This article will be the first in a series of articles discussing the most neglected and ignored factors that can have significant impacts on long-term oil prices (NYSEARCA:USO). The title ("The Unstated Case For Long-Term Low Oil Prices") was chosen because the majority of the neglected factors, with few exceptions, exert downward pressure on long-term oil prices. The exceptions, however, will also be covered.
I will be taking a "big picture" perspective, and will consequently be leaving out many details and making some inexact - though roughly accurate -simplifications along the way. This series is not intended to be an encyclopedia on the dynamics of oil pricing. (As one of my former law professors used to say, "A one-to-one [1:1] scale map isn't very useful.") Nor is it intended to be a definitive statement as to what exactly oil prices are going to do. The goal in writing these articles is simply to bring to the attention of investors and analysts those factors having the two characteristics of being both grossly neglected and significantly impactful.
Today's Topic: The Unconventional Enlightenment
On May 6th, 1954, for the first time in human history, Roger Bannister ran the mile in 3 minutes and 59 seconds. At the time, it was widely considered impossible to "break the four-minute-mile." It was dogmatically considered to be beyond the limits of human ability. Within three short years, it was broken by 13 more people. What changed? There were no major breakthroughs in sports training technology. All that changed was that for the first time in human history someone had proved to the rest of the world, beyond a shadow of a doubt, that the old dogma was wrong - that it was in fact possible to break the four-minute-mile.
Today's surge in unconventional oil production is most often described as being a fundamentally technology-driven phenomenon. While technology has undoubtedly played a vital role, the more fundamental, underlying shift has come in the form of a shift in awareness. As with the four-minute-mile, there has been a shift in the beliefs as to what is possible, affecting in turn beliefs in what resources are worth considering and what efforts are worth undertaking.
In the words of Range Resources' (NYSE:RRC) CEO Jeff Ventura (speaking here about shale gas, but the same can be said about shale oil):
Some people make the comment that "Well, we always knew the gas was in the shales; we didn't know how to get it out." I would challenge that... the conventional mindset was that shales were sources and seals, not reservoirs.
(Source: The American Shales, Nissa Darbonne, Kindle Edition, Location 4698).
Before the unconventional revolution, there was a certain academic-level understanding that, if pressed, would have said, "Sure, I suppose, in theory, there must be hydrocarbons in shales." But the thought of actually exploiting such resources was not even on the radar of industry professionals. The terms "shale" and "reservoir" simply did not fit together. A typical response - both from industry professionals and professors - would have been, "So... you're saying you want to target shale formations as if they were reservoirs? Um... [shaking head] I don't think you understand. Shales are sources and seals, not reservoirs."
Who Cares? And How Does This Affect Oil Prices?
The technology-driven pattern of new resource development (which is largely how the industry has advanced to date) is as follows: A rise in oil prices incentivizes the development of new built-to-purpose technologies designed to target known resources, or at least, in the case of undiscovered reservoirs, resources that are expected to conform to the preconceived notions of the technology innovators. These innovators develop technologies designed to exploit the specific kinds of reservoirs that they already have in mind. Such built-to-purpose new technologies come to market and unlock the new supplies that are already identified as the next new resources on the horizon. These new supplies reduce oil prices until production growth begins to slow and new innovations are needed again to go after the next new anticipated marginal source of hydrocarbons. The key here is that in the typical progression of the industry, there is simultaneous and proportional growth in both technological innovations and the awareness of what those innovations make possible.
The reason that the unconventional revolution is so different - why I call it an "enlightenment" - is because the dogma that once said shales were not even worth consideration caused a buildup of resources that could be developed under the then-current technological circumstances (with relatively minor tweaks and modifications). These resources were effectively "left behind" or "passed over" because of the dogma and not primarily because of a lack of technological means. Put another way, the bulk of the relevant technological innovations grew at a rate that far outpaced the awareness of what those innovations make possible.
To understand how these two distinct patterns of advancement affect oil prices in different ways, we have to consider their effects in determining which resources take on the role of the marginal producer.
In the more familiar case of technology-driven resource development, the new resource "unlocked" by built-to-purpose technologies becomes the new marginal producer. This is because technology innovators identify the next most plausible resource that's just barely out of reach at current prices - one that fits their current paradigm - and then engage in build-to-purpose innovation until either 1) they succeed in creating a technological context in which the new resource is just barely economic, or 2) a rise in oil prices makes the new resource economic in its own right. Once the resource is economic, the focus then typically shifts to ramping up production and profiting through a more volume-driven strategy. Under this pattern, the producer supply curve looks something like this:
*Oil shale and shale oil are two different resources. Oil shale is a type of rock formation that contains uncooked organic matter (kerogen), which has to be mined at the surface and cooked in an industrial process to convert the organic matter to oil. Shale oil - largely the topic of this article - is oil that comes from shale formations deep underground where natural processes have already converted the organic matter to oil.
In this simplified example, the vast oil shale deposits in Colorado (not to be confused with shale oil, see caption) are the next resource anticipated to be on the horizon. When that resource becomes economic, through either increased innovation or a rise in oil prices, it will simultaneously become the newest source of production and the marginal producer. In such a case, it makes sense to think that the newest source of production will also be the first to cut back if oil prices fall. (Even here there are some reasons which might prevent the newest resource from cutting back on its production, but those reasons will be covered in Part 2 of this series.)
In the second case, where we have an awareness-driven pattern of resource development (an "enlightenment"), the producer supply curve looks different. The new resource that was previously passed over - for lack of the awareness of what was possible in the current technological context -effectively inserts itself somewhere in the middle of the producer supply curve, shifting some of the well-established resources further to the right:
In this case, the newest source of production does not become the marginal producer. Instead, the role of marginal producer actually shifts back on to one of the resources that bore that role years before. In this example (meant for illustration purposes only), the role of marginal producer has fallen back to Deep Water Offshore, and the Canadian Oil Sands are no longer even economic. (Again, this does not mean that the oil sands will actually curtail their production. The reason for this has to do with differences between fixed and variable costs and their respective roles in affecting production curtailment decisions. It is more likely that the growth in new production capacity from these marginal resources will be curtailed while the current production rates will remain roughly constant. Again, this will be covered in greater detail in Part 2 of this series).
Another extremely important consequence of the "enlightenment" nature of the unconventional revolution - and one that is easy to underestimate - has been the industry's recent embrace of trial-and-error experimentation.
First, I need to convince you, the reader, that trial-and-error experimentation is an extremely powerful method for transforming an otherwise uneconomic shale formation into a profoundly economic one; that it is so powerful, in fact, that it could bring on more and more unconventional plays that might insert themselves in the middle of the producer supply curve (as we saw in Figure 2 above) and further undercut oil prices.
As a scientifically-minded society, we tend to hold the view that neat and tidy theoretical explanations and models are "scientific," whereas trial-and-error methods sound more like something a caveman might do to discover which foods are edible and which are not. This view is sadly mistaken. Today's leading technology companies, including Google (NASDAQ:GOOG) (NASDAQ:GOOGL) and Amazon (NASDAQ:AMZN), thrive on trial-and-error experimentation. With their millions of users, they can tweak their algorithms for a thousand users at a time (holding the other users' experiences constant) and watch how users' mouse-clicking behaviors change. In the vast majority of these experiments, the companies involved do not have preconceived ideas about what exactly is going to happen; they simply make a change, run the experiment, and watch what happens.
To give a more relevant example: When George Mitchell was doing his pioneering work in the Barnett Shale, theories and models said it would be a good idea to come into contact natural fractures in the shale formation. According to the then-popular theory, the fractures would serve as what's called "secondary porosity" and hold more oil and natural gas. Mitchell and his team initially tried following this theory, but as they continued tinkering, tweaking things, and drilling more wells, they eventually had enough data to see that the results they were getting showed the exact opposite - wells intersecting natural fractures did poorly while those that did not did much better. They didn't know exactly why this was happening, but the data was clear and so they changed their approach with great success. This shift in their approach was a huge step forward in making the play economic, but one that could only have been discovered through actual trial-and-error experimentation. (The current theory that explains why natural fractures ought to be avoided is that fractures absorb the fluids from the frac jobs and preventing the fracs from effectively "rubblizing" the targeted formation).
"But," you might ask, "is this really a new development? And, if so, what happened? Why the sudden rise in the popularity of this approach?"
Before the unconventional enlightenment, the dominant thinking was that all new significant sources of production would come from major, multi-billion-dollar, non-repeatable projects. When developing these kinds of projects, companies could not afford to rely on trial-and-error experimentation as a means for turning their projects into economic successes. It simply does not make sense to say, "Let's go ahead and develop this 20-billion-dollar project, even if there's a good chance it won't be economic, because later we'll be able to apply what we've learned from this project to our next 20-billion-dollar project, even though the next project will likely be substantially different."
At such high costs to develop unique, non-repeatable projects, the companies involved absolutely needed to be right the first time. Understandably, they placed emphasis on high-precision modeling, engineering, and planning - not on trial-and-error experimentation.
In contrast, when a company attempts to establish a new shale play, the initial costs to drill and complete the first few wells are relatively inexpensive. Further, the potential upside is much greater because what's learned from trial-and-error experimentation in the first few wells can be applied to the potentially many thousands of more wells in the play. This is because shale plays, by their nature, are more uniform, making the lessons learned from the first few wells more transferrable to the yet-to-be-drilled wells.
Another reason for the recent embrace of trial-and-error experimentation - and perhaps the most important - is the fact that this is precisely how George P. Mitchell succeeded in the Barnett Shale. This was the method by which he proved to the world, for the first time, that shale reservoirs could be unlocked and transformed into economic resources.
Thinking far beyond the confines of his pioneering efforts in the Barnett Shale, Mitchell assigned the task to his vice president of geology, Dan Steward, to chronicle their method and approach in the form of a book, The Barnett Shale Play: Phoenix of the Fort Worth Basin. Mitchell then went out of his way to share what he'd learned with other industry professionals. In one instance, Mitchell tracked down Harold Korell, the CEO of Southwestern Energy (NYSE:SWN), which was then trying to "unlock" the Fayetteville Shale in Arkansas, and shared with Korell his insights and gave him a copy of the book. As Korell recounts in Nissa Darbonne's The American Shales, "...for [Mitchell] to invite me to lunch and to, especially, give me a copy of that book. That was a very important book." Korell went on to order copies of the book for everyone on his staff.
Like a John Stuart Mill formalizing the scientific methods of agreement and different, or Aristotle developing and promulgating the laws of logic - both efforts that "unlocked" incredible future developments - George Mitchell started his own miniature, sector-specific enlightenment. Not only did he prove to the world that - dogmas be damned - it was in fact possible to economically produce from shale formations, but he also went on to put down in writing and share with the world the methods by which he and his team did it.
Objections and Counter Arguments
Undoubtedly someone will say, "How could anyone possibly say that the unconventional revolution has been more fundamentally about a change in awareness than improvements in technology? What about horizontal drilling? What about fracking?"
I confess, there's a good chance I'm over-emphasizing the shift in awareness and under-emphasizing the role of technology. But my choice to do this, however, has been very deliberate precisely because the role of the shift in awareness and its implications for long-term oil prices are so grossly overlooked.
Even with that said, there's a general lack of appreciation for just how much of this "breakthrough" technology was largely developed before the shift in focus to unconventional resources. These technologies required relatively minor tweaks and modifications for their use in "unlocking" unconventional formations once the change in awareness had arrived. To give just a few examples, prior to the unconventional revolution: directional drilling and extended reach technologies had been developed to access hard-to-reach conventional formations; horizontal drilling technologies had been developed for use in fractured reservoirs, steam-flood projects, and other enhanced oil recovery projects targeting conventional reservoirs; nitrogen-foam-fracs, CO2-foam-fracs, and slickwater fracs had all been widely used in vertical wells targeting conventional formations; various types of proppant (sand, ceramic, walnut shells, etc.) were all experimented with in conventional formations; various multi-stage-fracking and plug-and-perf technologies were developed for use in vertical wells targeting multiple conventional formations from a single wellbore.
The goal here is not to downplay the role of technology and discount these impressive achievements, but to recognize that there really was a vast array of technologies that could be readily repurposed for horizontal shale development. This accumulation of technology served in effect as a massive toolbox containing the options from which companies were able to select and begin their tinkering, going through the kind of trial-and-error experimentation that makes field-wide success in a shale play possible. The necessary tools were largely in place, but it was yet to be discovered just how much they could make possible when applied to shale formations and when used as part of an approach embracing trial-and-error experimentation.
For further reading on the progression of the unconventional revolution through the eyes of those on the front lines, I highly recommend Nissa Darbonne's book, The American Shales. The book is stuffed to the brim with notes from Mrs. Darbonne's interviews with the industry professionals who were on the cutting edge of these developments. My endorsement of her book, however, should not be taken to mean that she shares the views expressed in this article.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.