Why you should care
American oil won’t come to the rescue on a problem the country’s leadership has sparked.
As President Donald Trump’s decision to reinstate sanctions on Iran sends oil prices higher, consumers and the administration might hope that U.S. producers could come to the rescue with increased production. But logistical constraints, in particular insufficient pipeline capacity at the heart of the U.S. shale boom in West Texas, are limiting how quickly American companies will be able to replace any lost Iranian crude exports taken off the global oil market.
The difficulties being experienced in shale country help explain why the U.S. has talked to large oil producers abroad about ways to increase supply and offset any impact from its exit from the Iran nuclear deal. The talks were revealed by Steven Mnuchin, treasury secretary, hours after Trump’s announcement on Tuesday.
Oil produced in the Permian Basin of Texas and New Mexico, the white-hot center of the shale boom, is becoming trapped with no easy route to a refinery or an export terminal. The hectic pace of drilling and the productivity gains have boosted output from the Permian Basin by 60 percent in the past two years, to 3.2 million barrels a day. The problem is that the pace of the boom is straining the ability of the region to keep up, with workers, with equipment and with pipelines.
“There is a huge capacity issue,” says John Zanner of RBN Energy, a research firm. “For all intents and purposes, pipelines are full.”
The favorable economics for shale producers created by higher prices and lower costs mean that U.S. oil output is already rising fast, and is expected to average about 1.4 million barrels a day more in 2018 than in 2017. And in the U.S. oil industry’s recovery since May 2016, the Permian Basin has seen the strongest rebound in activity, with the number of active oil rigs tripling in the past two years. It now has 55 percent of the oil rigs running in the country.
But expanding production any faster will have to wait for new pipelines that are not coming online until the end of next year. Inadequate transport capacity in the region is reflected in the soaring discount for oil in Midland, West Texas, compared with U.S. benchmark crude. That discount hit $13 a barrel this week, meaning that while the easier-to-trade West Texas Intermediate was selling for about $70 a barrel, oil in Midland was just $57 a barrel.
Supply has risen because cost cuts and productivity gains have lowered the oil prices needed for Permian wells to be profitable. Scott Sheffield, chairman of Pioneer Natural Resources, one of the most successful Permian producers, said recently that the company’s wells needed oil only in the “low $20s” to break even.
Production techniques are also still improving. Concho Resources, another leading Permian producer, is one of many shifting to longer wells, running for up to 2 miles horizontally instead of one, to improve how much oil can be recovered from its reserves. Timothy Leach, Concho’s CEO, told analysts on a call this month that working that way raised the value of its acreage by about 45 percent.
“The exploration and production industry has really done well to cut the cost of supply,” says Artem Abramov, an analyst at Rystad Energy. “But the pipeline companies really missed their opportunity when there was a need for investment in new capacity.”
Some producers in the region, typically larger companies, including Pioneer, have already booked capacity on pipelines to refineries and export terminals along the Gulf of Mexico. Others, such as Parsley Energy, sell their production to customers who have access to those pipelines. But some producers are stuck without any attractive options for reaching customers.
“It is hard to get enough trucks and it is hard to get enough truckers,” says Jenna Delaney, of S&P Global. “So not many barrels are able to move that way.”
Trains are another possible transport route, but the railways of Texas have become congested with increased deliveries of sand, used in hydraulic fracturing to bring wells into production. The result is that companies that have not secured enough sought-after space on a pipeline are having to think about delaying some production.
Analysts at Tudor Pickering Holt argued this week that even though many companies in the Permian Basin could still sell oil at a profit, investors might prefer them to delay production, to wait for better prices. The U.S. Energy Information Administration said in its short-term energy outlook this week that weaker crude prices in the Permian Basin expected until mid-2019 meant that it “does not expect crude oil production in that region to rise as sharply as it would under a scenario with no transportation constraints.”
There is some flexibility in those constraints. Using drag-reducing agents, for example, can help oil flow through the pipelines faster. Rystad Energy thinks Permian production could rise to 3.7 million to 3.8 million barrels a day by the end of this year.
The real change will come next year, though, when three large new pipelines — Cactus II, Gray Oak and Epic — are scheduled to enter service, with a combined capacity of about 1.9 million barrels a day.
When that happens, U.S. production should be able to leap higher again, taking some of the heat out of oil prices. Until then, the Trump administration will need to keep a wary eye on what its Iran policy means for oil consumers.
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