Global oil prices are driven by a ‘rule of thumb’ that suggests prices will go up when the spare capacity of oil available on any given day is less than 5% of expected global demand. In today’s high priced oil market that swing in spare capacity is about 2%.
This a big deal because traders worry about risk such as events in the Middle East, or with Iran or any other places that supplies oil. Spare capacity or swing productive capacity is the volume of oil than can be delivered as a percentage of expected global demand in a thirty day period. Like any other commodity market, the tighter the supply the higher and more volatile the price.
America is in the midst of an inconvenient truth. We have a genuine energy boom market shaping up from the growth in domestic energy production from unconventional shale. The question is whether we will put this ‘spare capacity’ to work or keep debating environmental or energy policy issues until our choices run out.
Low Natural Gas Prices but High Oil Prices: Why is that? As I write this, we see the effects of this boom energy market from shale in near historic low prices for natural gas at the Henry Hub spot price of $1.91 per MMBTU on April 12, 2012. Our current low prices are being driven by warmer than average winter temperatures causing a 0.7% decrease in natural gas consumption. Natural gas storage as a result is nearly full with weak industrial demand from weak economic growth.
Meanwhile, on that same day, April 12, 2012, WTI Cushing spot prices for crude oil were $103.94 compared to $120.92 for Brent spot. High global oil prices reflect growing energy demand from China and other emerging economies, the fear premium built into oil prices from uncertainties over Iran and the Middle East conflict, weak EU market conditions and our own high unemployment rate and slow economic GDP growth.
But why is natural gas production growing while prices are low? The smaller, scrappier players focused on the private lands in the shale plays across North America are driving growth. They bet that shale gas would offer advantages over competing with the major oil companies in the Gulf of Mexico and deep water drilling. That bet paid off and many of those players went after natural gas when prices were high resulting in a spectacular increase in domestic gas production. There has been so much domestic production growth that the US passed Russia in 2009 as a global gas producer and became a net exporter of natural gas in 2010 for the first time in decades.
The result is a decoupling of natural gas prices in North America from the global oil price because of the growth in domestic natural gas supply. High global oil prices are encouraging producers to switch from natural gas to oil using the same American technology in horizontal drilling and hydraulic fracturing to exploit the potential of unconventional oil and gas liquids from shales.
But bring more oil to market from onshore requires additional pipeline expansion. The reversal of flow of the Seaway pipeline, the Keystone XL pipeline and other proposals are rationalizing the US energy infrastructure to make the oil boom possible just as it did for natural gas.
The US government is engaged in a relentless regulatory push to undermine the economics of fossil fuels in an effort to reduce greenhouse gas emissions. While US EPA issues rule after proposed rule to limit the use of coal, and the government slow walks oil E&P permits offshore and on public lands, it has not yet found a way to stop horizontal drilling and hydraulic fracturing use on private lands that are subject to the regulation of the states.
The major oil companies made big bets in deep water drilling but the BP spill and government energy policy bias against fossil fuels left them vulnerable to Federal control of off-shore drilling and E&P permitting on public lands. Meanwhile, onshore in the shale plays North Dakota has become the fourth largest oil producing state in the Bakken shale and on target to take third place from California. Production growth continues in the Barnett, Eagle Ford and Haynesville shales in Texas and the Gulf coast. The reassessment of recoverable shale potential in other plays such as the Monterrey Shale in California, the Niobrara shale in Colorado, Kansas and Nebraska and in the Marcellus Shale in the East that together suggests that America could also be a game changer in oil production in global markets again.
Will America put its ‘spare capacity in oil to good use? Spare oil capacity is that small amount of oil at the margins of global market equilibrium that sets the trading price of oil and gives producers, buyers and speculators the signal about price movements. How much swing capacity does it take to push the price of oil up or down? Much less than you think!
The pricing power of OPEC has traditionally been exercised by the ability of Saudi Arabia to expand or withhold about five million barrels of oil per day in spare swing capacity. We have seen this pricing power again recently as global markets got nervous about the loss of oil from Libya. So the Saudi’s said they would make it up. But while Saudi Arabia can increase production fast if needed it will not do so for long to protect its dominant role in the oil markets over time.
But what if America’s domestic energy production growth could double or triple the spare capacity in global markets? Would OPEC simply withhold capacity to drive the price back up? Current 2% per day and demonstrate that domestic US oil production growth will more quickly reduce America’s oil imports that we would see world oil prices fall dramatically.
The last thing a cartel like OPEC wants is competition. But America has the capacity to insure itself against oil price spikes by creating our own spare capacity market and put it to work to balance the cartel behaviour of OPEC and discipline the bad boys of the Middle East that use high oil price wealth to fund terrorism and other mischief.
If you want to stick it to Iran—drive down the price of oil!
If you want avoid the corruption in Nigeria or the nonsense of Hugo Chavez in Venezuela increase domestic oil production enough to reduce their imports.
If you’d rather see Canadian oil production flowing south into the US markets rather than shipped to China then build the dang pipeline that allows the integrated North American market—the most efficient in the world—to work!
Sound like a stretch to you? Consider this:
EIA projects that OPEC surplus production capacity will average 2.9 million bbl/d in 2012 and rise to 3.6 million bbl/d in 2013 (OPEC Surplus Crude Oil Production Capacity Chart in EIA STEO April 2012).
US crude oil production is over 6 million barrels per day (weekly Energy Information Administration Report in April 2012.
US reduced net imports of crude oil last year by 10%, or 1 million barrels a day. The U.S. now imports 45% of its petroleum, down from 57% in 2008. Net imports of oil are at about 7.5 million barrels per day, about the level in 1996.
Domestic crude oil production increased by an estimated 180 thousand bbl/d (3.2 percent) to 5.66 million bbl/d in 2011 according to US EIA the highest since 1998 almost entirely from shale oil production growth on private lands where a 440-thousand bbl/d increase in lower-48 onshore production in 2011 was partly offset by a 40-thousand-bbl/d production decline in Alaska and a 230-thousand bbl/d production decline in the Federal Gulf of Mexico (GOM).
US oil production drilling activity, particularly in onshore tight oil formations, continues to grow onshore with Baker Hughes reporting oil-directed drilling rigs increased from 777 at the beginning of 2011 to 1,329 on April 5, 2012 per STEO.
WTI to Brent crude oil price discount grew in March from $13/ barrel for the 5 day period ending March 1 to $19/barrel for the five day period ending April 5 (US EIA STEO Figure 3). The upward price spread trend is caused by higher transport congestion cost for moving the marginal barrel of WTI from Cushing Oklahoma to U.S. Gulf Coast refineries. We need more pipeline capacity like Keystone Xl to bring shale oil production to market.
Domestic oil produced in North Dakota’s Bakken region has grown from negligible amounts to 558,000 barrels per day in February 2012 a new high. Production at Eagle Ford produced just 787 barrels in 2004 grew to 30.5 million barrels in 2011.
It is time the play the hand we have been dealt in a resource rich energy portfolio. Not only will it improve our energy security and help get our economy growing again, but it will help stabilize global markets, reduce uncertainty and force our Middle East adversaries to get day jobs!
By. Gary L. Hunt
Gary Hunt is President, Scalable Growth Strategy Advisors, an independent energy technology and information services adviser and a partner in Tech & Creative Labs, a disruptive innovation software collaborative of high tech companies focused on the energy vertical. He served as VP-Global Analytics & Data at IHS/CERA; global Division President at Ventyx, now an ABB company; and Assistant City Manager-Austin Texas responsible for Austin Energy and Austin Water.