HERA RESEARCH NEWSLETTER: How will the BP catastrophe in the Gulf of Mexico affect the US oil and gas market?
Rick Rule: What interests me — the fly in the ointment — about the blowout in the Gulf of Mexico, is that the Gulf of Mexico supplies 30% of US domestic oil and gas. Gas wells in the Gulf, in particular, have very high decline curves, meaning that gas wells drilled this year will likely be played out in 2012 or 2014. Without sustained drilling in the Gulf of Mexico, we can expect very rapid declines in overall US gas production, which may or may not lead to increasing domestic prices at a time when most commentators are calling for decreasing domestic prices.
HRN: I read that there has been a build-out of capacity to refine heavy sour crude oil.
Rick Rule: Heavy oil is doing well and I think it will continue to do well for a couple of paradoxical reasons. There used to be a very large spread between heavy sour crude prices and sweet light crude because heavy oil required upgrading. The spread was so large that upgrading heavy oil was extremely profitable and, as a consequence, enormous capital investments were made over the past 10 years or so both in Canada and in the United States in heavy oil upgrading. What’s happened is that our capacity to upgrade heavy sour crude has begun to outstrip supplies, particularly from Mexico and Venezuela. Because of the oversupply of upgrading capacity and the relative undersupply of heavy crude oil, the spreads between heavy crude and light crude have declined to the point where producing heavy crude has become a very profitable activity.
HRN: What is your view on oil sands?
Rick Rule: North American speculators who are under-weighted in oil should probably take a position in the larger oil sands companies, just as they would buy car insurance or life insurance. In addition to the supply disruptions that I see from the lack of investment in conventional export crude, geopolitical instability in the Persian Gulf region, particularly where Iran is concerned, could disrupt supply. If the Iranians had cause to shut down the Strait of Hormuz for any period of time, we would see a tremendous escalation in oil prices and we would see the geopolitical benefit of the Athabasca oil sands, which is an enormous, bitumen-producing
Workers clean up oil washed onto the shoreline of Elmer Island, in the Gulf of Mexico. © BP p.l.c.region of Northern Alberta, Canada. I see oil sands as an absolute cornerstone in a North American energy investor’s portfolio because of its extraordinary size, the amount of capital that has already been expended and because of its particular importance to US consumers.
HRN: What’s the status of technology to recover oil from oil sands?
Rick Rule: Steam assisted gravity drainage (SAGD) is a technology that’s useful where the oil is heavy and doesn’t flow very well but where there is porosity and permeability. What we do is drill two horizontal legs into the reservoir. One leg pumps steam into the reservoir while the other leg pumps out the fluid produced as a consequence of the injection of energy and steam.
HRN: With the energy inputs, is it economic or energy-positive to produce oil from oil sands?
Rick Rule: In an ideal world, one would build about 2 GW of nuclear capacity at the Athabasca oil sands in Northern Alberta, which is the largest oil sands basin in the world, because the byproduct of a nuclear power plant is steam. The steam from 2 GW of nuclear capacity would be worth about a quarter of a billion dollars annually. In other words, you would sell your waste product for a quarter of a billion dollars and the cash flow from the waste (steam) would amortize most of the construction cost of the power plant and the power that would be generated would back out all of the natural gas fired power used in the province of Alberta, freeing all of that gas for export or other uses (other than generating steam for the oil sands). Unfortunately, that set of circumstances isn’t politically appropriate. Right now, what happens in the oil sands business is that, because oil commands a higher premium as a consequence of its easy conversion into a motor fuel compared with natural gas, the process involves an arbitrage between high oil prices and low gas prices. Enormous amounts of energy are consumed to produce energy.
HRN: Is there an environmental impact?
Rick Rule: A challenge facing the oil sands industry is that it alters, negatively, large quantities of water. Water supply and water treatment issues will come to the fore in the oil sands business. I’m not a knee-jerk environmentalist but I am a real environmentalist. The industry has to address the fact that it has improperly treated water for a long period of time and it consumes much more water at lower input prices than it ought to. The industry is going to have to deal with recycling processed water back into process and with cleaning up process water before putting it back into the environment. In oil mining operations, the industry is also going to have to deal with the water that builds up in the pit as oil that hasn’t been mined desorbs from the rocks in the pit and is ultimately released into the environment. There are costs associated with oil sands that aren’t being factored into the cost of the oil that’s being sold and society is going to demand solutions to those problems and that will increase the production cost.
HRN: That’s fascinating, can you comment on oil shale as well?
Rick Rule: The technologies that have been brought to bear on gas rich shales, particularly those that have a lot of liquids in them, can probably be brought to bear on some of the oil rich shales, in particular, the thermally mature oil shales. We know that some of these basins are like organic kitchens, cooking their organic content into oil, but they have neither the porosity nor the permeability to be produced economically. What we’ve done in the gas rich shales, because they have poor reservoir properties, is that we’ve effectively manufactured our own reservoirs. We drill into the gas shales horizontally rather than vertically, exposing more of the reservoir to our extractive mechanism, that is, our well. Because the shale is very tight we pump in water or sand or ceramic in a procedure called fracturing, keeping the reservoir open. In other words we are manufacturing a reservoir in rock that has oil and gas in place but that didn’t have a reservoir previously. That technology will probably work in certain applications for oil shales. It may be that a combination of technologies, fracturing and SAGD, can be used in oil shales. The tremendous advance of technology we’ve enjoyed in the last 30 years and the tens of billions of barrels of oil that are known to exist, suggest that we may see the same type of technological breakthrough in the oil shales that we have in the gas shales. In the oil sands, the billions of dollars invested are beginning to pay off in spades, both in terms of cash flows and in terms of the security of the supply.
HRN: What do you think about the Peak Oil theory?
Rick Rule: Peak oil is more an economic and political phenomenon than it is a geological phenomenon. I think we’re past $40 peak oil but I don’t think we’re past $200 peak oil. There are technologies, and an example is miscible CO2 flooding to recover oil from allegedly depleted oil fields. There are new basins, albeit remote, frontier basins. There are new technologies that allow dry gas or LNG to be substituted for liquid oil. It’s an economic function because these technologies and substitutions require higher energy prices. At $200 oil, we’ve got lots of oil.
HRN: Where do you see oil prices in the next few years?
Rick Rule: I think oil prices will move up dramatically in the next 5 years. The transition from a hydrocarbon economy to some other type of economy will require massive investment in new technologies and I don’t think we will adapt quickly enough to avoid an escalation of oil and gas prices. Hydrocarbons, oil and gas, are extremely efficient energy sources. They are extremely dense and there is an incredible installed capacity to utilize them in various forms. They seem ideally suited for use as motor fuels. Whatever replaces them will be long in coming and involve enormous expense. I suspect that the next 10 or 15 years will involve a transition away from the widespread use of oil and gas in applications otherthan motor fuel. As a consequence, increasing per capita consumption of hydrocarbons around the world with an increasing number of capita, and without a viable alternative in the near term means that higher oil and gas prices are inevitable.
Rick Rule is the founder of Global Resource Investments, Ltd. He leads a team of professionals trained in resourcerelated disciplines, including geology and engineering, to evaluate investment opportunities. The Hera Research Newsletter covers key economic data, trends and analyses, including reviews of companies with extraordinary value and upside potential.