The Danger of “Sub-Prime” Energy Resources

By Dr. Blaine D. Pope, © 2014 

In my fall 2014 class on international political-economy and energy, a group of my undergraduate social science students were given the following scenario, problem, and question to solve:

The Scenario 

“Tight oil (also known as shale oil or light tight oil, abbreviated LTO) is petroleum that consists of light crude oil contained in petroleum-bearing formations of low permeability, often shale or tight sandstone.”  Source: http://en.wikipedia.org/wiki/Tight_oil 

Based on the definition above, on the graph below, note the following details:

·         Time is displayed on the “X” axis, in 5 year increments.

·         Volume of oil (in millions of barrels per day, or “Mb/d”) is displayed the “Y” axis. 

·         The black line—which peaks around the year 1970—displays actual oil production statistics, starting from the year 1900 and ending somewhere between 2010 and 2015 (information shown after the black line ends is simply projected oil production).

Questions:

Part A: Sometime around the year 2010, after many years of steady decline, US oil production appears to rise again.  Why do you think this is so? Draw on everything you know from this class, to justify your answer as best you can.

Part B: What’s in a title?! The title of the above graph is “US Crude Oil Production.”  Based on what you’ve studied in this class, does that seem like an appropriate title for information in contained in this graph?

***

Answers:

Questions A & B are perhaps best thought of as two interralted parts of one overarching question: "Why is the United States—after many years of steady decline—now reporting an apparent upward trend in oil production?"  A student who performed reasonably well would have answered something like this:

Part A: The USA has begun reversing the long-term trend in domestic oil production as a result of the revolutionary new technology in hydraulic fracturing (or “fraking”), wherein water and chemicals are injected into the earth, to help break-up and release the carbon-rich material contained therein (at a rate of anywhere from 1-5 barrels of water for every 1 derived barrel of oil equivalent).  This has been combined with advanced mining, or digging, processes in other areas—involving the clearing of forest topsoil (at an approximate rate 4 tons of earth moved to derive 1 barrel of oil equivalent, or “BOE”), to get at the peat-like substance underneath. 

Part B: No, this is not an appropriate title for this graph.  It does not distinguish between the less expensive, traditional liquid crude oil, of the type shown here . . .

. . . and the more expensive, rocky (shale) formations shown below. These must be mined and then processed (requiring still more energy in order to be heated and liquified) before they can be converted into a substance more or less on par with liquid crude oil.  Ergo, these rocky formations are more complex and expensive to process and ultimately bring to market, compared liquid crude. 

Shale should really be called a different energy source.  It has to be treated much differently in order to bring it to market as a usable source of energy.  However, as the above graph implies, it is simply lumped together as “oil,” as if if were all the same. 

The real problem comes in at level the cost of extracting and processing shale (i.e., its production costs).  Many of these shales require a higher minimum price in the world oil market to make them worthwhile to extract.  Said another way, it order to make my imaginary shale extraction business profitable, I need to be able to earn approximately $70 per barrel of oil (in equivalent derrived shale oil product), assuming the average market price was $70 per barrel.  If the market price slips below that $70 “break-even point” (and stays there too long) then I am going out of business, because I won’t be able to earn enough to meet my production costs.  In other words, I wouldn't even be able to "break even," in terms of my investment in my business.  Different companies will likely have slightly different break-even points, so we are talking about industry sector averages here.   

I am calling shale oil "a sub-prime energy source" (as compared with liquid crude oil) precisely because of these higher (yet often hidden) production costs associated with it.  This is a problem—as we are now seeing—because once average BOE prices get close to the $70/barrel range, a lot of people in the shale business risk going bankrupt.  If this happens to too many energy companies too quickly, then what we are looking at (potentially) is a major collapse in the shale oil (or "oil derivatives") market, a lot of failed small and medium-sized business attached to the energy sector, and ultimately a return to higher, traditional liquid crude oil prices.  Yet, this sub-prime energy source has been bundled together with the more financially robust, traditional liquid crude oil, as if it were all the same.  

Does any of this sound familiar? 

Overall, this is a cyclical process; but with no two successive cycles being exactly alike. The key idea here is pattern recognition (on the part of both investors and policy-makers).  In another post, I will say more on the political-economic elements of this energy extraction process--including some of its international dimensions.

Blaine D. Pope, Ph.D.