Each year a
small portion of the world’s finite oil supply is drained. And over time this annual draw has
grown larger in a world that seems to be getting smaller. As global commerce gains fluidity, the
demand for this hydrocarbon appears to be insatiable.
Transportation
is of course by far the largest consumer of oil, responsible for about 60% of
global demand. Everything we own
and everything available to us to buy had to get from where it was made to
the point of sale. And it is oil
that fuels this transportation.
We must also
account for the many materials that go into what we own or consume. Whether it be
sugar for candy, rare metals for
iPads, or plastic for toys, these materials are
transported to a manufacturing plant somewhere in the world. And speaking of manufacturing, many
plants use oil as an energy source.
The industrial sector, of which manufacturing is the largest
component, accounts for about 30% of global oil demand.
When you
consider that the world’s population continues to grow, and that a
large part of this population is industrializing for the first time ever, the
demand for goods that need to be transported and manufactured will only
continue to grow. Regardless of
the interim state of the global economy, over the long run oil consumption will rise.
So with demand
destined to rise, supply remains under a lot of pressure in an environment
where oil is harder and harder to find.
Not only do reserves need to be replaced, they need to be developed at
a faster pace than depletion. And
with this “small” portion drained each year equivalent to about
32 billion barrels at today’s consumption rate,
oil’s suppliers have their work cut out for them.
It’s no
secret that new discoveries of large oil fields are exceedingly rare. Long gone are the days where onshore
near-surface gushers are found around every corner. And with not much low-hanging fruit
available for the picking, the oil companies have had to get creative in
developing the next generation of oil fields.
Thanks to
modern technology, the oil companies have so far been able to keep up with
demand. The ability to identify
geological anomalies from the surface, and drill deeper and more accurately,
has allowed operators to find and exploit the fruit that is a little harder
to reach. Offshore drilling for
example is one area that has really seen advances in recent decades, with
some of the world’s biggest discoveries being made underneath thousands
of feet of water.
But
provocatively since oil is indeed finite, technology can only get us so
far. And many experts believe we
either have or will soon reach a peak in conventional oil production. There are only so many conventional
oil reservoirs held in the Earth’s crust, and not enough new ones are
being found to support such a high level of demand.
Oil’s
delicate supply-and-demand balance of course hasn’t gone unnoticed,
hence the record high prices in recent years. But where higher prices are supposed
to temper demand, and thus drop consumption to reasonable supply levels,
demand has actually continued to rise.
Rather than suppressing consumption, these higher prices have opened
the door for another avenue of supply to support our increasing hunger for
oil.
These higher
oil prices have greatly increased the exploration for, development of, and
production of unconventional oil. Unconventional as opposed to
conventional oil doesn’t necessarily refer to a type of oil, as the end
product is essentially the same in its purpose. What it does refer to is the method of
extraction.
Typically
conventional oil is produced from within reservoirs that have enough natural
underground pressure that once tapped, the oil will flow up a well without
stimulation. When natural
pressure eventually subsides, pumping among other techniques can be utilized
to increase recoveries.
Unconventional
oil is petroleum that is extracted via non-traditional methods that
ultimately lack conventional simplicity.
This oil is held within reservoirs where it is trapped in thick sand
or tight shale, and doesn’t usually flow in its natural state. The methods of extracting and refining
it are thus a bit more involved.
And this involvement typically translates into higher costs.
But thanks to
higher prices and technological advances, oil companies are finding that the
production of unconventional oil can be highly
profitable even at these higher costs.
Even better is oil’s higher prices have afforded positive
economics to more of the world’s unconventional reserves.
And we’re
not talking a small smattering of reserves that may only attract risk-junkie
wildcatters. We’re talking
massive caches of reserves that are attracting some of the world’s
finest oil companies. In fact, it
is now widely agreed upon that there’s significantly more
unconventional reserves in the world than there are conventional reserves.
With the
now-huge incentive to pursue this avenue of production, we are finally
starting to see unconventional oil make a dent in supply. This is apparent in our chart below
that captures the U.S. Energy Information Administration’s (EIA)
outlook on supply, projected to the year 2035.
The data that
goes into this chart is from the EIA’s most-recent Annual Energy
Outlook. Its projections take
into account production, consumption, technology, and market trends among
many factors. And the results are
regarded as authority in the oil industry.
You’ll
also notice that this chart is labeled as Global Liquids Supply. In
addition to standard petroleum and a bit of natural-gas liquids, the EIA
includes non-petroleum-derived liquid fuels such as ethanol, biodiesel,
coal-to-liquids, and gas-to-liquids.
These non-petroleum fuels represent a very small portion of global liquids supply, so for our purpose I
use liquids and oil interchangeably.
In this chart
the red series represents conventional supply, and the blue series represents
unconventional supply. And as
would be expected, prior to oil’s secular bull (which commenced in
1999) the economics weren’t compelling enough for much commercial-scale
buildout of unconventional operations. Back in 2003 only 1.8m barrels per day
(bpd) of unconventional liquids hit the markets, equivalent to just 2.2% of
total supply.
But as the
price of oil started to take off and there was a growing realization that the
discovery of conventional oil reserves was becoming scarcer, unconventional
liquids gained attractiveness.
And with some big reserves suddenly possessing positive economics, the
oil companies started putting capital into development. By 2009 unconventional supply more
than doubled to 4.1m bpd. And per
the EIA’s projections, we are in for some big growth from this source
in the coming decades.
In general the
EIA’s projections forecast supply that will be needed in order to meet
demand. And its reference numbers
are based on a mid-line forecast.
This mid-line data factors in a business-as-usual trend estimate, in
which global demand is expected to be 111m
bpd by 2035. The EIA also
explores alternate scenarios that consider differing macroeconomic growth
rates, oil prices, and rates of technology progress. And even in the worst-case scenario,
demand would still be 108m bpd.
Well with
demand expected to rise regardless of the economic and price environment, the
oil has to come from somewhere.
And provocatively the EIA actually projects a bit of growth on the
conventional front. This is
definitely a controversial stance since many believe we’ve reached a
peak in conventional oil production.
But the EIA believes that conventional fields yet to be discovered
along with OPEC keeping a constant 40% share of total world supply will
deliver moderate conventional supply growth (25% from 2003 to 2035).
Regardless of
what we see play out in conventional production growth, the anticipated
growth on the unconventional front is going to be spectacular. Unconventional supply is projected to
grow by over 650% from 2003 to
2035, and more than triple from
today’s levels. By 2035
unconventional liquids will be responsible for a sizeable 12.2% of global supply.
With these
staggering growth projections, investors should really be keying in on
opportunities in the unconventional realm. And while this realm does include some
non-petroleum-based liquids, the biggest opportunities have come and will
arise in petroleum-based liquids.
Unconventional oil will be responsible for supply of
nearly 7.0m bpd by 2035. And much
of this will come from oil sands and extra-heavy oil, of which the world has
ample reserves. In fact, it is
estimated that Venezuela’s Orinoco Belt and Canada’s Athabasca
Oil Sands hold just as much oil reserves as all the conventional reserves in
the world combined!
For academic
reasons the EIA separates oil sands and extra-heavy oil. But depending on who
you ask, these categories can be synonymous by definition. Whether it be
Athabasca’s bituminous sands or Orinoco’s somewhat-less-viscous
extra-heavy crude, the oil doesn’t flow naturally. It is extracted on the surface via
mining, or subsurface via fascinating in-situ techniques. And Canada is currently responsible
for the lion’s share of this type of production as a result of
geopolitical roadblocks in developing Orinoco.
Interestingly
usually when people think oil sands they visualize large-scale strip
mining. But of the nearly 100
active oil-sands projects in Athabasca, only four are mining. The majority of operations are
in-situ, with one of the more common techniques being Steam-Assisted Gravity
Drainage (SAGD).
In SAGD, steam
is continuously injected into an upper well to reduce viscosity and thus
stimulate flow into a lower parallel production well. Even though developing and operating a
commercial-scale SAGD project that yields expensive-to-refine bitumen is more
expensive than operating a traditional conventional field that yields
light-sweet crude, it is still highly profitable at today’s prices.
With this
profit potential supported by massive reserves amenable to commercial
development, the EIA anticipates that oil-sands supply will deliver an annual growth rate of 4.4% to
2035. And that
oil sands will remain the world’s largest unconventional producer. Extra-heavy oil, mostly from
Venezuela, will also deliver a healthy annual growth rate of 3.1%. This is spectacular compared to conventional’s forecasted
annual growth rate of less than 1.0%.
The
fastest-growing unconventional supply source is expected to come from shale
oil. Although the cumulative
supply from shale oil will be less than 1.0m bpd, it is by far the biggest
growth area with an estimated annual growth rate of 12.1%. And many
believe that this number is well-understated.
Much of the
world’s shale-oil reserves are contained in the United States, trapped within deep, thin, and tight oil-bearing
horizontal formations that had historically been difficult to exploit. But thanks to radical technological
advances in horizontal drilling and hydraulic fracturing, of course supported
by higher oil prices, shale-oil extraction now has wildly-favorable economics.
Even though
shale oil is light in nature, it is categorized as unconventional since
simply sinking a well into a payable zone won’t deliver an economic
flow. As a result of its
tightness (low porosity and permeability), among other factors, a payable
shale zone must be stimulated (fracked) in order to
deliver economic recoveries. And
because shale formations tend to lack thickness, this stimulation is usually
performed across horizontal laterals that can extend as much as two miles.
One region
seeing major growth in shale-oil production is the prolific Williston Basin,
specifically from within the Bakken formation that
underlies North Dakota and Montana.
Oil companies have been flocking to this area in recent years,
accumulating as many leaseholds as possible. And they have found incredible success
pulling light crude from within these deep rocks.
Whether shale
oil, oil sands, or extra-heavy oil, unconventional oil represents the biggest
growth area in the global oil-supply chain. And when you consider the growing
scarcity of meaningful conventional discoveries compared to largely-untapped
massive reserves of unconventional deposits, this trend is not a fad or
short-term phenomenon. The
EIA’s conservative projections see big growth in unconventional supply,
and this trend will likely persist indefinitely.
In our recent
deep research project focused on mid-cap oil stocks trading in the US and
Canada, we found the sweet spot of this trend. And this is confirmed by the EIA,
revealing that the majority of unconventional oil supply will come from the
US and Canada. And mid-cap
exploration and production companies are pioneering much of this movement!
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The bottom line
is oil’s demand trend has and will know only one direction, up. Oil is the lubricant of global
commerce, and the industrialization of Asia has accelerated its demand. But with large conventional oil
deposits depleting and new meaningful discoveries becoming scarcer, the
supply chain is under some serious strain.
Thankfully an
alternate supply channel has come forth that is able to supplement
conventional reserves.
Unconventional oil resources had long been known, but technological
and economic constraints had prevented much commercial development. Higher oil prices and new innovations
have overcome these objections though, making unconventional oil development
one of the most exciting and robust growth areas in the industry.
Scott Wright
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