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Unconventional Oil

By Scott Wright
scottq@zealllc.com
zealllc.com
October 29th, 2011

Each year a small portion of the world’s finite oil supply is drained. And over time this annual draw has grown larger in a world that seems to be getting smaller. As global commerce gains fluidity, the demand for this hydrocarbon appears to be insatiable.

Transportation is of course by far the largest consumer of oil, responsible for about 60% of global demand. Everything we own and everything available to us to buy had to get from where it was made to the point of sale. And it is oil that fuels this transportation.

We must also account for the many materials that go into what we own or consume. Whether it be sugar for candy, rare metals for iPads, or plastic for toys, these materials are transported to a manufacturing plant somewhere in the world. And speaking of manufacturing, many plants use oil as an energy source. The industrial sector, of which manufacturing is the largest component, accounts for about 30% of global oil demand.

When you consider that the world’s population continues to grow, and that a large part of this population is industrializing for the first time ever, the demand for goods that need to be transported and manufactured will only continue to grow. Regardless of the interim state of the global economy, over the long run oil consumption will rise.

So with demand destined to rise, supply remains under a lot of pressure in an environment where oil is harder and harder to find. Not only do reserves need to be replaced, they need to be developed at a faster pace than depletion. And with this “small” portion drained each year equivalent to about 32 billion barrels at today’s consumption rate, oil’s suppliers have their work cut out for them.

It’s no secret that new discoveries of large oil fields are exceedingly rare. Long gone are the days where onshore near-surface gushers are found around every corner. And with not much low-hanging fruit available for the picking, the oil companies have had to get creative in developing the next generation of oil fields.

Thanks to modern technology, the oil companies have so far been able to keep up with demand. The ability to identify geological anomalies from the surface, and drill deeper and more accurately, has allowed operators to find and exploit the fruit that is a little harder to reach. Offshore drilling for example is one area that has really seen advances in recent decades, with some of the world’s biggest discoveries being made underneath thousands of feet of water.

But provocatively since oil is indeed finite, technology can only get us so far. And many experts believe we either have or will soon reach a peak in conventional oil production. There are only so many conventional oil reservoirs held in the Earth’s crust, and not enough new ones are being found to support such a high level of demand.

Oil’s delicate supply-and-demand balance of course hasn’t gone unnoticed, hence the record high prices in recent years. But where higher prices are supposed to temper demand, and thus drop consumption to reasonable supply levels, demand has actually continued to rise. Rather than suppressing consumption, these higher prices have opened the door for another avenue of supply to support our increasing hunger for oil.

These higher oil prices have greatly increased the exploration for, development of, and production of unconventional oil. Unconventional as opposed to conventional oil doesn’t necessarily refer to a type of oil, as the end product is essentially the same in its purpose. What it does refer to is the method of extraction.

Typically conventional oil is produced from within reservoirs that have enough natural underground pressure that once tapped, the oil will flow up a well without stimulation. When natural pressure eventually subsides, pumping among other techniques can be utilized to increase recoveries.

Unconventional oil is petroleum that is extracted via non-traditional methods that ultimately lack conventional simplicity. This oil is held within reservoirs where it is trapped in thick sand or tight shale, and doesn’t usually flow in its natural state. The methods of extracting and refining it are thus a bit more involved. And this involvement typically translates into higher costs.

But thanks to higher prices and technological advances, oil companies are finding that the production of unconventional oil can be highly profitable even at these higher costs. Even better is oil’s higher prices have afforded positive economics to more of the world’s unconventional reserves.

And we’re not talking a small smattering of reserves that may only attract risk-junkie wildcatters. We’re talking massive caches of reserves that are attracting some of the world’s finest oil companies. In fact, it is now widely agreed upon that there’s significantly more unconventional reserves in the world than there are conventional reserves.

With the now-huge incentive to pursue this avenue of production, we are finally starting to see unconventional oil make a dent in supply. This is apparent in our chart below that captures the U.S. Energy Information Administration’s (EIA) outlook on supply, projected to the year 2035.



The data that goes into this chart is from the EIA’s most-recent Annual Energy Outlook. Its projections take into account production, consumption, technology, and market trends among many factors. And the results are regarded as authority in the oil industry.

You’ll also notice that this chart is labeled as Global Liquids Supply. In addition to standard petroleum and a bit of natural-gas liquids, the EIA includes non-petroleum-derived liquid fuels such as ethanol, biodiesel, coal-to-liquids, and gas-to-liquids. These non-petroleum fuels represent a very small portion of global liquids supply, so for our purpose I use liquids and oil interchangeably.

In this chart the red series represents conventional supply, and the blue series represents unconventional supply. And as would be expected, prior to oil’s secular bull (which commenced in 1999) the economics weren’t compelling enough for much commercial-scale buildout of unconventional operations. Back in 2003 only 1.8m barrels per day (bpd) of unconventional liquids hit the markets, equivalent to just 2.2% of total supply.

But as the price of oil started to take off and there was a growing realization that the discovery of conventional oil reserves was becoming scarcer, unconventional liquids gained attractiveness. And with some big reserves suddenly possessing positive economics, the oil companies started putting capital into development. By 2009 unconventional supply more than doubled to 4.1m bpd. And per the EIA’s projections, we are in for some big growth from this source in the coming decades.

In general the EIA’s projections forecast supply that will be needed in order to meet demand. And its reference numbers are based on a mid-line forecast. This mid-line data factors in a business-as-usual trend estimate, in which global demand is expected to be 111m bpd by 2035. The EIA also explores alternate scenarios that consider differing macroeconomic growth rates, oil prices, and rates of technology progress. And even in the worst-case scenario, demand would still be 108m bpd.

Well with demand expected to rise regardless of the economic and price environment, the oil has to come from somewhere. And provocatively the EIA actually projects a bit of growth on the conventional front. This is definitely a controversial stance since many believe we’ve reached a peak in conventional oil production. But the EIA believes that conventional fields yet to be discovered along with OPEC keeping a constant 40% share of total world supply will deliver moderate conventional supply growth (25% from 2003 to 2035).

Regardless of what we see play out in conventional production growth, the anticipated growth on the unconventional front is going to be spectacular. Unconventional supply is projected to grow by over 650% from 2003 to 2035, and more than triple from today’s levels. By 2035 unconventional liquids will be responsible for a sizeable 12.2% of global supply.

With these staggering growth projections, investors should really be keying in on opportunities in the unconventional realm. And while this realm does include some non-petroleum-based liquids, the biggest opportunities have come and will arise in petroleum-based liquids.

Unconventional oil will be responsible for supply of nearly 7.0m bpd by 2035. And much of this will come from oil sands and extra-heavy oil, of which the world has ample reserves. In fact, it is estimated that Venezuela’s Orinoco Belt and Canada’s Athabasca Oil Sands hold just as much oil reserves as all the conventional reserves in the world combined!

For academic reasons the EIA separates oil sands and extra-heavy oil. But depending on who you ask, these categories can be synonymous by definition. Whether it be Athabasca’s bituminous sands or Orinoco’s somewhat-less-viscous extra-heavy crude, the oil doesn’t flow naturally. It is extracted on the surface via mining, or subsurface via fascinating in-situ techniques. And Canada is currently responsible for the lion’s share of this type of production as a result of geopolitical roadblocks in developing Orinoco.

Interestingly usually when people think oil sands they visualize large-scale strip mining. But of the nearly 100 active oil-sands projects in Athabasca, only four are mining. The majority of operations are in-situ, with one of the more common techniques being Steam-Assisted Gravity Drainage (SAGD).

In SAGD, steam is continuously injected into an upper well to reduce viscosity and thus stimulate flow into a lower parallel production well. Even though developing and operating a commercial-scale SAGD project that yields expensive-to-refine bitumen is more expensive than operating a traditional conventional field that yields light-sweet crude, it is still highly profitable at today’s prices.

With this profit potential supported by massive reserves amenable to commercial development, the EIA anticipates that oil-sands supply will deliver an annual growth rate of 4.4% to 2035. And that oil sands will remain the world’s largest unconventional producer. Extra-heavy oil, mostly from Venezuela, will also deliver a healthy annual growth rate of 3.1%. This is spectacular compared to conventional’s forecasted annual growth rate of less than 1.0%.

The fastest-growing unconventional supply source is expected to come from shale oil. Although the cumulative supply from shale oil will be less than 1.0m bpd, it is by far the biggest growth area with an estimated annual growth rate of 12.1%. And many believe that this number is well-understated.

Much of the world’s shale-oil reserves are contained in the United States, trapped within deep, thin, and tight oil-bearing horizontal formations that had historically been difficult to exploit. But thanks to radical technological advances in horizontal drilling and hydraulic fracturing, of course supported by higher oil prices, shale-oil extraction now has wildly-favorable economics.

Even though shale oil is light in nature, it is categorized as unconventional since simply sinking a well into a payable zone won’t deliver an economic flow. As a result of its tightness (low porosity and permeability), among other factors, a payable shale zone must be stimulated (fracked) in order to deliver economic recoveries. And because shale formations tend to lack thickness, this stimulation is usually performed across horizontal laterals that can extend as much as two miles.

One region seeing major growth in shale-oil production is the prolific Williston Basin, specifically from within the Bakken formation that underlies North Dakota and Montana. Oil companies have been flocking to this area in recent years, accumulating as many leaseholds as possible. And they have found incredible success pulling light crude from within these deep rocks.

Whether shale oil, oil sands, or extra-heavy oil, unconventional oil represents the biggest growth area in the global oil-supply chain. And when you consider the growing scarcity of meaningful conventional discoveries compared to largely-untapped massive reserves of unconventional deposits, this trend is not a fad or short-term phenomenon. The EIA’s conservative projections see big growth in unconventional supply, and this trend will likely persist indefinitely.

In our recent deep research project focused on mid-cap oil stocks trading in the US and Canada, we found the sweet spot of this trend. And this is confirmed by the EIA, revealing that the majority of unconventional oil supply will come from the US and Canada. And mid-cap exploration and production companies are pioneering much of this movement!

In this research we scrub the entire universe of stocks, profile our dozen favorites that we think have the highest probability for success, and package them in our popular sector reports available for sale. And we found that many of the best mid-cap oil stocks are going the unconventional route. In fact, 10 of our favorite 12 have unconventional projects as major components of their portfolios.

Among our favorites are companies that are some of the top Bakken players, those that operate heavy-oil projects in the US and Canada, and some of the world’s top emerging SAGD oil-sands players. Buy your report today to have these deep fundamental profiles at your fingertips!

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The bottom line is oil’s demand trend has and will know only one direction, up. Oil is the lubricant of global commerce, and the industrialization of Asia has accelerated its demand. But with large conventional oil deposits depleting and new meaningful discoveries becoming scarcer, the supply chain is under some serious strain.

Thankfully an alternate supply channel has come forth that is able to supplement conventional reserves. Unconventional oil resources had long been known, but technological and economic constraints had prevented much commercial development. Higher oil prices and new innovations have overcome these objections though, making unconventional oil development one of the most exciting and robust growth areas in the industry.

By Scott Wright
scottq@zealllc.com
zealllc.com
October 29th, 2011

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