The current Economist has an article on U.S. oil and gas that repeats an increasingly common view: tight oil will make “future oil shocks less severe” since “frackers can sink wells and start pumping within weeks”. (Here’s a variant from The Atlantic last August.) That speedy response means that “if the oil price spikes, [drillers will] drill more wells”, quickly spurring new production, and taming any price spike.
This is severely flawed – a point that recent experience reinforces.
It is undeniably true that the time from drilling to production is far lower for tight oil than for traditional wells. But that doesn’t mean that industry can respond quickly and powerfully to oil market shocks.
Imagine that a disruption in the Strait of Hormuz threatened to send oil prices up from one hundred to two hundred dollars a barrel for a span three months. How would U.S. oil producers respond?
The first thing they’d do is ask themselves whether new investment would make sense over the full life of any new well rather than just over the span of the disruption. Let’s take a best-case scenario: a developer realizes that something is afoot on Day 1 of the crisis and is confident the price rise will last three months. If you assume that about 20 percent of a well’s output comes in its first year, and that production declines by about 50 percent in a straight line over the course of that year, then you end up with 6-7 percent of total production during the period of elevated prices. Wells with break-evens up to 106 or so dollars a barrel, rather than merely 100 dollars a barrel, are now in the money. This will not spur radical change. (If I was doing this carefully, I’d discount future cash flow, making the up-front revenue boost more consequential. But the basic qualitative point would still stand.) Even if you extend the crisis to six months, you get a maximum break-even of about 112 dollars a barrel, a relatively small increment. And this assumes that drillers act instantly upon a supply disruption; in reality, making a decision to drill, mobilizing resources to begin production, and actually drilling and fracking a well would delay the start of production and further blunt the slightly-above-normal returns. One can argue with the numbers I’ve used to make this point, but the basic qualitative conclusion is solid.
In fact the numbers I’ve just presented overstate how strong drillers’ response would be. In the short run the number of rigs available for drilling is fixed. (I could make a similar argument about other capital and people needed to initiate production, but it’s useful to focus on one thing.) It’s true that producers can move rigs from natural gas toward oil, but that’s happened so much over the last couple years that there isn’t a huge margin to do that today. Over time, you could see more rigs get ordered. But companies aren’t going to order a bunch of rigs that will be active for a few months and then sit idle once prices return to normal – that’s not a profitable proposition. Instead companies faced with an impending price spike will bid for a fairly fixed set of rigs. Since those rigs are newly valuable – you can now make a bit more money using each one because oil prices are higher – companies will be willing to pay more. The break-even price for a given well will therefore rise, moving some seemingly profitable but marginal prospects back into the red, and leaving them untapped as a result. This dynamic also explains why newly cash-flush producers won’t be able to blindly plow all their money back into increased production even if they were inclined to: the necessary rigs wouldn’t be there.
And there’s one more constraint: transportation. Even if drillers can respond quickly, that doesn’t mean that they can get the oil they produce to market. If there isn’t sufficient pipeline or rail capacity to quickly move newly produced oil to market, companies aren’t going to produce that oil. It takes a decent amount of time, of course, to expand transport capacity. This won’t always be a big constraint, but it’s one more strike against the “tight oil production is always going to be super-responsive” line.
We’ve recently had an ugly piece of real-world experience in natural gas that backs this all up. Henry Hub natural gas prices rose from $4/MMBtu to about $5.50/MMBtu over the span of a few weeks in January. They’re still elevated. So are rigs rushing toward newly profitable opportunities in natural gas? Absolutely not: the gas-directed rig count declined 4 percent last week (half those rigs went to oil and the other half were inactive) and has fallen 20 percent over the last year. This is due in part to the fact that the cold snap driving prices up right now is ultimately going to dissipate, and in part because we don’t have the right infrastructure in place to move additional natural gas production to market quickly. (It’s also because using available rigs to drill for oil remains more profitable than moving them to gas, despite the price spike.)
To be certain, this story would look different if we were talking about long-term increases in the price of oil. A run-up like the one we saw in the 2000s, which unfolded over the span of almost a decade, would give drillers plenty of time to respond. (Though experience in the oil sands in the 2000s suggests that capital and labor constraints – and resulting cost inflation – would still be a major drag.) But for the sorts of oil price spikes we worry about most – those driven by sudden and intense geopolitical disruptions – the responsiveness of tight oil production is likely to do a lot less to blunt the consequences than many people seem to hope.