Will the New U.S. Shale Boom Kill Oil Prices?

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These days everybody wants to extol the virtues of rising U.S. domestic crude oil production.

From decades of increasing reliance on foreign providers, some hardly sympathetic to American interests, the new prospect of having significant unconventional oil reserves here at home has been a major development.

The assumption advanced says that domestic sources will be cheaper. As a result, this should comprise a positive boon to consumers of oil products but a problem for producers and refiners. In short, the mantra among some commentators is to proclaim the end of the oil market as an attractive option for investors.

As with most such simplistic observations, however, it turns out not to be true.

A number of these "analysts" are actually talking down the prospects of oil prices because they have already shorted the commodity and will benefit their own investments if they can continue the downward push.

Well, oil prices are now going up, with both West Texas Intermediate (WTI) in New York and Brent in London at more than three-month highs.

In addition, the spread between WTI and Brent is narrowing.

The narrowing of that spread is occurring while both benchmarks are rising in price. The mantra of the pricing doomsayers would expect it to be going in the other direction.

There are two broad categories of reasons why matters are not happening as the doomsayers had expected (aside from the obvious - they misunderstood the dynamics from the beginning).

And once you understand both, you'll be in position to profit as prices continue to rise.

The Cushing Effect Distorts U.S. Oil Prices

The first issue addresses a range of more or less traditional factors.

These have been affecting the market for decades. They don't disappear merely because pundits don't want to consider them. The widening of the spread in favor of Brent against WTI benefited from an ongoing transit glut in the American market resulting from an endemic bottleneck at Cushing, Okla. (the main intersection of U.S. pipelines and the location where the daily WTI price is set).

That problem, in turn, also provides a depressing impact on U.S. crude prices. Since a similar transit problem does not occur in the transport of North Sea crude (the basis of Brent pricing), European prices are not similarly depressed.

The "Cushing effect" has also produced a broader distortion in the market. Brent is now used daily as the benchmark for more global oil trades than WTI. Both are sweeter (having a lower sulfur content) than about 85% of all international transactions. That means most trades are at a discount to either Brent or WTI. Given that more of these use Brent as the yardstick, that selection serves as a secondary reason for the spread against Brent and the lowered WTI price.

But this is beginning to end.

Pipeline revisions are virtually finished moving crude away from Cushing to Gulf coast refineries. As the glut is lessened, the tendency is for domestic prices to rise.

But there are also another traditional reason why the price of U.S.-produced oil is not going to go down.

Anybody shorting crude would want you to believe that the geopolitical element is an infrequent contributor to price acceleration. Unfortunately, that is simply not the case. Despite more crude being drilled in North America, the market remains a global one. Events in one area affect prices in all areas. Having more domestic reserves does not result in a "fortress America."

Also, we are beginning to witness the rise of intensifying demand pressures. This is not simply (or even primarily) demand across the board. While the return of a more positive view of economic prospects will move prices up (the current environment), the demand pressure is experienced in specific sectors.

The U.S. refined product market continues to under-produce diesel and jet fuel (middle distillates) even as the availability of "summer blend" hi-octane gasoline will be tested in several of the mandated metropolitan areas again this year as we approach June 1.

Now there is not going to be an acute shortage. We are not running out of oil products. But the continued improvement in demand will result in some market dislocation because of infrastructure, refinery capacity, and location, as well as the emergence of terminal and wholesale/retail distribution shortcomings.

None of these problems has anything to do with reserves or production levels.

And they will hit before demand as a whole even spikes in earnest. Paradoxically, as oil product availability becomes more of a concern, we will experience a development these simpleminded pundits cannot explain - a rise in the import of refined oil products.

Unconventional Oil Production Set to Rise

It is in the second category of reasons that the pundits' argument fails even more significantly. The basic underpinning here is that the new huge availability of unconventional oil will depress the market price.

It seems plausible enough on its face. The advent of tight oil (often called, incorrectly, shale oil) has revised everything from how much is now estimated in the ground to the volume extracted. Final figures may show that the U.S. produced more oil in 2012 than in any year for almost four decades.

But that does not mean the oil coming into through the domestic market is cheaper. In fact, that had been the justification for rising imports. It was simply less expensive to produce abroad. The current argument wants to accord to the new domestic production that same pricing advantage.

Unfortunately, there are considerations making this quite unlikely. The operational costs to drill and extract the "new oil" are higher than conventional crude, while the crude produced requires more treatment, separation of impurities and processing than "old oil."

Then again, the location of tight oil deposits requires significant capital expenditures for upstream field development, feeder and trunk pipelines, initial treatment and processing, as well as a broad array of midstream services and facilities. Much of this is also much heavier oil, requiring specialized refining facilities or the need to turn it into synthetic flow (via an upgrader) before it can even make it to a refinery.

We are still far too early in the process of exploiting places like the Bakken, Williston, Eagle Ford and perhaps Utica plays to determine what additional cost elements will affect pricing. Some preliminary "guesstimates" put the average at six to ten cents higher per gallon.

The amount of unconventional reserves is not the issue. They are certainly there. But no economy of scale can offset the cost elements presented by the crude composite. It is not more expensive because there is insufficient volume produced.

Rather, it costs more because of the oil's characteristics.

It is still better to have a domestic option, and the U.S. will exploit it.

But it will not insulate the American market from the traditional factors that impact oil pricing. The unconventional oil itself will generate a second category of pricing considerations.

It is still essential to recognize that not all companies will benefit. Nonetheless, the oil sector is going to remain a major place for individual investors to make money.

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About the Author

Dr. Kent Moors is an internationally recognized expert in oil and natural gas policy, risk assessment, and emerging market economic development. He serves as an advisor to many U.S. governors and foreign governments. Kent details his latest global travels in his free Oil & Energy Investor e-letter. He makes specific investment recommendations in his newsletter, the Energy Advantage. For more active investors, he issues shorter-term trades in his Energy Inner Circle

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