Commentary – The Great Oil Market Experiment

Source: Pixabay.com

The oil market is undertaking a great new experiment. Historically, the market has relied on OPEC to “swing-up” their production quickly in the face of a supply shock. But today the cartel is in the process of swinging its taps fully open. In the future, it will be up to North American light tight oil (LTO) producers to quickly bring new barrels online in the event of future shortfalls.

By decreasing their spare capacity, OPEC has passed the torch for managing any potential oil supply outages to LTO producers – the supply type with the shortest duration between drilling a new well and producing the first barrel of oil.

Now, if an unplanned outage occurs, instead of cranking open a few valves in Saudi Arabia for an instant supply response, the extra barrels must come from new LTO wells. But the duration between North American producers deciding to send out idle drilling rigs and pumping trucks, and the surge of new supply is still unknown.

Any time a new system is demonstrated, it is advisable to have some contingency built in. For the oil markets that contingency comes in the form of full above-ground storage tanks. Ideally, while the market waits for LTO production to ramp-up, oil storage tanks should fill the void.

To understand this new dynamic, imagine a hypothetical future supply shock precipitated by sustained outages in major producing countries, for example Nigeria, Iraq or Venezuela. At the same time, assume OPEC spare capacity is low.

Assuming a strong enough price signal, LTO producers would increase their investment causing new barrels to flow into the market. However, the ability for LTO to ramp-up in an emergency has never been tested, and this fact will not be lost on the nervous market. Supply uncertainty usually causes price swings.

For example, when Libya lost one million barrels of production in the spring of 2011, Brent oil price rocketed-up to $US 126 per barrel, and that was when OPEC had four million barrels of spare capacity, two times more than today.

Returning back to the future supply shock scenario: Once the higher price signal is sent, the first new LTO barrels will flow from the inventory of drilled but uncompleted wells, also known as DUCs.  While there are differing views, sending out the pressure pumping trucks could add in the range of 500,000 barrels per day of new supply. The timing for DUCs to add new supply will likely be measured in months, and not days.

Beyond the DUCs, oil producers need to start drilling new horizontal oil wells. For these investments, the timeline between the decision to drill a new well and the first barrel of oil is longer, possibly more like six months to one year. Also consider that the service industry is smaller than a few years ago, and it will likely take longer to ramp-up than before the downturn.

A potential supply shock scenario illustrates how high levels of above-ground oil storage now act an important buffer in the absence of OPEC spare capacity.  There are good reasons for keeping oil storage tanks topped up.