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The importance of shale gas-ification of oil

Everyone now knows what happened in the US’ natural-gas sector. Strong Henry Hub prices brought a costly, tricky method of gas extraction into the mainstream. Just a few years after US politicians and forecasters were fretting about dwindling reserves and firms rushed to build liquefied natural gas import terminals to capitalise on the inevitable rise in prices, hydraulic fracturing and horizontal drilling unleashed vast new supplies. Production costs tumbled as the drillers honed the technology. The US is now in an age of gas abundance.

It's time to stop stockpiling canned foods and ammunition, because a similar story is playing out in the oil world. From Brazil’s pre-salt deep-water play to Canada’s oil sands to the Bakken of North Dakota, peak-oil theories are being demolished, well by well, barrel by barrel.

A study by Harvard University’s Belfer Center says the world is entering an era of “unprecedented” growth in global oil supply. Within a decade, says the study, global output capacity will reach more than 110 million barrels a day (b/d), if not much more. Just as the US shale-gas revolution has begun to spread across the world so, too, will the revolution under way in North America’s oil sector reach other shores. It is a “paradigm-shifter”, says the study’s author, deploying the kind of language that has become a shale-gas cliché. Beyond Iraq, the additions to supply will almost all come from outside Opec.

The market has worked: high oil prices have moderated demand growth and poured vast new sums of investment into the upstream. There is, however, a catch.

If prices drop before 2015, says the Belfer report, much of the new forecast production growth will be delayed. A price fall beyond that point, by contrast, would lead to a “steep” slump. Sunken costs by then would mean that projects remained online, despite a softer market. To see that in action, look again to the US’ gas sector, where drilling continues apace, despite the glut in supply and historically weak Henry Hub prices.

For consumer countries, this means that oil abundance and energy security is on its way – but only if they stomach prices that the International Energy Agency, their dogged representative, says remain too high for their economies.

It leaves governments in the West in a tricky spot. In the UK, the Conservative government’s announcement on 26 June that it would postpone a £0.03 ($0.05) rise in fuel duty showed just how much of a threat it believes high oil prices pose to economic recovery. If the postponement doesn’t sound like a lot, the move would cost the treasury more than £500m: a pricey tax-cut while the rest of the UK’s economy buckles under the Cameron government’s austerity programme.

It wasn’t a move to shake oil markets. Net UK consumption in 2011 was only about 440,000 b/d and no one expects a jump in demand: the country already punishes drivers with some of the highest forecourt prices in the world, helping to explain why consumption keeps falling. In the first quarter of this year, it dropped by nearly 2% against the year-earlier figure.

Across the world, though, high oil prices are a headache. In the US, President Obama’s re-election bid is at risk. Thanks to a fall in Brent prices, which dipped well beneath $100/b in mid-June before regaining strength at the end of the month, average fuel prices are down on highs hit in the spring. But at around $3.44 a gallon, they’re still a drain on Americans’ budgets. US fuel taxes are already low, so the White House can’t offer the kind of fiscal fillip introduced by the UK. Instead, the Obama government is still waiting for the right moment to release strategic stocks onto the crude market.

That time might be drawing near because, after a hiatus, the market is worried about supply threats again. Deadlock in negotiations between six countries and Iran over its nuclear programme could soon turn to a total break-down in the talks. That’s a big change: just two months ago, the smart money was on incremental progress. Instead, Iran’s parliament is talking of closing the Strait of Hormuz again. The military fired some test missiles again. And the US has again moved more weaponry into the Gulf.

The market pays too much heed to the Hormuz bogeyman. Iran, whose budget is under severe strain as its oil exports decline, knows that a salve can be found in inflating global prices merely by mentioning the H-word. In turn, Western governments persist with tough-talk and sanctions because, as one diplomat told Petroleum Economist, stomaching the inevitable price rises will show Iran they are serious.

For Iran, Iraq, Venezuela, Algeria – Opec’s price hawks – a decade of strong oil markets has left them dependent on inflated prices. Saudi Arabia’s budget is in better shape. It can handle a price of just over $78/b, according to Deutsche Bank. With the exception of Bahrain, other Gulf countries have a similar break-even point. In part, that explains why the kingdom and its Gulf Cooperation Council allies emerged from last month’s Opec meeting – where the group officially rolled over a 30m b/d production ceiling that has been exceeded for months – pledging to keep pumping as much oil as the market needs (see p8).

That has helped create a far looser market than in earlier quarters. Despite the as-yet unquantifiable loss of Iran’s oil, stocks are building rapidly. The Centre for Global Energy Studies reckons inventories may have added a whopping 2.5m b/d in the second quarter.

Geopolitical forces will keep adding support to Brent – Iraq, say UK diplomats, is disintegrating rapidly, for example, which threatens its recent supply growth – but the fundamentals are bearish. A much-praised deal in Brussels at the end of June to ease the Eurozone crisis already shows signs of unravelling. The Chinese and US economies are struggling.

Paradoxically, such macro-weakness is also supporting oil prices, because markets expect more stimulus from central banks. Still, there’s suddenly a lot of oil around and great doubt about whether global demand, which fell in the first half of the year, will rise to absorb it all.

Opec’s oil revenue topped $1 trillion last year. So a price fall would let consumers claw back some of all the extra cash they have been sending to the group. Russia’s economy depends on a price of more than $115/b, says Deutsche Bank. So a price drop would also help weaken Vladimir Putin’s government. For the White House, a price drop is a win-win.

As the Belfer study shows, though, that would be the wrong way to see it. The shale gasification of the oil sector is just beginning, but it means that the lines between producers and consumers will begin to blur in the coming years.

The US is on the verge of a leap in production that could change its economy – and its relationship with the oil exporters on which the world’s biggest consumer has depended for so long. But this is costly oil. If the West wants its own, indigenous supplies, it should recognise that $100/b offers short-term pain for long-term gain, and may hold the key to a new age of oil abundance.

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