Last week, a barrel of West Texas Intermediate (WTI) oil was fetching $23 (U.S.) less than one produced in the North Sea (Brent). That’s a major price discount on $110 a barrel and it’s also getting close to the 2012 maximum of $25/b posted last month. Edgy investors are nervous about the persistent cheapening of domestic barrels, and are also fearful about market frailty outside of North America. The question is getting louder, “Is the price of oil as fallible as natural gas was a few years ago?”
It’s a question that also includes many derivative queries, such as whether or not Chinese consumption is moderating and is growth in global supply accelerating?
Yet the biggest concern of all is the impact of rapidly rising light tight oil (LTO) production from poster plays like the Bakken in North Dakota and Cardium in Alberta. The increases in productive capacity from these and other fields across North America are playing out like the Barnett-style shale gas stories before them. So much so that the International Energy Agency (IEA) said Monday that U.S. oil production could exceed that of Saudi Arabia in the next six years or so. The interim result: Topped up oil storage tanks at Cushing, Okla., are like a stale retweet of burgeoning natural gas storage caverns at Henry Hub. No wonder oil is trading at a 20 per cent discount to world prices.
Yet it’s folly to equate the fundamentals of crude oil to those of natural gas.
After a herd of drilling rigs and fracking trucks expanded dry gas production, the price of the commodity fell precipitously. By 2012, natural gas prices at Henry Hub had collapsed to $2/MMBtu ($1.50 Canadian/Mcf at AECO), which was well below the marginal cost of replacement. In return, the free market worked; rigs began migrating away from unprofitable dry gas prospects toward more lucrative natural gas liquids (NGL) plays. As NGL prices began to fall on similar capacity expansion, packs of rigs sporting their new-age drilling and completion tools moved toward the most lucrative liquid of all, light oil.
All the while, natural gas production didn’t decline – as it should have – concurrently with the exodus of the rigs. The reason was – and still is – because drilling and completing wells that produce NGLs and crude oil also liberate large quantities of “associated gas.” In other words, natural gas has become a significant byproduct of drilling for NGLs and crude oil. Such associated gas production has risen from approximately 4 Bcf/d to 9 Bcf/d between 2000 and 2012. Today, this byproduct component contributes to about 14 per cent of U.S. natural gas supply and has helped to keep prices below the true replacement cost of the primary sources.
Put another way, aggressive drilling for NGLs and light oil has interfered with the free market dynamics of dry gas. In the absence of associated gas production, natural gas supply would have declined much more quickly, and prices would have recovered by now, likely to levels above $4.50 U.S./MMBtu.
Now consider light oil. The herd of rigs and fracking trucks has been progressively creating excess capacity for at least 18 months. Domestic prices have weakened relative to the rest of the world and without access to global markets the $20/b discount remains stubborn. Yet, where will the herd go now that oil prices are weakening? After crippling natural gas prices, then softening NGLs, and now burdening light oil, there isn’t a go-to-next commodity that is more profitable for a rack of drill pipe to chase. Even if there was, there is no energy commodity to drill that will produce excess quantities of “associated oil” as a price antagonist. And that’s why we’re unlikely to see a sustained collapse in oil prices.
Yes, there is a chance the price of oil can fall further in the near term and there are convincing arguments to suggest that it will. However, if the benchmark WTI falls much below $80/b – a notional estimate of the marginal cost of light oil – the next stop for the herd of rigs is not another exciting play, but the contractor’s yard behind the chain-linked fence. In fact, after two years of uninterrupted growth, oil-targeted drilling activity looks like it has finally levelled out, suggesting that marginal cost may even be in the mid-$80 range.
Declining price, followed by retreating drilling activity that leads to falling output has always been a self-regulating market mechanism that has ensured that commodity prices can’t stay below marginal cost for long. Steep production declines from horizontally drilled and fractured wells will only amplify the sensitivity of this new-age supply system to uneconomic prices.
Peter Tertzakian is chief energy economist and managing director with Arc Financial Corp. in Calgary and provides analysis on technology and energy-related businesses to fund managers and portfolio companies.