What's new in production

Is the world’s relentlessly growing petroleum supply finally past its peak? The International Energy Agency (IEA) reports that in the last week of April, the U.S. saw its first inventory drawdown after 17 straight weeks of increases. This was a pull-back from the highest reported stockpile of oil since the end of 1929, when the Great Depression was dragging down demand.

As stated in the IEA’s Oil Market Report for May: “Signs that U.S. production growth has come to a halt are appearing, with both the U.S. Energy Information Administration’s latest weekly oil statistics, and its most recent Drilling Productivity Report indicating that lower oil prices and capital expenditures, alongside continuous declines in the rig count, are starting to take a toll on output.” In the words of the IEA, it was a standoff between OPEC and U.S. light tight oil (LTO), and “LTO blinked.”

Crude prices, which toppled at the end of November last year, were widely expected to follow the laws of rational markets and bring down excess production in fairly short order, and that appears to have happened. Drilling was stifled in the U.S., rig counts fell, and graphic artists were forced to find new baselines for their rig count charts. But actual production curtailment took quite awhile, as it always does.

But just to spritz in a cold spray of reality, the modest drawdown in April is miniscule compared to the inventory builds of first-quarter 2015. The 14% price recovery in West Texas Intermediate during the past couple of months is a result of bullish speculation, not the iron laws of supply and demand.

Wild rides are the rule. Early in May, at the annual Offshore Technology Conference in Houston, the most interesting talk I personally attended focused on the onshore, specifically the LTO from shale plays. Torstein Hole, a senior V.P. for Statoil, and head of North American onshore operations, gave a captivating history lesson in oil prices and production, a story that spans two centuries and provides some welcome, long-term perspective.

Torstein is an economist by education, but 30 years ago, he became interested in oil and gas, and went to work in the Norwegian offshore. This was just as oil prices were beginning their mid-1980s swan dive. Soon, he said, “we were having to think of ways to be profitable at $10/bbl.” In other words, we’ve been down this road before.

In the long history of oil, big shifts in supply and demand, and price volatility, were the rule rather than the exception. The first oil glut came at the beginning of the Industrial Revolution, when crude oil was used primarily to make kerosene for illumination and grease for machinery. When Edwin Drake, a retired railroad man, drilled the first commercially successful oil well in Titusville, Pa., in 1859, it set off the first American oil rush.

The first two years of Pennsylvania production led to the first price collapse, from around $4/bbl to less than 10 cents. This inspired producers in the region to form the Oil Creek Association and pursue a noble but futile effort to restrict output and support prices. Only with heavy demand during the American Civil War, did the price eventually begin to recover.

The last two decades of the 19th Century were a time of wild price swings in the price of oil, but demand moved restlessly upwards, and prices trended higher. In 1901, a few years after the great Klondike Gold Rush (in which Torstein Hole’s grandfather participated but did not strike it rich), Pattillo Higgins brought in the first Spindletop gusher, inaugurating the nation’s second great oil boom.

Much like the Klondike, the Spindletop boom resulted in a tremendous rush of people to the region, not just oil workers, but adventurers and opportunists of all flavors. The population in the area swelled from 10,000 to 50,000 in a few months. (Today’s residents of North Dakota can sympathize.) There was a mad scramble for leases, and land previously worth $10/acre could go for as much as $900,000. The price of crude oil, once again, was walloped, falling to an all-time low of 3 cents/bbl in places.

The longest period of relative price stability was from the 1930s to the early 1970s, a time that Torstein describes as “a reasonably stable period, when markets weren’t functioning well at all.” The roller coaster returned with the OPEC oil embargo of the 1970s, which was an attempt to manipulate supply. It pushed technology investment to unprecedented levels. Many previously uneconomical regions were developed, particularly offshore. Scarcity was supplanted by oversupply in the 1980s, as the same players who had tried to manipulate prices went for market share.

By comparison, the price disruption of 2015 is fairly minor. Rising prices after 2008 led to the shale revolution, which produced an oversupply, which brought down prices.

The biggest problem is that in recent years, the industry has been spending more and more to produce less oil. “That’s what we call a ‘scorpion’s tail’,” said Torstein. “Production is on the X axis, and development cost is on the Y axis.” (Graph it out, and you’ll see what he means). Before the latest downturn, Statoil had already started a program to bring down costs. But now the company sees the situation as critical.

“Our industry needs to go back to basics,” said Torstein, “doing what we do best, even better. We need a steep reduction in development costs. In the U.S. onshore, Statoil is well on its way. We have reduced the cost per barrel by nearly 20% in the last two years. We need reduced rates from our service providers, and are achieving that. But the focus is on real, lasting efficiency improvements.”