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A View on U.S. Oil Industry Dynamics

 12/06/2011 

 


 

 

U.S. crude oil production is on track for its 3rd consecutive year of growth. The most important catalyst for the improving production outlook has been the rapid growth in oil-bearing onshore shale plays. According to the U.S. Energy Information Administration (EIA), oil shale plays will continue to contribute to further rises in U.S. oil production over the next 25 years. Advances in horizontal drilling, hydraulic fracturing and enhanced recovery techniques have given rise to profitable extraction of liquid-rich resources from shale formations in the Bakken in N.Dakota/Montana, the Permian Basin in W.Texas, the Eagle Ford in S.Texas and Utica in Ohio.

  

 

 

Although these discoveries may not prove enough to declare U.S. energy independence, their contribution to the U.S. economy and the trade deficit matters as it reduces demand for imported oil and petroleum products, which amount to 60% of the U.S. trade deficit. In fact, the U.S. has managed recently to become a net exporter of petroleum products, for the first time since 1949, due to lagging U.S. domestic demand and increasing foreign demand e.g. from Mexico, Brazil, Argentina, Peru, the Netherlands and Singapore.

 

 

 

 

 

As we can see from the below rig count and pricing data, successful horizontal drilling in U.S. unconventional natural gas resources has led to declining natural gas prices and has largely established self-sufficiency (90%) in the fuel.  As a result, exploration and production (E&P) companies are incrementally shifting their activities to oil drilling that offers more growth opportunities due to the U.S. crude oil supply deficit  and increasing foreign demand for U.S. refined petroleum products.

 

 

 

 

 

 

 

U.S. Mid-Continent oil supply debottlenecking and Impact on Refining Margins:

The Mid-Continent region, specifically Cushing in Oklahoma, remains the nexus of North American crude supply and movements. Several major pipeline corridors service the Cushing hub, including supply from the Western Canadian Sedimentary Basin, making the Cushing hub and its surrounding region strategically important to North American market dynamics. Cushing holds 5 to 10 % of the total U.S. crude inventory and it remains the price settlement point for the benchmark West Texas Intermediate (WTI) on the NYMEX.

 

A recent industry development has been the debottlenecking of oil supplies in the U.S. Mid-continent. This was caused by the Seaway Pipeline Company which has sold half its company and the new owners are planning to reverse the flow of oil so that it will flow from Oklahoma to the Gulf Coast. In addition, the new owners are planning to expand its current pipeline capacity which will further alleviate excess supply in the Mid-Continent. Thus, increased access to seaborne markets has caused the price of WTI crude oil to rise and has also led to the reduction of WTI’s discount to Brent crude oil.  In addition, as a result of the higher feedstock cost, Gulf Coast refining margins have declined. Weaker demand for U.S. gasoline in the current year has also been weighing on margins, largely due to persistent unemployment.

 

 

 

 Moving forward, additional pipeline capacity between the Midwest region and the Mid-Continent is in the process of being constructed with additional capacity being planned in the middle of this decade. Continued supply growth from Western Canada and domestic oil shale is expected to be seeking markets in the Mid-Continent and in the Gulf Coast vicinity, where complex refineries can process heavier Canadian grades of oil.

 

 

The emergence of alternative crude sources is thus pushing Midwest and Mid-Continent pipelines to realign existing infrastructure to back out traditional imports from the Gulf Coast in favor of growing supply from the north. In addition to evolving market dynamics, a pressing issue for the network of crude oil pipelines across North America is the age of existing infrastructure combined with encroachment from urban development and concerns around public safety. Together, these issues will likely lead to increasingly stringent regulatory environment where additional capital will be required to enhance the safety and securing of oil infrastructure in North America. Lastly, cheaper pipeline infrastructure will alleviate some of the current rail and truck transport cost pressures, as new pipelines reach the newly developed shale formations.

 

 

 

 

Oil shale resource base in an international context:

 

A new study by PFC Energy, a Washington-based consultancy, predicts that the U.S. will be the top global oil and gas producer by 2020, bypassing Saudi Arabia and Russia. Excluding the U.S. Strategic Petroleum Reserve (727 million barrels), current proven oil reserves in the U.S. are 21 billion barrels (a decline of 46% from 39 billion barrels in 1970). However, despite the current lagging proven reserves, one must not overlook the fact that the U.S. is currently the world’s 3rd largest producer of oil and also the 3rd largest contributor to Non-OPEC supply growth in the next 2 years.

 

 

 

 

More critically, the U.S. has the largest known deposits of oil shale in the world and according to the Bureau of Land Management it holds more than 2 trillion barrels of potentially recoverable oil. 

 

 

In addition to U.S. oil shale formations, Canada’s Oil Sands constitute a widely publicized vast resource of N.American oil (i.e. heavy oil and bitumen).

 

 

In a $100 oil world whereby geopolitical risk out of the Middle East is running very high, one may question why 70% of western U.S. oil shale deposits on federal lands are closed to private development, despite the growing need for new sources of oil supply amidst tightening global spare oil capacity.  These federal oil shale formations include the thickest and richest deposits, primarily in Colorado, Utah and Wyoming.

 

 

 

Therefore, increased supply from unconventional oil resources would at least reduce any potential impact to the economy from an oil crisis. Such an oil shock would stem from an embargo on Iranian oil supplies (9.3% of the world’s total reserves) or a disruption to the critical Gulf tanker choke point of the Strait of Hormuz, which handles  ~33% of the world’s seaborne oil shipments (and 17% of global oil shipments). Also of note is the recent decision by Saudi Aramco to not raise its capacity beyond its current target of 12.5m barrels a day and also to halt the $100bn expansion of its oil production capacity, which aimed at expanding production to 15m b/d by 2020. The Saudis are focusing on domestic social spending on the back of the Arab Spring and thus require a high break-even price of ~$88 to meet their fiscal budget requirements.

 

Conclusion:

The above discussion highlights the dynamic nature of the U.S. oil industry and underscores the significant opportunities that lie ahead for unconventional oil production and related mid-stream energy infrastructure such as pipelines. Although oil supply and demand is not immune from cyclical challenges, the secular backdrop appears favorable for the U.S. oil industry and for MLPs in particular which are well positioned to benefit from the above structural opportunities.

 

 


 

Christos Charalambous CFA  

Senior Strategist

christos.charalambous@edgewealth.com

 

 

 

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