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A ‘red button’ and other implications of new oil supply

Of all regions, oil production is growing the fastest in the United States and Canada. That's well known. But what's less obvious is the changing mechanics of the assembly line that's bringing all those new barrels to market.

The oily North American conveyor belt is running on a leaner system, with similarities to a just-in-time (JIT) delivery model. There is little slack in the system. New barrels are more responsive to price. What are the implications of this big-wrench retooling of the world's Western oil supply?

Last week we demonstrated how sensitive new North American oil production is to upstream drilling activity, and how the sensitivity is increasing, because more and more of the incremental barrels are coming from new drilling and completion methods that accelerate the drainage of oil-bearing reservoirs.

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Alberta's seasonal drilling cycle clearly shows that when drilling activity stops, production volumes now wane by an annualized rate of 20 per cent. That's staggering compared to average global decline rates that typically range between 4 and 8 per cent. For now, this high-decline-rate oil is exclusive to the U.S. and Canada (excluding the oil sands). However, the rapidity of its emergence makes this new supply paradigm consequential to the world's systems.

Our feature chart this week illustrates the recent dominance of North America's contribution to the world's rising oil needs. The only other region that shows meaningful growth is the collective mosaic of countries from the former Soviet Union (e.g. Russia, Kazakhstan, Azerbaijan). The North Sea is on a wounded decline of 5 per cent a year (in line with the global average), a case study that illustrates what happens when geriatric oil plays are starved of capital.

How significant are North America's JIT barrels? Canada and the U.S. have added about six million barrels a day (MMB/d) of new capacity over the past six years. Subtracting one MMB/d of oil sands supply growth means that five MMB/d of the increment has flowed to market from a high-decline JIT system. The trend suggests expansion at a rate of one MMB/d a year – assuming non-proliferation of the new techniques to other parts of the world (perhaps a poor assumption, which means there will eventually be even more JIT oil coming from other regions).

Here are some of the implications:

Responsiveness of oil prices

JIT systems like auto manufacturing are very sensitive to the economy. During the onset of recession, it doesn't take long for managers to hit the red button on the assembly line, trimming car output immediately. Recessions soften oil consumption too, but oil production hasn't historically responded quickly due to the low decline rates. In the past, that's why oil gluts formed quickly and price drops were amplified. But now there is a red button that shuts down oil drilling too. With 20-per-cent declines at the margins of new production, supply should respond more quickly to price than in the past.

A floor for oil prices

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At what oil price does a CEO slap the big red button to stop the rigs from drilling? It varies greatly. High-cost producers get their palms ready around $85 a barrel (U.S.). Oil company executives with the best assets and most efficient processes clutch the button closer to $65. But nothing is static. Oil field technologies are improving, so the floor price may be moving lower over the next few years. Yet, "Hold the button!" It's not that simple. The same oil field technologies are also serving to drain the reservoirs faster, steepening the decline curves, and making the oil JIT systems even more sensitive.

U.S. energy security

This is the vogue topic of discussion as North American oil production grows and foreign imports diminish. Yet few talk about price, even though there is a price for everything, including energy security. The price of strengthening energy security must be well above the floor price, probably well above $80, if the current growth rate is to be sustained. We'll know if and when red buttons start getting pushed.

The role of OPEC

Historically, when oil supply gluts formed, a handful of "swing producers" among the Organization of the Petroleum Exporting Countries (OPEC), notably Saudi Arabia, had to turn off some of their valves to simulate a high decline rate. Consumers cringed when prices firmed up. Western oil producers sighed relief. But when is the next OPEC meeting anyway? Does anyone care? The U.S. and Canada are looking like the new swing producers.

Capital investment

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Capital, and lots of it, has always been a necessary lubricant for the oil business to function. Increasingly, large-scale, sophisticated oil field techniques require a greater quantum of upfront investment. Wells today typically cost five to 10 times more than in the past. That means the red buttons that regulate rig activity are not only a function of the prevailing oil price, but also the availability and cost of capital. In other words, oil supply increasingly relies on a banker.

The corporate energy ecosystem

Today's capital-intense, JIT-type oil processes mimic big company manufacturing plants. Achieving economies of scale is of paramount importance to reducing costs. The upstream industry will no longer be composed of generic "E&P" (exploration and production) companies. Big companies will specialize in production. Smaller companies will have to focus on being specialists in exploration, identifying and developing new plays for the big producers.

Over time, these and many other consequences of a progressively more responsive oil supply system will affect energy policies, geopolitics and repercussions we have yet to think about. Yet from an oil producer's perspective, one conclusion is clear: Adopting a low-cost discipline will prevent having to hit the red button.

Peter Tertzakian is chief energy economist at ARC Financial Corp. in Calgary and the author of two best-selling books, A Thousand Barrels a Second and The End of Energy Obesity.

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About the Author

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. More


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