Shifting risks in global oil supply

Emerging technical challenges to tight oil’s growth

If the demand side of the equation is relatively predictable, oil supply is notoriously difficult. Many of the market’s most colourful moments through history have revolved around supply, with OPEC at the centre of most in the last six decades. Swingeing cuts to production in the early 1970s and a turning on of the taps in the mid-1980s whiplashed the price. That double whammy has been repeated, in reverse, these last three years.

Unplanned disruptions have also influenced the market balance and price in recent years. Iran sanctions and civil unrest are among the factors that kept over 4 million b/d of liquids (4% of global supply) off the market in 2014 and 2015.

As Iran rebuilds production post-sanctions and stability returns to other producer hotspots, unplanned outages are already down to 3 million b/d and could slip to 2 million b/d by 2020. Kurdistan shows how sensitive price can be to disruption in today’s more balanced market. But in general, we think that constraints to supply from above ground risk are waning.

Volumes on our forecasts reach 10 million b/d next decade (from 4.7 million b/d currently) and by 2025 will satisfy 10% of global demand. Two-thirds of the growth, or 3.5 million b/d, is from the Permian Basin deep in the heart of Texas.

But does this tectonic shift away from geopolitical hot spots and OPEC producers de-risk global supply? As a supplier at the margin, price is a primary risk for tight oil production; and there are technical risks that may manifest as the industry climbs a steep learning curve. Two are emerging already.

First, reserves or EUR (estimated ultimate recovery), on which a shadow was cast by Pioneer’s Q2 results in August.

The company revealed higher gas/oil ratios (GOR) in its Permian Midland Basin wells – more gas was produced with the oil than expected at this stage. The company believes that higher gas volumes do not indicate lower oil EUR.

Some reservoir engineers will contend that a high GOR at this stage could indicate early release of gas in solution, raising the viscosity and lowering the mobility of the remaining liquids. In short it could mean more oil than expected is left stranded in the reservoir and lower EUR.

Pioneer is aptly named – it was an early mover in the Midland Basin. It has a higher number of older producing wells than other operators. The concern is that over time, others now at an earlier stage of development will encounter the same phenomenon.

It could be months before any meaningful trend from Pioneer’s acreage can be properly assessed, and whether it poses any threat to the overall Permian growth story. We have held our relatively conservative view on type curves and still expect Pioneer’s Permian volumes to treble to 0.54 million b/d by 2025.

Second, geological constraints.

Our analysis, "Geology vs technology," challenges our Permian base case in a scenario that reduces future EURs by 30%, production by 1 million barrels a day, and brings forward peak production by five years.

So far technology has delivered the goods in tight oil. Advanced horizontal well completions, multi-fracs, exponential increases in frac pressures and proppant volumes have increased IP rates and implied EURs. The evolution of technology will no doubt lead to further upgrades in time.

But intensifying development may also lead to diminishing returns.

Ever tighter well spacing can compromise the independence of individual wells – ‘child’ wells, drilled too close to an earlier ‘parent’ are becoming more frequent as operators exploit sweet spots.

The child well impinges on the same fluid system with resulting lower oil flow and EUR. Separately there are ‘frac hits’ – a new well frac penetrates the casing of an existing nearby well undermining production. Time will tell if these challenges can be mitigated.

They will be seen coming for starters – any ‘red flag’ from one operator will be construed as signalling problems down the line for others. Tight oil’s delivery will be scrutinised more minutely than that of new conventional fields, because it’s unconventional and the vagaries of the reservoirs are unknown quantities. But also because it's so crucial to future global supply.