Energy Economist: Substitution, not shale, is the real revolution

In this article selected from the offerings of the October issue of Platts Energy Economist, Ross McCracken looks at the prospects for further substitution of cheaper natural gas for applications now using oil.

The massive expansion of shale oil and gas liquids production in the United States has fundamentally altered the country’s perspective on future security of energy supply. It has doused peak oil fever and apparently given a new lease of life to the hydrocarbon economy. But there is one key problem: it has not delivered cheap oil. Nor has the regulatory onslaught against high emission hydrocarbons diminished. Oil substitution not shale is the real energy revolution.

Cheap gas sure, cheap coal sure, and by extension cheap electricity, but where’s the cheap oil?

Rises in US oil output will make the single largest contribution to non-OPEC oil supply this year and next, but the price of gasoline in the US has continued to climb, reaching for all grades in the densely populated East Coast an average of $3.695/gallon in 2012, its highest ever level on an annual basis. The US revolution in unconventional oil production has delivered little to oil’s end consumers.

Now consider this: Tesla, which makes Plug in Electric Vehicles, produced just over 5,000 of its Model S in the second quarter and has seen its market valuation rocket to an eye-watering $20 billion since April. GM Motors, whose dealers delivered about 275,847 vehicles in the US in August alone, has a market cap of $50 billion.

And further: the ratio of natural gas ($/MMBtu) in the US to oil prices ($/b) was 9.47 in 2006 and rose steadily to a huge 33.26 in 2012. The small recovery in US gas prices in 2013 and a halt in oil’s rise have reduced this ratio to 26.29 as of mid-September, but oil’s comparative price in relation to gas is still much, much higher now than in the past.

Relative values

The cross-commodity impact of unconventional oil and gas has been much greater than its impact on the oil market alone, and it is this impact that may have the most far reaching consequences. The real sea-change has not been the end of concerns over peak oil, nor the change in US security interests abroad, but in the relative value of the different hydrocarbons.

True, the United States’ hydrocarbon economy now appears ‘sustainable’ — at least beyond the time horizons of the current generation — but the unconventional oil and gas boom has not diminished the threat of climate change, nor the regulatory impetus for demand reduction and emissions control measures.

If anything, by dispelling the idea that the hydrocarbon economy is heading imminently toward the edge of a supply precipice, the shale boom has raised environmental concerns that hydrocarbons will in fact be much harder to shake off, or worse, may gain a new lease of life. From a climate change perspective, greater availability of unconventional oil and gas is a reason for greater activism.

There are two major processes in train. A shift in the current and future availability of oil and gas, and the substitution of hydrocarbons for low carbon sources of energy. Both are supportive of oil substitution because there is considerable doubt that the increased availability of economically recoverable oil reserves will deliver significantly lower oil prices in the future.

The specter of peak oil may have lost its menace, but that does not reduce the challenges faced by an industry with mature assets and insecure supply chains that still has to meet continued rises in demand. Even if the extraction costs in some countries, such as Iraq, and for some unconventional liquids, are low compared with current prices, so far they do not make up a significant enough share of the market to impact the marginal price.

Other key segments of future output growth — Canadian oil sands and carbonate plays, Brazilian and West African pre-salt, deep and ultra deepwater, Venezuelan heavy oil, the Arctic and Russian shale oil — are all at the high end of the cost spectrum. High oil prices mobilize capital in support of new production, but they also sustain the investment conditions for substitution.

Change in transport technologies and major shifts in power generation mixes are generally measured in decades rather than years. Disruptive technologies tend to follow an S-curve, in which rates of adoption are low in the early years as infrastructure and manufacturing capacity is built out, allowing a later, steeper acceleration in uptake. Judging by its market cap, investors seem to think Tesla is close to this point.

Compressed Natural Gas users in Asia, Tesla Model S drivers in the United States and Norwegians buying LNG-powered ships may seem like a disparate bunch, but they all have one thing in common; they are early adopters, driven by supportive regulatory frameworks and the economic fact that the unconventional oil and gas boom has not delivered cheap oil.

At some point, and again the measurement is likely to be decadal, the oil industry may have to confront the possibility that even if it has the capacity to grapple with the supply-side issues that dominate pricing in an international market, it is the slow-burn demand-side revolution that proves to be their real undoing.

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