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About The Author

Frank Wolak

is the Holbrook Working Professor of Commodity Price Studies in the Economics Department and the Director of the Program on Energy and Sustainable Development. Wolak’s recent research focuses on regulation, design, and monitoring of energy and environmental markets. From April 1998 to April 2011, he was Chair of the Market Surveillance Committee (MSC) of the California Independent System Operator. In this capacity, he has testified numerous times at the Federal Energy Regulatory Commission (FERC), and at various Committees of the US Senate and House of Representatives on issues relating to market monitoring and regulatory oversight of energy markets. Until December 2013, Wolak served as a member of the Emissions Market Advisory Committee (EMAC) for California’s market for greenhouse gas emissions allowances. This committee advised the California Air Resources Board on the design and monitoring of the state’s cap-and-trade market for greenhouse gas emissions allowances.

Stanford University • March 2015

Stanford Institute for Economic Policy Researchon the web: http://siepr.stanford.edu

SIEPR

policy brief

1. The North American Shale Resource Bonanza

The shale oil and gas revolution in the United States (U.S.) has led to a more than 4 million barrels per day increase in domestic oil production since 2008. Combined with an almost 1 million barrel per day increase from the Alberta tar sands, the surge in North American oil production has significantly reduced the region’s demand for imported oil. Increased production of shale gas in North America and the significantly lower dollar per million British thermal unit (BTU) price of natural gas versus oil have caused a number of sectors of the U.S. economy to shift away from consuming oil to natural gas. Consequently, China, rather than the United States, is now the world’s largest oil importer, purchasing more than 7 million barrels per day from the global market. Figure 1 shows domestic production of oil in December of 2014 approaching the historical high of slightly more than 10 million barrels per day in November of 1970.

2. The Declining Role of OPEC

The increase in North American oil production and decline in U.S. oil consumption have also significantly reduced the share of global oil demand served by the OPEC countries. Recognizing this fact, Saudi Arabia, the largest OPEC producer, recently decided not to reduce its production in response to prices in the $50 to $40 per barrel range. One can make a strong case that Saudi Arabia concluded that reducing its output would not increase the global price enough to make this unilateral reduction in output profitable. One plausible reason is that Saudi Arabia inferred that other OPEC countries would not follow its lead in reducing output to the extent needed to achieve a jointly profitable (for all OPEC members) global oil price increase. A number of factors point to stable or even higher output levels from the OPEC countries. Most OPEC countries are currently experiencing massive fiscal shortfalls because of low oil prices. The desire of these countries to avoid

The End of Expensive Oil?

By Frank A. Wolak

continued on inside...

SIEPR

policy brief

further domestic unrest makes oil output reductions unlikely because this would lead to even larger fiscal shortfalls unless these actions could be successfully coordinated among the OPEC countries to produce a significant increase in the global oil price. Slower demand growth in China and Europe makes unilateral output reductions by Saudi Arabia and other OPEC countries even less likely to increase global oil prices. Finally, over the past year, oil production has increased by almost 1 million barrels per day in Iraq and Libya.

3. Increasing Standardization of Well Drilling

The share of global oil production from the OPEC countries should continue to fall as more countries adopt shale oil and gas production technology. The recovered from a given well. Another important trend likely to reduce both drilling and production costs and enhance productive efficiency is the greater integration between oil and gas service companies. Historically, drilling and production activities were undertaken by a range of suppliers. Recently, an increasing number of companies are offering one-stop shopping for all drilling and production activities, which can reduce production costs and increase well efficiency. A prominent example of this trend is the merger between Halliburton and Baker-Hughes, two of the largest oil and gas services companies. This merger is motivated by the desire for a single company that provides fully integrated services for all aspects of oil and natural gas drilling and production.technology of shale oil and natural gas production is less than 10 years old, so there is still significant scope for cost reductions in exploration, drilling, and production activity, even in the U.S. According to the oilfield services firm Baker/Hughes, more than 37,000 wells were drilled in the U.S. in 2014. This volume of drilling activity has led to increasing standardization of the drilling and production activity. This so-called “factory drilling” process has reduced the time necessary to drill a well to less than 10 days. Historically, approximately 40 percent of the wells drilled are uneconomic in the sense that less oil and gas is recovered than it costs to drill the well. Consequently, there is considerable scope for improvement in well completion efficiency, which should increase the amount of oil or gas that can be

Figure 1 Monthly U.S. Field Production of Crude Oil

192002,5005,0007,50010,00012,500Thousand Barrels per Day1940 1960 1980 2000

Source: U.S. Energy Information Administration.

4. Natural Gas and Oil Interactions

One key driver of a reduced global demand for oil is the development of technologies that are able to exploit the differential between the dollar per MMBTU cost of oil and the dollar per MMBTU cost of natural gas. Even at $40/barrel, the dollar per MMBTU price of oil is still substantially in excess of the dollar per MMBTU price of natural gas. Assuming the industry standard 5.8 MMBTU per barrel of oil conversion factor implies an $8.60 per MMBTU price of oil. The current dollar per MMBTU price of Henry Hub natural gas is less than half that amount, which implies further switching away from oil is likely to occur in North America, particularly in the heavy-vehicle transportation sector.The production of associated gas from oil extraction is an additional driver of fuel switching from oil to natural gas. Roughly one-third of the growth in new U.S. natural gas supplies and approximately 10 percent of total domestic natural gas production are derived from the production of oil. Increases in the supply of associated natural gas are driven by the price of oil, but this increased supply of natural gas reduces the price of natural gas. Consequently, the production of associated natural gas increases the difference between the dollar per MMBTU price of oil and dollar per MMBTU price of natural gas, which leads to further switching from oil to natural gas for fossil fuel-based energy services.

5. Technologies that Reduce Oil versus Natural Gas Price Differential

An innovation limiting the amount of natural gas flaring (gas burned at the source without doing any useful work) that takes place in regions with significant shale oil production, such as North Dakota, is the CNG-in-a-Box technology recently developed by General Electric (GE). CNG-in-a-Box is a mobile technology that captures the natural gas that was formerly being flared off and compresses it to produce compressed natural gas (CNG) for use in vehicles serving the region and in drilling equipment, reducing the demand for diesel fuel in the region. This technology makes productive use of natural gas in regions without natural gas pipeline infrastructure.The pricing of natural gas versus oil-based fuels favors substitution away from oil to natural gas in the transportation sector. At the current price of natural gas in the U.S. in the range of $3/MMBTU, the dollar per gasoline gallon equivalent (GGE) cost of compressed natural gas is approximately $0.50 and the dollar per diesel gallon equivalent (DGE) is $0.60, because of the higher energy content of a gallon of diesel fuel versus a gallon of gasoline. According to the U.S. Energy Information Administration (EIA), at $50 per barrel of oil, the current wholesale price of gasoline is $1.50 per gallon and the wholesale price of diesel is $1.80 per gallon. These price differences between CNG and gasoline and diesel suggest there are still significant opportunities for cost savings from switching from oil to natural gas in the transportation sector and any other sectors that use diesel fuel, even at a price of oil in the range of $50 to $55 per barrel.

6. Exporting Shale Oil and Gas Technology

Although the recent reductions in oil and natural gas prices have caused investments in oil and natural gas exploration and drilling in the U.S. to decline, delivered natural gas prices in the remainder of the world, particularly, Latin America and Asia, remain substantially higher. This fact and a robust global oil demand driven by China and the developing world are sufficient to support continued investments in oil and natural gas exploration outside the U.S. China has embarked on an aggressive program to develop its shale gas resources in an effort to reduce its demand for coal. Major participants in virtually every major shale oil and gas play in the U.S. have a Chinese partner. There are also many joint ventures between U.S. and Chinese companies to explore for shale oil and natural gas in China. International oil and natural gas companies are also continuing to explore for shale oil and natural gas outside of the U.S., albeit at a slower rate, as horizontal drilling and hydraulic fracturing technologies spread outside of the U.S. For the above reasons, the prospects are bright for a stable and growing source of oil and natural gas from unconventional resources outside of the U.S.

7. Flattening of the Supply Curve of Oil

The exploration and development of shale oil and natural gas resources have