The Oil Price Crash and the Future of Unconventional Oil & Gas

Introduction

A variety of unconventional gaseous liquid and solid hydrocarbons can be processed to produce petroleum products. However, as argued by Burwen and Flegal[1], these hydrocarbons are extra-heavy and highly impure thus require large energy inputs for preprocessing and purification into crude oil, also known as feedstock, that can then be processed into the final petroleum products. Some of the materials in solid form have to be extracted through heating in situ to liquid-like form to enhance flowing[2]. Compared to conventional crude, these materials maybe less valuable as conventional crude is readily transformed into the final products. Since mid 2014, oil prices have dropped significantly to almost half[3]. Give the fact that the market price is uniform for both conventional and unconventional oil products, the current oil price drop is sure to have an impact on unconventional oil production as a factor of the higher production costs compared to conventional oil. This paper therefore will seek to establish the effect of the current, one and half year running, oil price crash on unconventional oil. This will be done by focusing on the American unconventional oil and gas industry, being one of the fastest growing globally[4], exploration and extraction methods used then provide recommendation and prediction for the future of the industry.

The American unconventional oil and gas industry

The US unconventional oil and gas industry has grown rapidly for the 2004-2014 period primarily due to technological advancements that allow for oil extraction from sea as well as other unconventional oil resources[5]. Essentially, the unconventional oil reserves for America cover the entire North America continent however; the other countries within North America are out of scope for this paper. The materials for unconventional oil and gas have shale and oil sand as the top two sources for the American industry product.

In the second half of 2014, the production of oil in the US was repeatedly revised upwards[6]^,[7]. Even though this upward revision was partly as a result of the favorable post-2009 rise in the prices of oil and bettering financial environment, the extraction of oil from right rock formation and tar sand played an exceptional role. Extraction was done using hydraulic fracturing and horizontal drilling which make the extraction process profitable[8]. American unconventional oil project are however characterized by short life-cycle compared to the conventional alternatives, i.e. 2-5 to 3 years from start of development to complete extraction. As stated by Baffes et al.[9], by the end of January 2015, the total rig count for shale oil in the US had dropped to 1223 from a high of 1609 in October 2014.

As stated above, the success of unconventional oil and gas extraction in the US is credited to the technology used – hydraulic fracturing and directional drilling. The use of the methods has enabled the economical production of natural gas and oil from shale formations as well as other formation of unconventional, at a worldwide scale[10]. As a result of these methods and extraction of unconventional formation, in 2009, the US was the world’s largest producer of natural gas[11]. The incremental effect was not only in the gas front of the industry but also for the oil front, with the country experiencing an increase in oil production in 2009, from the 2008 levels, the first annual increase since 1991, and continued annual oil increase. Between 2008 and May 2014, America experienced a monthly crude oil production increase of 3.2 million barrels per day with 85% of this increase coming from shale and other tight oil formation mainly in North Dakota and Texas[12].

Analysis of hydraulic fracturing and directional drilling methods

One of the many definitions of unconventional oil and gas is that, it refers to the extraction method used. As unconventional oil and gas are impounded in porous, low-permeability features that are spongy e.g. shale rock, coal seams, and sandstone, to extract oil and gas component requires unconventional methods as from the conventional vertical drilling through stone to extract trapped subterranean reservoirs of oil and gas. Hydraulic fracturing and horizontal drilling are economical and effective[13].

Horizontal drilling starts with vertical shaft just like the typical oil well, but when it approaches the depth of the targeted reservoir, the shaft bears off at an arc so as to intersect the reservoir at a near-horizontal angle. Horizontally, the shaft continues through the reservoir for the desired length. As hydrocarbon rich part of the rock is mainly a layer, horizontal wells are meant to maximize the production of a well by creating an increased area of contact with the reservoir layer[14]. Even though the capital required for construction is a directional well is two or three times as much as the amount required for construction of a conventional well, the initial production is three to four times compared to the initial production of a conventional well[15].

The technology behind hydraulic fracturing involves injection of millions of gallons of proppant, chemicals, and water at high pressure into the sand stone or shale formation. The injections cause pressure buildup hence fracturing the formation, followed by proppants filling the fractures to avoid resealing. Natural gas impounded in the formation is caused to rush into the well for extraction. For the majority of wells, fracturing is done repeatedly over the course of operation of the well because fractures reseal naturally over time.

Economics of unconventional oil production

Some analytics argue that even if the current low oil prices remain for an extended period of time, some of the oil companies will still be able to remain in costs sufficient for production of free cash flow just as they didn’t in 2005[16]. This is a counterargument to the proposition that, it is more expensive to produce oil now that it did a decade ago, when petroleum companies had positive cash flow with West Texas Intermediate (WTI) priced at $56.64/bbl[17]. This argument is however based on the assumption that, it took higher costs for the shale oil to result to a boom and thus, it will also take a significant price to keep it going.

The above notwithstanding, it is import to first consider the economics involved in the production of shale oil today. The costs involved in oil economics broadly speaking are hinged to the capital cost, i.e. the costs involved in drilling and completion of the well as to the amount of gas, oil, and natural gas liquids that are produced from the well during its lifetime[18]. The capital investment for unconventional oil is the most significant thus the reason for being used in economic analysis however, there are also other operational expenses incurred; exploration costs, taxes, and administration costs among others.

With focus on drilling costs and the amount of oil produced, if a petroleum company spends $5 million as capital costs for an unconventional well, and recovers 100,000 barrels of oil, then that would result to $50/bbl for only the capital costs. If on a hypothetical basis, the company recovers one million barrels of oil, then the result is just $5/bbl on capital costs. This indicates that the amount of oil recovered from a well has a major impact on the costs of production. At the initial years of unconventional oil exploration and production, it was highly expensive to drill and complete a well in comparison to the amount of oil, gas, and natural gas liquids ultimately recovered from the well[19].

Through the years of experimentation with fracturing and with new technology, drilling and completions costs of an unconventional well has significantly dropped. By 2009, as technological advancement allowed for addition of more hydraulic fracturing stages to horizontal wells, the economics of oil production from unconventional wells improved significantly[20].

Conclusions

The production of unconventional oil over the last decade has increased significantly. This increase is credited to the advancement in technology and in particular, the hydraulic fracturing and directional drilling method. This method has significantly cut down the capitals costs required for unconventional wells, plus it has significantly increased the amount of oil, gas, and natural gas liquids recovered from these well. Nevertheless, compared to conventional wells’ capital costs, capitals costs for unconventional wells is three to four times higher. However, the amount of oil, gas, and natural gas liquids recovered from unconventional wells initially are three to four times higher than the conventional wells. In light of the decreasing oil prices, it is true that there is some effect on unconventional wells’ profitability. However, due to the current technology and the amount of oil recovered from such well, they are able to break even and still realize a profit margin. This explains the reason why unconventional wells, especially from the US are still operational even in face of the current price crash and can still compete with conventional oil producing countries.

Recommendations

Even though unconventional oil is till profitable, it is no doubt that the industry is affected negatively by the current oil crash compared to conventional oil. As a result, it is important that government take an initiative to protect the industry, especially in the US where unconventional oil has injected 85% of oil over the past ten years[21]. Recommended government initiatives for the industry include:

Cash stimulus: while the low oil price has a non-severe effect on the gas and oil industry, the collapse has significant positive effect on the economy at a global scale. According to Husain et al.[22] a reduction of $50 in the price of oil results to a $4.6 billion per day stimulus injected into the global economy, which is more than $1.7 trillion per years. In the US, the stimulus would be about $959 million per day which total to $350 billion per years. It is the government’s role to redirect the economic gain to the oil industry through maybe tax reduction, or cash injections[23].

Contraction in upstream oil investment: it is obvious that unconventional oil companies are realizing little profits in the face of the oil crash. So as to sustain production and probably survive the current price crash, it is recommended that unconventional oil companies should cut on exploration and drilling of new well but only focus on short-term production[24]. In brief, unconventional companies should suspend capital spending and focus on the “sweet-spots”. In case of any capitals invested for unconventional companies with large market share, the investments shouldn’t exceed the market price.

Prediction of future trends

It is impossible to tell whether the current conditions will be the new normal for the oil and gas industry. The energy industry is highly complex and diversified therefore highly uncertain. Regardless of the turn of events, it is predicted that executives in the unconventional oil and gas industry will focus on creating financial and operation resilience.

As argued by Ratner & Tiemann[25], due to unconventional companies cutting on capitals investments, and given the short-term nature of unconventional wells, the production of shale oil in the US has started to decline. The prediction thus is obvious, that shale oil will decline and cutting oil and gas production in the US, the relevant question is when? As low price causes increase in demand, it is predicted that the increased global demand will result to fast depletion of crude inventories, then eventually, a raise in oil prices. How long this lasts will depend on how many companies, both conventional and unconventional, will remain standing[26].

References

1. Baffes, J., Kose, M.K., Ohnsorge, F. & Stocker, M. The Great Plunge in Oil Prices: Causes, Consequences, and Policy Responses. World Bank Group, March, 2015
2. Basu, K. and Indrawati, S.M. Cheap Oil for Change. Project Syndicate. February 9, 2015.
3. Baumeister, C. and Kilian, L. Understanding the Decline in the Price of Oil since June 2014. CFS Working Paper No. 501. 2015.
4. Brogan, A., Byers, D., Castaneda, L., Fane, M., Munro, B. & Preiss, A. Resilience in times of volatility: oil prices and the energy industry. EYGM Limited. 2015
5. Burwen, J. & Flegal, J. Unconventional Gas Exploration & Production. American Energy Innovation Council. March 2013
6. Canuto, O. The commodity supercycle: Is this time different? Economic Premise, no. 150. World Bank, June 2014.
7. Gordon, D. Understanding Unconventional Oil, Carnegie Endowment for International Peace, 2012.
8. Husain, A.M., Arezki, R., Breuer, P., Haksar, V., Helbling, T., Medas, P., Sommer, M. & IMF Staff Team. Global Implications of Lower Oil Prices, INTERNATIONAL MONETARY FUND, July 2015
9. IEA, International Energy Agency. Oil Market Report, December 12, Paris, 2014.
10. Isfeld, G. Low Oil to Have ‘Both Positive and Negative Effects’ on Canadian Economy, Ottawa Told.Financial Post, March 12, 2015.
11. McCracken, R. Shale oil’s response to prices may call for industry re-evaluation, Energy Economist, Platts, February 2015.
12. Monaldi, F. THE IMPACT OF THE DECLINE IN OIL PRICES ON THE ECONOMICS, POLITICS AND OIL INDUSTRY OF VENEZUELA. CENTER ON GLOBAL ENERGY POLICY, COLUMBIA SIPA, SEPTEMBER 2015
13. Rapier, R. How Shale Oil Will Survive The Crude Carnage. Oilprice.com. 08 November 2015. Retrieved from: http://oilprice.com/Energy/Oil-Prices/How-Shale-Oil-Will-Survive-The-Crude-Carnage.html (Accessed 1 March 2016)
14. Ratner, M. & Tiemann, M. An Overview of Unconventional Oil and Natural Gas: Resources and Federal Actions, Congressional Research Service, 2015.
15. VINING, B. A. & PICKERING, S. C. (Eds) Petroleum Geology: From Mature Basins to New Frontiers – Proceedings of the 7th Petroleum Geology Conference, 2011, 1061–1063.

[1] J. Burwen & J. Flegal. Unconventional Gas Exploration & Production. American Energy Innovation Council. 2013

[2] B. A. VINING, & S. C. PICKERING, (eds) Petroleum Geology: From Mature Basins to New Frontiers – Proceedings of the 7th Petroleum Geology Conference, 2011

[3] F. Monaldi. THE IMPACT OF THE DECLINE IN OIL PRICES ON THE ECONOMICS, POLITICS AND OIL INDUSTRY OF VENEZUELA. CENTER ON GLOBAL ENERGY POLICY , COLUMBIA SIPA, 2015

[4] M. Ratner. & M. Tiemann. An Overview of Unconventional Oil and Natural Gas: Resources and Federal Actions, Congressional Research Service, 2015

[5] Ibid

[6] IEA, International Energy Agency. Oil Market Report, December 12, Paris, 2014

[7] J. Baffes, M.K. Kose, F. Ohnsorge & M. Stocker. The Great Plunge in Oil Prices: Causes, Consequences, and Policy Responses. World Bank Group, 2015

[8] Ibid

[9] J. Baffes et al., 2015

[10] M. Ratner. & M. Tiemann, 2015

[11] IEA, 2014

[12] M. Ratner. & M. Tiemann, 2015

[13] R. Rapier. How Shale Oil Will Survive The Crude Carnage. Oilprice.com. 2015.

[14] D. Gordon. Understanding Unconventional Oil, Carnegie Endowment for International Peace, 2012

[15] Ibid

[16] R. Rapier. 2015

[17] Ibid

[18] G. Isfeld. Low Oil to Have ‘Both Positive and Negative Effects’ on Canadian Economy, Ottawa Told. Financial Post, 2015

[19] F. Monaldi. 2015

[20] K. Basu and S.M. Indrawati. Cheap Oil for Change. Project Syndicate. 2015

[21] O. Canuto, The commodity supercycle: Is this time different? Economic Premise, no. 150. World Bank, 2014.

[22] A.M. Husain et al., Global Implications of Lower Oil Prices, INTERNATIONAL MONETARY FUND, 2015

[23] C. Baumeister, and L. Kilian, Understanding the Decline in the Price of Oil since June 2014. CFS Working Paper No. 501. 2015

[24] A. Brogan, D. Byers, L. Castaneda, M. Fane, B. Munro & A. Preiss, Resilience in times of volatility: oil prices and the energy industry. EYGM Limited. 2015

[25] M. Ratner & M. Tiemann, 2015

[26] R. McCracken, Shale oil’s response to prices may call for industry re-evaluation, Energy Economist, Platts, 2015