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Jeremy Grantham - Oil Industry Future

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    For ASX companies whose business is shale E&P I think this is really good read. You have to make your own conclusions to the specifics of your investment - whether it is EFS focused, Bakken focused etc., as each location has a different profile but overall how shale in general fits into the current world of oil I think this is highly relevant piece to each individual company.

    This article came to my attention via my Barron's subscription - so I can't post that directly but Jeremy Grantham is a noted (some say legendary - check his Bio) investor and co-founder of GMO - an asset allocation fund with about $120B under management.

    This link will take you to what Jeremy wrote in the GMO Qtrly newsletter - pages 8-15.

    If invested in US shale I hope you take the time to read the complete article - I would definitely encourage a read. He is making industry wide generalizations - not all shales are the same (they share the generalizations e.g. high decline - but there's a difference between 80% 1st year and 50% and EURs of 800MmBOE and 400Mmboe in all of the cost equations).

    I'll quote from Barron's where Jeremy essentially paraphrases his report. I've bolded pieces that really have me thinking and reinforces my current view that Cash Costs are of utmost importance and longer term the full cycle costs will again be "prime mover" once the cheap capital machine is taken away. Enjoy (I think).

    "The simplest argument for the oil price decline is for once correct. A wave of new U.S. fracking oil could be seen to be overtaking the modestly growing global oil demand. It became clear that OPEC, mainly Saudi Arabia, must cut back production if the price were to stay around $100 a barrel, which many, including me, believe is necessary to justify continued heavy spending to find traditional oil. The Saudis declined to pull back their production and the oil market entered into glut mode, in which storage is full and production continues above demand. Under glut conditions, oil (and natural gas) is uniquely sensitive to declines toward marginal cost (ignoring sunk costs), which can approach a few dollars a barrel — the cost of just pumping the oil. "

    "The Saudis are obviously expecting that these low prices will turn off U.S. fracking, and I’m sure they are right. Almost no new drilling programs will be initiated at current prices except by the financially desperate and the irrationally impatient, and in three years over 80% of all production from current wells will be gone! Thus, in a few months (six to nine?) I believe oil supply is likely to drop to a new equilibrium, probably in the $30 to $50 per barrel range. For the following few years, U.S. fracking costs will determine the global oil balance. At each level, as prices rise more, fracking production will gear up. U.S. fracking is unique in oil industry history in the speed with which it can turn on and off. In five to eight years, depending on global GDP growth and how quickly prices recover, U.S. fracking production will start to peak out and the full cost of an incremental barrel of traditional oil will become, once again, the main input into price. This is believed to be about $80 today and rising. In five to eight years it is likely to be $100 to $150 in my opinion. U.S. fracking reserves that are available up to $120 a barrel are probably only equal to about one year of current global demand."

    "The arguments that this is a demand-driven bust do not seem to tally with the data, although longer term the lack of cheap oil will be a real threat if we have not pushed ahead with renewables. Most likely though, beyond 10 years electric cars and alternative energy will begin to eat into potential oil demand, threatening longer-term oil prices. "

    "it was not unexpectedly weak demand but relentlessly increasing U.S. oil supply that broke the market."

    "U.S. fracking, which accounted for over 100% of the U.S. increase, went from about 0% to 4% of global production in only five years – have not been seen since the early glory days in Texas, Pennsylvania, and Baku in the 19th century and in the Middle East in the 1950s and 1960s.... In 2013 and 2014 increases in U.S. fracking production equaled 100% of the increase in global oil demand. Worse yet for OPEC, the estimate by June 2014, with the price still around $100, was for U.S. fracking production in 2015 to be even higher than the estimated total increase in global demand this year! More importantly, the increasing surge from U.S. fracking had absolutely not been expected as recently as 2009."

    "Oil and natural gas are particular problems because when all of the vast expense of finding and developing new reserves and writing off dry holes are past and have become sunk costs, the marginal price can fall as low as the cost of turning on the tap for gas or merely paying for the electricity to run the oil pump. That is why people today talk of the possibility of going to $20 a barrel in a sustained glut."

    "the stress came not from obstreperous OPEC members but from the U.S. fracking cowboys, each attempting to produce as fast as utterly possible even if they had to borrow more than their cash flow to do so. This was an avenue previously closed to most OPEC and non-OPEC producers alike, engineered in the U.S. by a Fed-manipulated era of low interest rates and, for frackers anyway, available debt. Faced with the reality of the rapid rise of U.S. fracking production and the declining share for OPEC, and confronted with the possibility that at over $100 a barrel the U.S. increases might continue at around an incremental one million barrels a day for another two or even three years, OPEC, especially the Saudis, had to do some unusual calculations. The trade-offs they faced had never arisen before. This is the first time that fracking has played a major role in global production, and fracking, particularly in the U.S., has a feature totally unlike other oil: its production can be turned on and off far more rapidly than conventional oil. It is easy to understand the Saudi’s reluctance to cede market share to the U.S. frackers for several years into the future, perhaps down to half of their usual production. They may believe that: a) lower prices can be maintained for a long time, if not forever; and b) that at such lower prices much of U.S. fracking oil will never be produced. "

    "So what happens now? ..... And this is a key point: U.S. fracking is the only important component of global supply that can turn up almost immediately by bringing in new rigs and drilling wells in under two weeks, adding 20-30% to production in a year as it did for each of the last two years. It is also the only important component that can turn off quickly by depleting almost completely in three years. As with Alice’s Red Queen, if you pause for breath in fracking you go backwards: more wells must be drilled all the time to even stay still as the wall of rapidly depleting wells builds up behind you. Nothing remotely like this has ever been experienced before so drawing wrong conclusions, as if the traditional data applied, is particularly easy. "

 
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