The last time the U.S. and Iran had diplomatic relations was before 1980, back when high oil prices were threatening energy security. Monday's nuclear deal with Iran is a geopolitical twist that is likely to keep prices soft. That's because roughly 1.5 million barrels a day (MMB/d) of sanction-choked Iranian oil may start flowing back into anxious markets that are soaked with U.S. and Canadian oil.
Soaked is an understatement. By the end of this year, pump jacks and oil sands projects will combine to push North American production past 11.2 MMB/d. That's the highest level since 1973 (see Figure 1).
But the drilling gusto in Texas, North Dakota and Alberta doesn't seem to faze the second-largest producer of oil in the world: Saudi Arabia. Last week they reaffirmed their position that high-cost U.S. light tight oil (LTO) is not a concern, and that global consumption can mop up any excess.
Denying this tectonic resource-play trend reeks of hubris in a disruptive business environment that has humbled many big-headed oilmen. Yet, few will accuse the Saudis of not being smart, so why are they not concerned about what's happening in North America?
Looking at production growth, the tendency is to side with team Canada-U.S. as winners of additional market share at the expense of the Saudis, Russians and other big producers. Every month now, on average, Canada and the U.S. are pushing out an additional 95 thousand barrels a day of production. Simple extrapolation of the trend in Figure 1 points to complete "oil independence" for North America by 2022, and for the U.S. on its own by 2027.
Yet nothing is so simple. And drawing straight lines with a ruler is always dangerous in economics.
The Saudis are likely taking comfort in two things beyond global demand growth. Firstly, that North American oil is likely to remain trapped in North America for a while; Canadian oil will be landlocked for the next several years, and American exportability may be policy-locked for just as long. The thinking goes that domestic overproduction and distended pipelines will progressively yield lower continental prices, reduced drilling and a loss of output momentum. Under this scenario (which is admittedly difficult to debate right now), global markets could remain relatively unscathed for leading exporters like Saudi Arabia.
Secondly, in the event that North American shorelines open up, and oil does pour into global markets, the Saudis probably believe they can withstand lower prices longer than their new Western competitors. With almost $800-billion in foreign exchange reserves, and some of the lowest operating costs in the world, they have some cause to be confident.
Having said that, Alberta's oil sands facilities can now stream production resilient to prices below $50 (U.S.) a barrel (West Texas intermediate equivalent). Several Canadian producers claim to be able to increase their in-situ oil sands output even at such low prices. But this isn't likely of major concern to the Saudis. Expansion of oil sands output depends on big capital expenditures and is slow to grow compared to hydraulically fractured LTO in the U.S.
The high-volume rush of LTO coming from North Dakota and Texas is akin to a bucket brigade. Fast-draining horizontal wells are bailing out subterranean reservoirs at a faster and faster pace. But rigs that drill these expensive wells probably start retreating if oil falls below the $80-a-barrel mark. Some strident LTO producers, like good oil sands operators, can maintain their mojo at lower prices, but such companies are also in need of a secret sauce to keep their brigades moving: Cheap capital.
The nature of very expensive LTO wells with steep production declines is that their economic viability is very sensitive to oil prices, especially on the down side. In other words, financial returns of these wells (many of which are leveraged with debt) diminish disproportionately faster than the oil prices they are linked to. All of which means that cash flow and access to capital – both a necessity for the type of LTO growth being witnessed in Figure 1 – should dry up quickly if oil prices fall. That's what the Saudis see, although this theory has yet to be tested.
But here is the profound thing. Most would agree that the sustainability of North American oil independence, especially in the U.S., depends on high oil prices in the $80-to-$100 range. That's a real twist from the past. Energy security was always associated with lower oil prices.
Peter Tertzakian is chief energy economist at ARC Financial Corp. in Calgary and the author of two best-selling books, A Thousand Barrels a Second and The End of Energy Obesity.
Peter Tertzakian