US shale oil: How the US can become a lead exporter by updating business practices. By Bob Peterson
The phenomenal development of shale oil and gas production in the US is a result of innovation, solid infrastructure and easy access to capital markets. Shale production grew from nothing to four million barrels per day from 2008 to 2014, and is expected to increase by another four million per day by 2022. This growth has been largely in the Permian basin in Texas and New Mexico. By 2022, the US’ production in the Permian alone will achieve parity with that of large OPEC producing countries such as Kuwait and Nigeria.
Because of this dramatic increase, the US has become an oil exporter, having moved some two million barrels per day in 2018 – but to what markets, and at what price? Maintaining a leadership position in production will require developers to make significant changes in their behavior and capabilities. They must consider and manage a number of complex issues, including establishing global markets, finding new partners, collaborating more effectively, and attracting new sources of capital.
Traditional independents and partnerships
Independents are just that: ‘independent,’ specifically from owning refining and marketing operations. As a result, these companies sell their oil at the wellhead and move on to the next drilling campaign. It is a simple world, but a risky one as the US becomes a major exporter and competition rises in global markets such as Latin America and the Pacific Rim.
In this environment, the ‘drill, sell direct at the wellhead, repeat’ behaviour will need to change if independents want to maximise steady cash flow. They will need to comprehend and exploit global markets; just as Canadian heavy oil producers have done with excess heavy production. For example, in order to cover shortages in input by Reliance, an Indian oil and gas refiner, Husky and Devon has entered into long-term oil supply arrangements, in exchange for a slight price premium on the heavy oil index.
Regional pricing spreads’ effect on profitability
Under the traditional model of selling oil at the wellhead, independent producers have become accustomed to success without factoring in fluctuations in the global markets. Those days are gone, as regional pricing spreads will certainly impact producers’ ability to stay predictably profitable.
Consider the widening gap between the two primary benchmarks for the pricing of oil, West Texas Intermediate (WTI) and Brent light, a North Sea-based index. Since the advent of shale, WTI has traded at a discount to Brent as steep as $10/barrel (2011–2014), which largely reflects the lack of ‘take-away infrastructure’ as production has ramped up in North America.
Independents can stay ahead of the pricing fray by identifying and establishing strategies for not only reducing that discount, but also realising premiums for their oil in some cases. These players will need to develop new export-shipping capacity at ports such as Brownsville, Texas to alleviate the growing bottlenecks at Houston and Corpus Christie (also in Texas). Additionally, new, dedicated pipelines for ultra-light Delaware basin production can avoid blending with lower-quality crude and command premium pricing. Finally, independent operators with sophisticated trading capabilities can take advantage of short-term WTI pricing variations by timing hedge puts and calls with ‘on-demand’ well completions – similar to the strategy that Shell is currently following.
Case example: The Permian basin
According to our recent research on production growth challenges in the Permian basin, more than 41,000 wells, at a total capital cost of approximately $300 billion, are planned over the next five years. The demands on infrastructure will be tremendous. Trucking, roads, water usage, power consumption, and sand to frack the wells, as well as community services such as housing, schools, and hospitals, will all be necessary to sustain rapid development. We estimate that about one million barrels per day in production growth are at risk due to the inability of the local infrastructure to support daily operations.
As one example, the Wall Street Journal estimates that as activity increases, 120,000 truckloads of sand will be hauled within the Permian on a road system that was built to handle less than 1000. Considering that this figure does not account for the water and chemicals that will also need to be transported in and out of the area, this is clearly unsustainable. It offers an opportunity for operators to pool capital and planning to build a robust road system, which would also reduce trucking demand by ten to 20 per cent.
While building out the Permian requires collaboration, it also calls for a massive influx of capital. This is perhaps the greatest challenge in the basin. To provide potential solutions, operators have to think more creatively about funding structured projects. Pioneer’s proposed power generation scheme offers a strong example in this case. The company seeks to pool operator electric power demand as an incentive to infrastructure investors. In return those investors, such as insurance companies, retirement funds and family offices, would receive a 20-year, low-risk, annuity-like return. Similar projects have already become commonplace in the pipeline space, but these practices must expand to areas such as water management, community infrastructure, roads, and transportation to enable sustainable development.
The development of shale oil sources in the US, such as the Permian, is a challenge unlike any yet encountered in the global oil industry: to grow production to exceed that of all oil-exporting countries except Saudi Arabia and Russia in less than five years. It is uncertain whether this challenge can be met. It demands that US independents go against their nature by collaborating in key areas. It requires establishing new global markets, building new partnerships to a level not yet seen in the sector, and giving up control of traditionally competitive capabilities in order to attract the necessary investment capital. Forward-thinking players will change the way they do business, giving rise to a new ecosystem that will be able to capitalise on current opportunities and create new avenues for growth.
Arthur D. Little
Bob Peterson works at Arthur D. Little. Founded in 1886, Arthur D. Little is the world’s first management consultancy. It is a recognised expert in companies that want to combine strategy, innovation and transformation in technology-intensive and converging industries. Arthur D. Little navigates clients through changing markets and ecosystems, helping them to take the lead and shape in this transformation.
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