Will Falling Prices Shift Oil Industry's Focus to Cost Reduction?

• Lower oil prices may have less impact on US oil production from shale than competitors in Saudi Arabia and elsewhere appear to assume.
• The cost of  producing tight oil is not static, and US producers have various options for cost reduction, including optimizing their logistics. The newly elected Congress can help.

Oil prices have dropped by more than 20% since July, based on futures contracts for UK Brent crude. Some expect prices to rebound relatively quickly, apparently including at least one large oil services company. However, indications that the official policy of Saudi Arabia may have shifted away from its customary role of "swing producer" raise the possibility of an extended period of lower prices. This is new territory for the relatively young US shale industry.

From the end of 2010 to the first half of this year, as the rapid development of light tight oil (LTO) from shale deposits was adding more than 2.9 million barrels per day (bpd) to US output, the benchmark price of West Texas Intermediate crude oil (WTI) averaged $96/bbl. The global oil price, represented by UK Brent, averaged $110/bbl for the same period. Having now fallen to the $80s, if prices were to stay here or lower for long, we should expect to learn a great deal about the actual cost structure of new and existing LTO production in the Bakken, Eagle Ford, Permian Basin and other shale plays.

Based on my experience of several oil-price declines from the inside during my time at Texaco, Inc., I'm skeptical that many LTO producers would be inclined to trim output from currently producing wells, other than as a last resort. From late 1997 to the end of '98, WTI prices fell by almost half, from around $20/bbl to under $11--equivalent to roughly $15 today.  Prices for heavier grades of oil fell to single digits. After months of that, revenues from some oil fields no longer covered variable costs, and upstream management took the decision to shut in high-cost production. Once prices revived, they discovered that some of that capacity had been lost essentially permanently.

I suspect there would be even greater uncertainty and hesitation today about shutting in producing shale wells for any significant period, especially in light of the limited experience with such wells. The bigger question is whether the drilling of new wells would slow or stop, resulting in a gradual slide in output as existing wells decline.

Then and presumably now, however, the first option in a situation like this is generally to cut costs, rather than output. I saw this in the mid-1980s, when oil prices fell by nearly 60% and took more than a decade to recover fully, then again in the late '90s, and during periodic, smaller market corrections. Suppliers were squeezed, big projects deferred, and employees saw travel, raises and benefits curtailed. Similar actions now could make a difference in keeping new shale drilling going.

Even for relatively efficient operators, it can be surprising how much expense can be reduced without affecting near-term productivity, and many of those savings would persist if prices recovered. LTO producers might ultimately become more profitable after weathering a period of weak prices.

A heightened focus on costs would also likely extend beyond producing company budgets and supplier agreements. One of the biggest non-production costs for LTO is transportation, whether paid directly by the producer or deducted by the purchaser from the market price.  Because of its rapid growth and the constraints of existing infrastructure, a high proportion of LTO output must currently be shipped by rail--up to one million bpd in the second quarter of 2014.

Rail offers flexibility and can reach many destinations, but it is expensive.  For example, if it costs over $10/bbl to ship Bakken crude to the Gulf Coast by rail, that means that with WTI at $78/bbl the producer might realize less than $70/bbl at the wellhead.  Pipelines are often cheaper to use, though not in all cases. The current tariff on the existing Keystone Pipeline for taking oil from the Canadian border to Cushing, OK, the storage hub for WTI, works out to around $4/bbl. If oil prices stayed low for a while, that might increase interest in the proposed Bakken Marketlink Project. It would connect the Bakken shale operations to the Keystone XL pipeline, the prospects for which look decidedly better after the outcome of Tuesday's mid-term election.

Another aspect of transportation costs that could come under a different kind of pressure relates to federal restrictions on shipping oil and petroleum products by vessel between US ports. Under the "Jones Act", only US-flagged, -owned and -crewed ships can perform such deliveries, even though the rates for such shipments are normally significantly higher than on foreign-flag tankers in comparable service. This is a significant factor in current petroleum trade patterns, in which refined products from Gulf Coast refineries are often shipped halfway around the world, while blenders and marketers on the east and west coasts must import gasoline and other products from outside North America.

And as long as US crude oil exports are prohibited, with a few exceptions, the combination of the Jones Act and the export ban effectively keep LTO bottled up on the Gulf Coast--depressing its price--or force it onto rail. Amending the Jones Act to exempt LTO, or the issuance of a waiver to that effect from the Executive Branch, could increase producers' margins while expanding the supply options for US refineries on the other coasts. I wouldn't be surprised to see this taken up by the new Congress early next year.

 Based on the current behavior of oil markets, the global impact of the US shale oil boom has been greater than many expected and seems very much in the national interest of the US--and of US consumers--to keep it going. It remains to be seen whether measures such as new pipeline infrastructure and reform of shipping regulations, together with more traditional forms of expense reduction, could boost producers' returns on LTO sufficiently to sustain drilling at roughly current rates while oil prices are weak. 

Even if both drilling and tight oil production slowed for a while, this price correction won't spell the end of the shale boom. As the Heard on the Street column in the Wall Street Journal put it recently, "Once someone has cracked it, it can't be unlearned. Barring a prolonged period of very low prices, the US oil industry isn't about to disintegrate." Rather than an existential crisis, the current weakness in oil markets looks like a test of adaptability for this new but important energy sector.

A different version of this posting was previously published on the website of Pacific Energy Development Corporation.

The Pros and Cons of Exporting US Crude Oil

• Calls for an end to the effective ban on exporting most crude oil produced in the US are based on a growing imbalance in domestic crude quality.
• At least recently, the ban has likely benefited refiners more than consumers. Assessing the impact of its repeal on energy security requires further study. 

Senator Lisa Murkowski (R-AK), the ranking member of the Senate Energy & Natural Resources Committee, issued a white paper earlier this month calling for an end to the current ban on US crude oil exports. Her characterization of existing regulations in this area as "antiquated" is spot on; the policy is a legacy of the 1970s Arab Oil Embargo. However, not everyone sees it the same way, either in Congress or the energy industry.

This isn't just a matter of politics, or of self-interest on the part of those benefiting from the current rules. Questions of economics and energy security must also be considered. The main reason these restrictions are still in place is that for much of the last three decades US oil production was declining. The main challenges for the US oil industry were slowing that decline while ensuring that US refineries were equipped to receive and process the increasingly heavy and "sour" (high sulfur) crudes available in the global market. The shale revolution has sharply reversed these trends in just a few years.

No one would suggest that the US has more oil than it needs. Despite the recent revival of production, the US still imported around 48% of its net crude oil requirements last year. Even when production reaches its previous high of 9.6 million barrels per day (MBD) as the Energy Information Agency now projects to occur by 2017, the country is still expected to import a net 38% of refinery inputs, or 25% of total liquid fuel supply. The US is a long way from becoming a net oil exporter.

The driving force behind the current interest in exporting US crude oil is quality, not quantity, coupled with logistics. If the shale deposits of North Dakota and Texas yielded oil of similar quality to what most US refineries have been configured to process optimally, exports would be unnecessary; US refiners would be willing to pay as much for the new production as any non-US buyer might. Instead, the new production is mainly what Senator Murkowski's report refers to as "LTO"--light tight oil. It's too good for the hardware in many US refineries to handle in large quantities, and for most that can process it, its better yield of transportation fuels doesn't justify as large a price premium as for international refineries with less complex equipment.

As a result, and with exports to most non-US destinations other than Canada or a few special exceptions effectively barred, US producers of LTO must discount it to sell it to domestic refiners. Based on recent oil prices and market differentials, producers might be able to earn as much as $5-10 per barrel more by exporting it. Meanwhile the refiners currently processing this oil are enjoying something of a buyer's market and are able to expand their margins. The export issue thus pits shale oil producers and large, integrated companies (those with both production and refining) such as ExxonMobil against independent refiners like Valero.

Producers are justified in claiming that these regulations penalize them and threaten their growth as available domestic refining capacity for LTO becomes saturated. Additional production is forced to compete mainly with other LTO production, rather than with imports and OPEC.

I believe producers are also largely correct that claims that crude exports would raise US refined product prices are mistaken. The US markets for gasoline, diesel fuel, jet fuel and other refined petroleum products have long been linked to global markets, with prices especially near the coasts generally moving in sync with global product prices, plus or minus freight costs. I participated in that trade myself in the 1980s and '90s. What's at stake here isn't so much pump prices for consumers as US refinery margins and utilization rates.

Petroleum product exports have become a major factor in US refining profitability, and refiners are reportedly investing and reconfiguring to enhance their export capabilities. This provides a hedge against tepid domestic demand. Nationally, refined products have become the largest US export sector and contributed to shrinking the US trade deficit to its lowest level in four years.  If prices for light tight oil rose to world levels US refineries might be unable to sustain their current export pace. It's up to policymakers to assess whether that risk is merely of concern to the shareholders of refining companies or a potential threat to US GDP and employment.

The quest to capture the "value added"--the difference between the value of manufactured products and raw materials--from petroleum production is not new. It helped motivate the creation of the integrated US oil companies more than a century ago and impelled national oil companies such as Saudi Aramco, Kuwait Petroleum Company, and Venezuela's PdVSA to purchase or buy into refineries in Europe, North America and Asia in the 1980s and '90s.

On the whole, OPEC's producers probably would have been better off investing in T-bills or the stock market, because the return on capital employed in refining has frequently averaged at or below the cost of capital over the last several decades. It's no accident most of the major oil companies have reduced their exposure to this sector. When today's US refiners argue that it is in the national interest to preserve the advantage that discounted LTO gives them they are swimming against the tide of oil industry history.

The energy security case for crude exports looks harder to make. An excellent article from the Associated Press quoted Michael Levi of the Council on Foreign Relations as saying, "It runs against the conventional wisdom about what oil security means. Something seems upside-down when we say energy security means producing oil and sending it somewhere else."  The argument hinges on whether allowing US crude exports would simultaneously promote more production and increase the pressure on global oil prices. That makes sense to me as a former crude oil and refined products trader, but it will be a harder sell to Senators, Members of Congress, and their constituencies back home.

The politics of exports may be easing somewhat, though, as a Senate vacancy in Montana could lead to a new Chair at Energy & Natural Resources who would be a natural partner for Senator Murkowski on this issue. (That shift may incidentally be part of a strategy to help Democrats retain control of the Senate.) Will that be enough to overcome election-year inertia and the populist arguments arrayed against it?

As for logistics, the administration could ease the pressure on producers without opening the export floodgates by exempting the oil output from the Bakken, Eagle Ford and other shale deposits from the Jones Act requirement to use only US-flag tankers between US ports. That could open up new domestic markets for today's light tight oil, while allowing Congress the time necessary to debate the complex and thorny export question.

Senator Murkowski wasn't alone in calling for an end to the oil export ban. In his annual State of American Energy speech presented the day as the Senator's remarks, Jack Gerard, CEO of the American Petroleum Institute, noted, "We should consider and review quickly the role of crude exports along with LNG exports and finished products exports, because of the advantages it creates for this country and job creation and in our balance of payments." In a similar address on Wednesday, the head of the US Chamber of Commerce stated, "I want to lift the ban. It's not going to happen overnight, but it's going to happen."  I'd wager he at least has the timing right.

A different version of this posting was previously published on the website of Pacific Energy Development Corporation.