Dallas Fed chief sees global energy markets retaining “fragile equilibrium” during the next few years

Kaplan said that because of the recent years’ reduced investments in large offshore and oilsands projects that can take many years and many millions up to billions of dollars to accomplish, the global energy market has increased its dependence on future production growth from shale oil.

In a personal essay published Tuesday by Federal Reserve Bank of Dallas President Robert Kaplan, the Dallas branch of the central bank CEO said his team of economists believes that “due to expected growth in daily global demand, the trend of global supply/demand is fundamentally toward balance” for the medium term.

“First quarter 2018 estimates indicate that global average oil production was approximately 98.3 million barrels per day and global consumption was approximately 98.4 million barrels per day. These estimates incorporate the December 2016 agreement made by the Organization of the Petroleum Exporting Countries (OPEC) and other oil-producing countries to cut crude oil production by approximately 1.8 million barrels per day,” Kaplan said.

Kaplan said the U.S. now represents approximately 13 percent of global crude oil production, almost doubling what it was 10 years ago.

“Dallas Fed economists estimate that by year-end 2018, the U.S. will consume approximately 20.6 million barrels per day of oil. Our economists believe that, over the next several years, the U.S. will continue to increase its oil production, while consumption growth is expected to flatten due to energy efficiency gains as well as greater use of natural gas and renewable energy sources to meet energy demand.”

How shale fits the equation

“Shale production has the benefit of being more financially manageable and operationally nimble. However, shale wells typically have very rapid production decline characteristics (discussed below). Specifically, a shale project is a much more “short-cycle” investment than a typical conventional project—it can be drilled and brought onstream very quickly and, on average, for approximately $6 million to $8 million per well. However, because of its rapid production decline features, shale requires additional and continuous investment in order to maintain production levels,” Kaplan said.

Ten years ago U.S. shale produced approximately 0.5 million barrels per day, or less than 1 percent of global crude oil production, Kaplan said. But in 2017, U.S. shale’s 4.7 million barrels per day made up 6 percent of global crude oil production. “As shale makes up an increasing percentage of global crude oil supply, the challenge will be to find ways to increase shale well productivity, overcome input shortages and ramp up production to meet incremental global demand growth,” he said.

Fed sources show global oil demand is likely to increase from an average of 98.4 million barrels per day in the first quarter of 2018 to approximately 101.5 million barrels per day by 2020, driven primarily by emerging-market economies. Kaplan said that global demand growth of approximately 1.1 million to 1.5 million barrels per day should provide a strong underpinning for global energy markets and the resulting price of oil. The Dallas Fed CEO said the challenge will be producing enough oil to meet demand growth over the next three to five years.

Below are the Fed chief’s outline of challenges to the growth of shale:

  1. Rapid production decline curve of shale.

The primary method for drilling wells in shale-rock formations is known as horizontal drilling—where a well is drilled vertically (averaging approximately 10,000 feet) before being guided horizontally through the rock (averaging a distance of between 5,000 and 10,000 feet). Although a highly effective method, horizontal wells often reach peak crude oil production in the first few months, with output declining rapidly thereafter, sometimes as much as 80 percent after one year. As a result, in order to grow overall crude oil production, more wells must be drilled and well productivity must be boosted substantially. While companies are drilling more wells this year to overcome this decline curve, they face constraints regarding labor, input costs, infrastructure and the return requirements of capital providers.

  1. Shortages of labor.

Dallas Fed industry contacts report that the oil and gas industry in the Permian Basin faces a shortage of workers. Our contacts note that industry service companies are facing higher levels of turnover as workers either leave for higher pay at competitors or leave the industry due to the highly strenuous working conditions. In addition, companies report finding it difficult to attract previously laid-off workers back to the industry. Bureau of Labor Statistics data indicate that layoffs during the oil price decline of 2014–15 resulted in an estimated loss of one-third of the workforce, and industry contacts report that many workers either are reluctant to return to the industry or need significant financial and/or job security incentives to return given the boom/bust nature of the industry.

While the oil and gas industry has become more efficient, drilling and completing wells is still a labor-intensive endeavor. The oil production sector has added more than 40,000 jobs in Texas and more than 60,000 jobs in the U.S. from December 2016 through April 2018, and high demand for workers has led to significant wage pressures. Our Dallas Fed Energy Survey shows that energy companies based in the Eleventh Federal Reserve District (which includes Texas, northern Louisiana and southern New Mexico) increased wages and benefits throughout 2017 and have been accelerating this pace in 2018.

Labor shortages are particularly acute in the Permian Basin. The May 2018 unemployment rate in Midland, Texas, the heart of the Permian, was 2.2 percent.

  1. Raw material, environmental and infrastructure challenges.

Water and sand are key inputs used in shale production, accounting for 30 to 35 percent of the cost of drilling and completing a well.[18] Contacts report that sand costs have increased substantially during the past 12 months. Specifically, increasing volumes of sand used in well fracking are creating strains on infrastructure in the region (10,000 tons of sand per well is not uncommon, requiring 100 railcars or 400 truckloads for transport).

In addition, water availability has become more of a logistical and financial challenge. As operators pursue larger well-completion projects and often operate on multiple well pads, the need for more advanced planning to arrange for water-supply logistics is becoming a more significant challenge. Another concern is water disposal. While companies often source water used in fracking from an underground aquifer in the Permian, operators cite greater concerns regarding the disposal of wastewater that is produced as a byproduct of oil. On average, three to five barrels of water come out of the ground for every barrel of oil that is produced. This water must either be transported to an approved saltwater disposal well, further straining transportation infrastructure, or recycled and used as frack water—a process that is generally considered too expensive for most operators.

Several industry contacts and other observers have cited their concerns regarding water and air pollution, wastewater management and other issues relating to emissions of greenhouse gases. These are critical issues which state as well as federal regulatory agencies must actively monitor and are important operating considerations for firms participating in this industry. Several of our contacts, and industry observers, have discussed the critical need for proper safeguards in order to prevent degradation of water and air quality, and loss of land use.

In the Permian, oil and natural gas pipeline capacity—used to transport oil and natural gas to refineries and processing plants hundreds of miles from the well site—remains a potential problem in 2018 and 2019. Our expectation is that oil pipeline capacity will become very tight late in 2018 and early 2019, as shown in Chart 5, and possibly sooner if production surprises to the upside or pipelines and refineries experience unforeseen downtime. However, the pipeline bottlenecks should be alleviated in the second half of 2019 as new pipelines come onstream.

  1. Capital discipline exerted by equity owners.

Energy executives report that public-market capital providers are much more focused on capital discipline from oil and gas companies. From January 2, 2017, through June 13, 2018, energy stocks increased only 1.1 percent, while the price of oil and the S&P 500 increased 35.8 percent and 24.2 percent, respectively.

As a result of this underperformance, industry contacts report that capital providers are increasingly pressuring management teams to increase their focus on achieving higher rates of return, rather than focusing primarily on increasing overall production levels. Contacts report that this capital-discipline focus is causing many boards of directors to revise incentive structures and compensation arrangements for company management teams. It may also have the impact of encouraging some independent production companies to more proactively consider mergers and other actions that increase scale and improve operating margins.

Implications for energy markets

“Over the next few years, we believe that global oil markets will be in a “fragile equilibrium” in which demand growth should likely be met in large part by growth in U.S. shale oil production. ‎This, of course, assumes no new material disruptions from major oil-producing countries in the Middle East or other producers such as Russia, Nigeria or Venezuela.

“However, given the current lack of investment in long-lived production projects, and assuming global oil demand continues to grow between 1.1 million and 1.5 million barrels per day, we would expect future world consumption growth to be more dependent on shale production growth.

A global undersupply could result

Kaplan said due to the impediments he outlined, an eventual global undersupply situation could occur “in which shale will be unable to keep up with demand growth.”

“Overall, given our forecast and the potential impediments to substantial growth in shale oil production, we believe global oil markets are likely to be more vulnerable in the medium term to geopolitical shocks and disruptions that would create a potential for price risk to the upside.

“Finally, the U.S. economy is less oil-intensive than in the past, due to substitution for oil by other forms of energy, improved fuel efficiency and growth in the less-energy-intensive services sector as a share of the overall economy. For example, in 1970, the U.S. consumed 1.1 barrels of oil for every $1,000 of GDP; by 2017, only 0.4 barrels of oil were consumed for every $1,000 of GDP.

“Based on these various factors, it is the view of Dallas Fed economists that the negative impact of higher oil prices on GDP growth is likely to be more muted than in the past. It is our view that a 10 percent increase in the oil price should have a relatively modest negative impact on U.S. GDP growth. This negative impact should further diminish as the U.S. continues to grow its domestic oil production,” Kaplan said.




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