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For oil executives, the fracking revolution raises spectre of a gas flashback

I don't know any oil executives who use Twitter, but if they did, their "trending" hashtag might be #gasflashback. Behind this virtual podium, their tweets would focus on what is now the most anxiously-asked question in the oil patch: "Can the fracking revolution do to oil prices what it has done so ruthlessly to North American natural gas?"

No one in the business wants to say that the answer is yes. That's because the oil data that's coming in every week is scary enough to instill the usual human response to change: denial. Although some circumstances on the oil side are different than natural gas, North American oil prices could easily come under further pressure over the next year or two, just like a #gasflashback.

Nevertheless, changes are afoot to counter the pressure, and opportunity always accompanies such turmoil.

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Oil fundamentals today are showing very similar characteristics to natural gas a few years ago: A rapid increase in productive capacity; weak domestic consumption that can't absorb the rising output; old takeaway infrastructure (for example, pipelines) that is not adapting quickly enough to match new sources of supply with shifting demand; and a fenced-in continental marketplace that inhibits exports to higher-value global markets.

Rapid production growth, the number one antagonist, continues to astound with every new data point received. From North Dakota to Alberta, Saskatchewan to Oklahoma, new light oil barrels from horizontally-fracked wells keep flowing in greater quantities every month. If there is one chart that turns this story into Technicolor, it's Figure 1, the long-term production profile for Texas.

In the peak oil years, between 1981 and 2001, the Lone Star state, the largest producer of oil in the US, was witnessing a steady output decline of 75,000 B/d every year. The declining trend began slowing down last decade, but the real drama started less than 18 months ago, when the combination of high prices and innovation really kicked in. Texas is now growing its rate of oil output by 35,000 B/d, every month, for an annualized growth rate of 425,000 B/d per year! To put this in perspective, that's the equivalent of one-third of Libya's oil production developed and brought to market in 12 months. It's also close to China's incremental consumption in 2011 (505,000 B/d).

Here in Alberta, the production of light, tight oil, or LTO, is now up by 175,000 B/d relative to what would have been expected without the new technologies. Putting this in perspective, Alberta has built the equivalent capacity of a big oil sands project in less than 18 months – complete with an upgrader to light oil!

Yet there are major differences between the oil and gas stories. Foremost is that Canada and the U.S. imported very little natural gas when shale gas boom started. So there was no room to push out foreign gas suppliers, making the continent more susceptible to oversupply.

Not so with oil. The U.S. still imports 6.3 million barrels of foreign oil every day (excluding Canada) while consuming 18.2 million. Eastern Canada is also a major importer of oil, bringing in about 800,000 barrels every day from faraway places like Nigeria and Algeria. Pushing out foreign suppliers with new domestic production is akin to a synthetic export that taps into global markets. That's why getting this flood of new oil, by pipeline or rail, to coastal facilities is important.

But there are long-term limits to this dynamic of substituting foreign oil for North American crude -- not the least of which is the simple economic argument that foreign oil suppliers are generally lower-cost producers than those on this continent, and they typically have long-term import contracts that are not easily displaced. Above all other factors, if and when this limit is reached will dictate whether or not a #gasflashback will happen.

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Also, unlike natural gas, North American oil can easily be refined into secondary products like diesel and gasoline for export. The limiting factors here are capacity and also being able to compete against low-cost refineries popping up on the other side of the world.

On the surface, the trends in motion make a pretty good case for weaker oil prices over the next year or two, especially because we've seen a similar story with gas. Like natural gas, the domestic price discounts on oil – North American crude trades well below world oil benchmarks – are proof of the disruptive dynamics in play.

Yet it's too early to tweet #gasflashback. Oil infrastructure is being retooled across North America to adapt to production growth and market diversification. In Canada, we are witnessing the biggest changes to pipelines since the 1950s with line reversals, expansions and proposed new builds to access new points. In the meantime, oil producers should take a lesson from their natural gas brethren and understand that the big winners in this environment will be the ones who are part of a trend called #lowcostproducer.

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.

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About the Author

Peter Tertzakian is chief energy economist and managing director with Arc Financial Corp. in Calgary and provides analysis on technology and energy-related businesses to fund managers and portfolio companies. More

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