The idea that we will use up all of the earth’s oil has just gone from extreme to ludicrous.
According to a new report by BP plc (BP), the oil game has significantly changed over the last few years.
What you thought you knew about how the oil industry works is wrong. But that doesn’t mean we are in any worse shape than before. However, if you are even thinking about getting into today’s incredibly low-priced oil company’s stocks, you need to pay attention.
BP’s report, titled "New Economics of Oil," lays out why conventional thinking about oil production and prices is all wrong.
For starters, the "Beverly Hillbillies" idea of get-rich-quick oil finds is over. Oil is not something that is found in huge quantities that can be traditionally drilled for decades anymore.
Geologists have gotten darn good at finding the big fields, leaving new ones in short supply.
So, according to BP’s Spencer Dale, instead of the big oil finds and decades of production, the industry is now turning into a more "manufacturing-like" process. Here’s what that means.
Conventional wells and fields are still the breadwinners in the industry. That’s where the huge multinationals still compete — companies like ExxonMobil (XOM), Chevron (CVX) and even the author of this report, BP.
However, with the thousands of independent "fracking" and unconventional operators, especially in the U.S., production is more flexible.
Back when these new techniques really started taking off — about a decade ago in the U.S. — traditional drillers stayed away from them because of the short-term benefits of those technologies.
That is, the total production from shale oil wells drops off the chart after the first year.
As you can see in this chart, after the first year, production in the Bakken shale basin dries up by 75% after the first year. Meanwhile, in the Gulf of Mexico — something BP knows a thing or two about — production takes nearly a decade to slow that much.
But that doesn’t mean there’s no value in short-lived wells.
You see, for a company like BP to begin production at a traditional onshore — or even offshore — site, it takes years and sometimes decades to get the permits … buy and construct the platforms and equipment … and reach peak production levels.
For an unconventional independent driller, they can just pick up their equipment from a well that has already fallen 75% in production and move it a few miles down the road. It can begin producing within a year already at that site’s peak levels.
Shale producers don’t have to build new equipment. They don’t have to go through the same regulations and restrictions — simply because most of these sites were already used once when they could produce conventional oil. And they can move down the road at any time they please.
That flexibility lends itself to a more sustained approach to production. Unfortunately, these producers boomed too much right out of the gate.
If you haven’t seen the effect of shale production for total U.S. output, take a look here:
But with the most recent price collapse in oil, that period is over. Producers are starting to make more economic choices on where to drill and how much to produce.
As the U.S. Energy Information Agency and more recently OPEC predicts, next year will be the first year since 2008 that U.S. oil production falls.
But this shale trend isn’t going away.
For starters, just because we had record-breaking production growth over the last decade here in the U.S. doesn’t mean these shale producers have used up all that new recoverable oil. In fact, according to this BP report, "total proved reserves of oil … are almost two-and-a-half times greater today than in 1980."
When oil prices recover — and nearly everyone agrees they will — shale will be back in business. But instead of flooding the market with excess oil, as many believe it has, it will be used as a buffer to both take advantage of higher prices and to keep up with demand.
Essentially, shale will smooth the price volatility going forward. That’s what BP means by a more "manufacturing-like" industry.
Conventional drillers will continue to produce their large oil fields for decades on end. And shale producers will get in when demand and prices are high and out when supply catches up.
That doesn’t mean we won’t see the kind of volatility we all have grown accustomed to in the oil industry going forward. In fact, at times, it could be worse than ever.
You see, traditional drillers like Exxon and Chevron are loaded with cash. They also have international operations that give them geographic diversification. So their cash flows and balance sheets can sustain periods of tight credit — like we saw in 2008-’09. Sure, those companies saw their share prices cut with the rest of the market, but you didn’t see Exxon go bankrupt.
The opposite is true for independent shale producers. They tend to be far smaller and have lower margins. So if credit becomes tight again — say, if interest rates rise too fast — they will suffer. They won’t be able to expand enough to cover their short-term production issues.
So imagine a scenario where the Fed raises rates just when oil begins to recover. If the Fed goes too fast, these shale producers will need credit the most at just the time when it becomes harder to come by.
Those large companies have the cash and motivation to begin scooping up the smaller independent drillers. But now, with this new approach to the industry, that consolidation could continue even if oil prices climb. It all depends on interest rates at that time.
The best way to play it remains to own the larger producers. Right now, it would be impossible to know which of the small shale players will be left out in the cold when credit begins to tighten … and which ones will be targeted by the likes of Exxon, Chevron, Shell, BP and Total.
But if you don’t have some of your long-term investments in oil, now’s the time … even if production declines for the first time in eight years.
The Uncommon Wisdom Daily Team