US shale oil and gas have reshuffled the cards in the world energy industry
Many column inches have been written about the economic ramifications of the shale oil and gas revolution in the US. We have sought to assess the likely impact of this new source of production on the world oil industry and what the implications of this might be when it comes to investment.
Apart from the technological breakthroughs that helped ‘crack the code’ to unlock the reserves of shale oil, this phenomenon has proved most striking because of not just the unexpected nature of the revolution, but also the shockwaves sent through the world oil industry. Its repercussions will be a combination of both the temporary, on the oil market itself, and the structural, on the gas market.
The United States is the third biggest oil producer in the world
In the space of just a few years, the technological combination of horizontal drilling and hydraulic fracturing (‘fracking’), researched for many years by George Mitchell, the leading light of shale oil and gas, at Barnett in northern Texas, has altered the fate of the US energy industry. This revolution, exploited commercially in two successive waves since the early 2000s, first made its impact on the natural gas industry before it spilled over into the oil sector as well. After hitting peak oil production in the early 1970s at around 10 million barrels a day (MMb/d), US oil output had appeared on course to slide ever downwards as production shrank by almost half up to 2010. Since 2011 though, production from shale deposits had added some 3MMb/day, confirming the US’s rank as the third biggest producer worldwide with 8.5MMb/day. An annualised increase of that magnitude is unparalleled in history by all but one oil-producing state, Saudi Arabia. Although the potential incremental rise in production is still shrouded in uncertainty, output does look set to stay locked on to its upward trajectory for the next couple of years.
This rapid increase in volumes of oil being produced has sparked a renaissance in the US refinery industry which has seldom been as profitable as it has been over the last three years. Europe has been a loser as a result of this turn of events as it is confronted by climbing US exports of refined petroleum products. These have been soaring in a setting of anaemic demand and a need for streamlining in Europe’s own refinery capacities.
Plentiful supplies of gas produced on the North American continent have also had significant advantageous knock-on effects on US industry. Productivity gains achieved at the Texas and Pennsylvania gas-drilling basins, coupled with sizeable volumes of gas being produced along with the oil, have put the squeeze on US natural gas prices. Although this may have dented margins of oil services companies, it has proved a windfall for bulk petrochemicals companies who, in little more than the blink of an eye, have gone from being bit players on the margins to powerful producers competing hard with the Middle East giants.
Only seven years ago, the US was preparing to import gas at its Gulf of Mexico terminals whereas the shale revolution will see the US propelled by 2020 up the rankings of exporters of liquefied natural gas (LNG) to be third, behind just Australia and Qatar. The US alone will by then account for 15%-20% of world trade in LNG. This ascent through the ranks will send big ripples through LNG markets, marginalising or delaying some projects, such as those on the cards in Canada or Australia, and casting a cloud over the structure of long-standing contracts.
Factors powering the US’s energy lift-off
Apart, obviously, from having the right geology, the US has also benefited from three key factors driving expansion of shale oil and gas production: (1) a highly developed energy industry infrastructure; (2) a legal system according mining rights to those owning the land; (3) and a basically favourable political and legislative environment despite some fierce opposition coming from some lobby groups. Another invaluable advantage has been the rich reserves of experience and knowhow in the US oil exploration and production (E&P) industry. Purely US companies of all sizes have made significant contributions towards driving expertise and technology forward. Today, they have provided the bulk of the investment to get the shale oil out of the ground. Their capital expenditure will have totalled around $140bn in 2014, a sum on a par with the investment spend of all five oil majors combined. This investment has made it possible to cover practically all of the annual growth in world demand for oil, i.e. around 1MMb/day. Looked at from another angle, US companies, in spite of themselves, have been entrusted with the mandate of supplying energy to the world, a task historically shouldered implicitly by the national oil companies of OPEC member states and the oil majors. That is a twist of fate of seismic proportions. It is no coincidence the oil majors, extensively exposed to international energy-sector dynamics and the deepwater offshore oil industry, have been modulating their tone with shareholders, employing such watchwords as ‘capital discipline’ or ‘cost control/containment’ along with other measures to optimise and streamline operations, postponing their costly projects, generally deepsea offshore drilling. The US has provided some breathing-room for the rest of the oil industry. The main casualties on this new playing-field are the oil services companies, especially those specialising in deepwater drilling or the engineering/construction groups broadly exposed to offshore projects. They have been badly wrong-footed as they were pumping all their investment into one basket and now find themselves with surplus capacity.
Rise and rise of US shale oil: the jury is still out
Although it is a well-established fact that there is an abundant supply of US shale gas and that its feed-through impact on world gas markets will be felt for many years to come, opinions are much more divided over the case for shale oil. Considerable uncertainties remain over how much more drilling potential remains, how long the production momentum can be kept up once the peak is passed and just how profitable this type of oil deposit really is. It is, however, widely acknowledged it will be hard for the industry to discover oil-bearing basins comparable with those of Eagle Ford (Texas) or Bakken (North Dakota), deemed to be assets of global relevance, as these two fields account for almost 70% of US onshore oil production.
Moreover, although production is still climbing, the fields are gradually nearing maturity. The oil industry is, however, still investing heavily in research and development, in honing drilling techniques and in optimising production.
US shale oil has provided the oil market with a self-stabilising mechanism, i.e. natural elasticity inherent in production in relation to pricing, an aspect that had never existed before. In some respects, OPEC had served to do this to date, acting as an external regulatory valve for the markets. Recent movements in oil prices are likely to provide a good way of testing how resilient this new US model is if prices were to become trapped for some time in a pricing band below the one that triggered the boom in the shale industry.
Equity markets reflecting the revolution underway
The shale oil and gas revolution has had a significant impact on the world’s equity markets. Apart from the slowdown in capital spending on deepwater offshore projects in evidence over the last couple of years, triggering the slump in share prices of many oil services groups, shale oil has completely torpedoed the classic exploration and production companies, traded for the most part on the London Stock Exchange. They had founded their business models and value propositions for investors on exploration, often in a high-risk/high-reward gamble, i.e. projects with 15%-20% chances of success in the best-case scenario associated with development projects fraught with risk. In contrast, US exploration and production companies can offer investors fairly low geological risk quotients, exposure to OECD economies, judged to be more stable, and all with rapid and visible volume growth potential. Over the last two years, we have seen a blatantly binary pattern develop on equity markets, working to the advantage of shares tapping into the shale oil/gas play, but against those stocks with too broad an international exposure granted that risks beyond the US have risen unmistakably in recent years. What is more, a good many US companies have been revamping their business portfolios, selling off international assets to reposition themselves on US shale interests:
take, for instance, Devon Energy, Hess Corporation, Occidental Petroleum or Apache Corporation, to name just four.
Although market operators’ eyes are being blinded by the extraordinary shale oil/gas story in North America, it is crucial to see it through the prism of its contribution to future oil demand considering the rate of decline in world oil production. It is estimated that, by 2020, an extra 20MMb/d will have to be produced and come on to the market each day to keep up current output levels. Working on the basis of optimistic assumptions, US shale oil could deliver 10%-15% of what is needed.
In the wake of the plummet in oil industry share prices and the gloomy sentiment engulfing the sector at present, several stocks look attractively valued and seemingly offer investors some appealing upside for the coming twelve months. Some companies, both producers and services groups, active in the US shale oil/gas industry still look to be strongly placed and enjoying bright growth prospects. The deepsea offshore play also still looks appealing. Owing to the sheer complexity involved in drilling for offshore oil far out to sea, the advanced technology inherent in the production equipment used does throw up high barriers of entry, providing sturdy protection for several niche firms. European oil majors also look to be in a comfortable position considering the potential to make operational improvements in their businesses which remain quite sizeable compared with those of US oil majors and given that they are trading now at more attractive valuations.