exploration activities did not die off instantaneously due to contractual commitments, or in the middle of drilling, drilling rig is hired for a number of year(s) etc. Therefore, the trends depict a lag before the impact of increase/decrease in oil prices is fully realized. A similar trend could be witnessed when relationship between oil prices and oil production are analyzed (Figures-3 & 4). The response of oil production to changes in oil prices took longer adjustment times than the drilling rig count.

 

Figure-1: Correlation between US Onshore Rig & Prices  

Figure-2:Correlation between US Offshore Rig & Prices

Figure-3:Correlation between Oil Prices & Oil Production

Figure-4:Correlation between Onshore Rig & Production

 

Figures-5 & 6 depict the best fitted graph for both onshore and offshore based on best estimated model. Onshore drilling is more responsive and requires less number of months to increase/decrease in drilling activities in response to changes in oil prices. Whilst offshore drilling activities are less sensitive, erratic and require more time to respond to changes in oil prices.

Both the models fit quite well as more than 97% of the variations are explained by the given explanatory variables. The higher sustained oil prices results in acceleration of exploration activities leading to more oil and gas discoveries and enhanced production. Whilst lower oil prices over extended period of time not only constrained industry profitability but also hampered the required investment in exploration and development activities.  What we have learned from history is that neither higher nor lower oil prices are sustainable over an extended period of time and world would continue to live in cyclical uncertain environment. That is, lower oil prices over extended period of time will choke the supply side but continue encouraging oil demand that in turn will gradually push the oil prices – another episode of higher oil price will be followed. Though some episodes are short lived while others could hold back for a number of months depending on global economic situation and inventories level. The cyclical movement in oil prices will ensure that neither high nor low oil prices will continue to stay forever – giving a hope of oil and gas industry to continuously progress and also allows to develop new-state-of-the-art-technology.  It appears that such episodic oil price regime is necessary condition in balancing the global supply/demand.  

 

 

Figure-5: Onshore drilling best fit

Figure-6: Offshore drilling best fit

 

Note: the above article has been published in International Energy Investments as well as placed on my linkedin

If you have any comments or share some thought that would add value to readers are welcome.

 

 

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[1] Dr. Ghouri is oil and gas industry adviser. The views, findings, interpretations, and conclusions expressed in this paper are those of authors. .

[2]Mian Aneesuddin is Specialist Oil and Gas Industry, Portfolio Assessment and Economic Evaluation

 

[3] Author’s forecast.

[4] Most of the major energy consuming countries like USA, Europe and emerging economies where demand for energy is likely to increase aggressively – most of them are blessed with enormous quantities of coal reserves. Should the CTL become economically viable, it will encourage construction of CTL – driving down oil demand.

Plunging oil prices – US Tight Oil Boom or the Burst?

 Dr. Salman Ghouri [1] and Dr. Amjad Ansari[2]

The global shale oil and gas industry is still in its infancy (in the learning curve) but the United States industry is far ahead and has shown inspiring results as their shale/tight oil production increased from1.24 million barrels daily (MMBD) in 2007 to 4.68 MMBD in 2014 – which represents approximately a 3-3/4 fold increase[3]. This increase in oil production was supported by sustained higher oil prices of over $100/BBL that provided a breathing space to the industry, allowing it to develop and master innovative technology (horizontal drilling, hydraulic fracturing, multi fracturing, less use of water etc) and was well supported by favorable policies of various States. The sustained higher oil prices encouraged a shale gas boom in the US that also produces substantial condensate. Even in the regime of very low Henry Hub (HH) prices, we saw tremendous growth in US gas production – resulting in reduced gas imports from Canada. The combined effect of both these and other factors allowed the US to reduce its net oil import dependency from 60% in 2005 to below 27% in 2014, despite the growth in domestic oil demand that was hovering around 18 MMBD recently  (Figure-1).

Figure-1: US net oil import dependency. Source - EIA

The question is how will the collapsing oil prices from over $95/BBL during the period of March 2011-October 2014, to below $45/BBL that now hovers around mid fifties affect the US tight oil industry? Do we expect a continued boom in the US tight oil production or is a burst immanent? One possible outcome is that lower oil prices result in  cutting back drilling activities that in turn would reduce US tight oil production with some lags. The reason being that tight oil/gas is expensive to develop/produce and the production decline rate is significantly higher than the conventional oil. Therefore, in order to sustain the level of production more wells need to be drilled and fractured. However, thus far, this has not been the case in the face of plunging oil prices, US tight oil production is still increasing, even after a number of months of sustained lower oil prices and decline   of the drilling rig count. This paper reviews and explores each of the seven tight oil plays – Bakken, Eagle Ford, Haynesville, Marcellus, Niobrara, Permian and Utica (see Map-1)[4]. It looks at how the production from these prospects will help the country in reducing oil import dependency and why tight oil production is insensitive to oil prices and rig count. The analysis is both qualitative and quantitative using econometric modeling.

Map-1 US Shale/Tight resources in various regions. Source: EIA web-site

Figure-2[5] illustrates the US total tight oil profile. The burgeoning oil prices during 2007/2008 set the momentum of US tight oil boom. The higher oil price expectations allowed breathing space to the oil and gas industry in exploitation of unconventional resources that are more abundant than conventional. During the early period, generally daily productivity per well was quite low and hence so was the production level. But drilling of thousands of wells allowed a deeper understanding of the geological prospects and technology in carrying out hydraulic fracturing more efficiently – improving productivity per well. As a result of higher oil prices, horizontal drilling and hydraulic fracturing, tight oil production increased from 1.24 MMBD in 2007 to over 4.68 MMBD at the end of 2014. Visual inspection of these trends demonstrates that there is a positive correlation between the number of rig count and oil prices with some lags. However, both oil production and daily production per rig seems to be insensitive to both oil prices and rig count. The aggregating of data for the seven different prospects could be providing a biased assessment, therefore it is imperative to analyze the individual prospects to determine whether the similarities and divergences exist across the prospects.  And if so why.

Figure-2 (a): Total Rig & Price Relationship  
 Figure-2 (b): Total US Tight Oil Profile 

  United States Tight Oil Behavior

Figures-3 to 9 illustrate the relationship of oil prices, rig count, production and productivity per well (daily barrel production per rig) for each of the seven plays. Visual inspection of these trends generally demonstrates that all the seven prospects - Bakken, Eagle Ford, Haynesville, Marcellus, Niobrara, Permian and Utica  show similarities (Figure-3-9 (a)). Generally, all seven prospects demonstrate a positive correlation between oil prices and rig count, though magnitude and number of lags differs from prospect to prospect. This could be due to different cost structures that vary between prospects, to differences in geological conditions, the extent of difficulty, extent of available infrastructure, proximity to market, etc. For example, some wells or plays are significantly deeper than others thus more costly to drill and complete. In addition, the period of contracts with service companies also vary, therefore the response to increase/decrease in rig counts to increase/decrease in oil prices differ.

Another interesting feature of these trends is highlighted in Figures-3-9 (b). With the exception of Haynesville to some extent, oil production and productivity per rig did not respond to either oil prices, or the number of rig count. In fact, collapsing oil prices did not deter aggressive upward movement in oil production even after several months had elapsed. The question is what causes this to happen? Is it that the break-even prices have substantially declined or can we expect a burst soon, or something else?

One explanation is certainly related to the industry learning curve. That is drilling and hydraulic fracturing of thousands of wells allowed them to better understand the geology, optimum number of fractured spaces required to maximize production, less use of water for hydraulic fracturing which may have helped them to cut costs. Yet another explanation could be related to the difference between drilling strategies for unconventional and conventional resources. The strategy of unconventional resources is driven by economics (profitability of individual wells) rather than maximizing the overall resources recovery. Therefore the biggest challenge in the case of unconventional resources is not to find the productive zones, but rather to find zones that are most conductive to effective stimulation. As a result of this strategy, they often select the potential fracture treatment parameters that produce profitable wells, but leave behind considerable hydrocarbon resources. 

Therefore, when oil prices tumbled  production and productivity per rig kept increasing, this may have been due to revisiting these reserves that were not fractured earlier during the regime of higher oil prices. Revisiting and fracking of these  reserves previously left behind probably helped the industry to continue to increase production as this does not require additional drilling of wells. Thus production continues to move upwards, despite a decline in rig count and oil prices. The question is how long this phenomenon will last. This is difficult to predict in the absence of historical data, however some of these unusual trends will become visible during the next few months if oil prices remain around $50/BBL. If oil production increase continues even after several months have passed then this could be due to the combination of revisiting untapped reservoirs to frack and declining break-even costs to below $50/BBL for some prospects. If this is the case it would be alarming for OPEC, who are trying to increase/maintain their market share and are therefore refusing to cut oil production.  Should Iranian sanctions be lifted and if the US Congress waives export restrictions, it will be a dilemma for OPEC members how to compromise between market share and balance their ever rising budgetary requirements.

Figure-3 (a): Bakken – Rig & Price Relationship

Figure-3 (b): Bakken Tight Oil Profile

Figure-4 (a): Eagle Ford – Rig & Price Relationship

Figure-4 (b): Eagle Ford Tight Oil Profile

 

Figure-5 (a) Haynesville – Rig & Price Relationship

Figure-5 (b) Haynesville Tight Oil  Profile
 

Figure-6 (a): Marcellus – Rig & Price Relationship  Figure-6 (b): Marcellus Tight Oil Profile

Figure-7 (a): Niobrara - Rig & Price Relationship

Figure-7 (b): Niobrara Tight Oil Profile

 

Figure-8 (a): Permian – Rig & Price Relationship

Figure-8 (b): Permian Tight Oil Profile

Figure-9 (a): Utica – Rig & Price Relationship

Figure-9 (b): Utica Tight Oil Profile

 
Visual inspection  reveals that there is a positive correlation between rig count and oil prices, but there seems to be no correlation  between oil production, rig count and oil prices. Table-1 depicts the estimated results for each of the seven plays. In each of the prospects, rig count is run against oil prices and monthly oil production also tested against oil prices using monthly data for the period January 2007 to February 2015. Analysis of the graphs has established there is lag structure present. We have used polynomial distributed lag models with varying weights and lag structure. The best estimated results are reported here.

As was expected the rig count did not increase/decrease in response to increase/decrease in oil prices instantaneously, rather it took a number of months before the full impact of one percent increase/decrease in oil price affected the rig count. Generally the data shows that the response during the first two periods was either statistically insignificant or marginal; however, it strengthened with time and full impact was witnessed after a lag of four periods. The short-term elasticity is generally insignificant while the full strength was established in the long-run when one percent increase/decrease in oil prices lead to increase/decrease in rig count between 0.2% for Haynesville and 0.57% for Permian. More than 99% of the variation in rig count is explained by oil prices. When monthly oil production is run against rig count and oil prices in all the cases models were suffering from an autocorrelation problem and the given explanatory variables were also statistically insignificant.  

Table-1: Estimated Results US Tight Oil Plays

	Bakken	Eagle Ford	Haynesville	Marcellus	Niobrara	Permian	Utica
Constant	3.47 (4.6)*	4.75 (1.5)^	-0.15 (-0.01)	3.57 (6.7)*	2.40 (4.45)*	3.93 (1.91)^	1.98 (0.96)
P0	-0.08 (-1.38)	0.01 (0.10)	-0.03 ((-0.89)	0.01 (0.53)	-0.01 (-0.27)	0.02 (0.6)	-0.13 (-0.58)
P1	0.03 (0.97)	0.1 (1.64)^	0.06 (1.74)^	0.04 (1.22)	0.03 (0.69)	0.07 (1.93)^	0.38 (1.55)^
P2	0.15 (4.1)*	0.27 (2.23)**	0.19 (2.51)**	0.08 (3.15)*	0.13 (3.77)*	0.17 (5.59)*	-
P3	0.28 (4.1)*	-	-	0.12 (1.98)^	0.28 (3.51)*	0.30 (4.47)*	-
P ∑ Pi	0.38 (3.0)*	0.38 (2.91)*	0.2 (1.74)^	0.26 (3.15)*	0.43 (3.77)*	0.57 (5.59)*	0.24 (1.30)
AR(1)	0.97 (56)*	0.99 (67.7)	0.99 (83.2)	0.97 (61.4)*	0.94 (31.8)*	0.99 (51.8)*	0.98 (39.9)*
MA(1)	0.51 (5.5)*	0.26 (2.52)	0.44 (4.5)*	-	0.26 (2.55)**	0.43 (4.42)*	0.95 (39.9)*
Adj.R2	0.99	0.99	0.99	0.99	0.96	0.99	0.95
DW	1.92	1.96	1.75	1.96	1.93	1.86	2.21

Note: *, **, ^ represents 99%, 95% and 90% level of confidence. 

Conclusions

What we have learned from history is that our oil and gas industry is quite dynamic and adjusts quickly in challenging situations which is supported by innovative technology. In any given situation oil production and more particularly tight oil production should be responsive to changes in oil prices and rig count. However, the contrary seems to be the case, despite decreasing rig count and oil prices, US tight production kept rising in almost all seven plays. Normally a lag of few months occurs before a   response to changes in oil prices can be observed, however, generally tight oil production aggressively moves upward. This may be due to a number of factors – decrease in break-even cost and revisiting and fracturing leftover reserves from the period of higher oil prices. The US tight oil industry would be clearly a winner  if they sustain their current level of production with oil price of mid-fifties during the rest of the year. So far it appears that US tight oil industry successfully weathers this episode of lower oil prices. Having said that the next few months will be critical to determine whether the US tight oil industry continues to boom or will burst in response to lower oil prices.  

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[1]




Dr. Ghouri is Oil & Gas advisor with expertise in global / regional,  macroeconomic analysis and market assessments. Expertise in long-term forecasting for crude oil and LNG prices in various markets. Have been extensive writing the possible implications of US shale oil and shale gas on global oil and LNG industry. I have developed Oil & Gas industry models/analyses in support of industry leaders, investment bankers and politicians. My publications (80+) have appeared in international industry journals and presented papers at several international-energy conferences (WPC, WEC, ECSSR, GasArabia, SPE, IPTC, IEA/OPEC, ICEED, IEF, MEPGC). I have taught courses on “Global Energy Economics & Petroleum Project Evaluation”, “Petroleum Economics” worldwide.
[2]    Dr. Ansari is a general dentist in private practice in Qatar, with an original background of statistics and economics

[3]                      The US industry uses the term tight oil production instead of shale oil because it is a more encompassing term with respect to the different geologic formations producing oil at any particular well. Tight oil is produced from low-permeability sandstones, carbonates (e.g., limestone), and shale formations.

[4]                      While shale resources and production are found in many U.S. regions, this paper is focusing on the seven most prolific areas, which are located in the Lower 48 states. These seven regions accounted for 95% of domestic oil production growth and all domestic natural gas production growth during 2011-13.

[5]                      Source for Figures 2 to 9 – Energy Information Administration (EIA) web-site data base.