Dangerous Curves Ahead

Decline curves graphically depict the rates at which oil and gas well production levels fall -- or plummet -- over time. They may also illustrate how unlikely it is that the world's oil producers will be able to meet the expected increases in global demand. Energy giant ExxonMobil (NYSE: XOM  ) and the Energy Information Administration arm of the U.S. Department of Energy are just two of the many entities that have studied this important question.

These prognosticators generally agree that total crude oil production -- which currently averages nearly 85 million barrels daily -- will need to reach about 120 million barrels per day, or more than 40% above the current rate, by the year 2030. This is largely because of rapidly escalating energy usage in the world's developing nations, such as China and India. Any significant shortfall in meeting that projected level could have dire consequences, including a meaningful decline in your quality of life and heightened hostilities among nations.

Unfortunately, those whose knowledge of energy ends at the gasoline pump often believe that meeting higher energy demand simply involves drilling a few new wells. However, as The Wall Street Journal indicated in an excellent article last week, the decline rates of many of the world's largest oil fields appear to be escalating, meaning that more and more energy producers will need to run faster and faster just to keep up with current production levels, let alone achieve any sort of significant production increases.

Mexican sweat
The Journal's article focuses on Mexico's giant Cantarell field, which, just since the beginning of last year, has suffered a 20% drop in its production, from two million barrels a day to about 1.6 million barrels. Its current production rate ranks Cantarell as the world's second-most prolific field -- behind only Saudi Arabia's behemoth Ghawar field. Unfortunately, its declining output is a dire portent for Mexico's status as a net energy exporter; for the nation's overall economy; for the world's other large wells, whose once-youthful vitality is starting to wane; and for mankind's future ability to crank out enough crude to supply its growing needs.

At Cantarell, as in many parts of the world, the problems are part structural and part human. As fate would have it, most of the world's elephantine oil fields have been located in places where they are under the auspices of national oil companies. In those instances, both the fields and the national companies that operate them are viewed by the ruling governments primarily as cash cows. As such, their capital spending flexibility and access to emerging technology are often severely limited.

For instance, the Mexican oil company Petroleos Mexicanos, better known as Pemex, contributed $53 billion to the Mexican government's coffers last year, with $25 billion of that figure coming from Cantarell alone. And yet, when water began to increase in the field's wells as a percentage of the oil being pumped -- a typical occurrence in aging fields -- there was no separation equipment available to remove it.

But Cantarell's situation -- that of an aging field that's been relegated to steadily declining production volumes -- is likely to become more and more common. The Journal quotes Houston energy banker Matthew Simmons, who notes that in the decades preceding the 1970s, eight fields were discovered that were capable of producing at least 500,000 barrels a day each. In the 1970s and 1980s, two more large fields were found. Since then, only the Kashagan field in Kazakhstan has joined the ranks of the world's biggest fields.  

And while new discoveries are now typically smaller fields, a host of producing horizons have seen their daily output levels slide. For instance, as Simmons pointed out in February at an International Petroleum Week presentation in London, U.S. production decreased from 7.5 million barrels of oil a day in 1990 to 5.5 million in 2005, with a significant percentage of that figure coming from deepwater wells, which were almost nonexistent as recently as 1990.

Old and tired
At the same time, Simmons also notes that North Sea production by Norway and the U.K. totaled about 6.1 million barrels per day in 1999, but has since shrunk to barely four million daily barrels. And at Alaska's Prudhoe Bay field, while estimated recoverable reserves have been increased by nearly 35% over time, daily production nevertheless peaked at 1.5 million barrels several years ago, and since has slid to approximately 400,000 barrels per day.

Along with declining production in many horizons, Simmons contends that the world's ability to predict and deal with the effects of peak oil (the somewhat ominous point where demand first exceeds productive capacity) is being hindered by a lack of good data on the true reserve positions of most countries. In fact, while there are guesses at those reserves for most of the major producing nations, as he says, "In harsh reality, the data quality of all these reserve estimates is nonexistent."

But with the world's largest wells located in Saudi Arabia, Mexico, Iran, Kuwait, Algeria, China, Iran, Azerbaijan, and Russia, that data quality seems unlikely to improve. In fact, Simmons (who is hardly without critics of his own) thinks that Saudi Arabia's Ghawar field, which alone produces more oil in a given day than any other OPEC nation, may have also seen its best days. But we're really not certain of its status, because, as he also points out, unlike the practice undertaken annually by publicly held oil companies, no OPEC producer has ever submitted to an independent, third-party audit of its reserves.

And if declining wells can serve to thwart meaningful increases in our ability to keep up with higher energy demand, "above-the-ground" difficulties seemingly can be even more negative to the process. For instance, Venezuela's Hugo Chavez, in a current nationalization effort, is evicting ExxonMobil, Chevron (NYSE: CVX  ) , and ConocoPhillips (NYSE: COP  ) from their operating positions in the Orinoco basin, a tar belt where thick and difficult-to-refine crude may prove to be an insurmountable challenge for that nation's petroleum engineers. At the same time, Iran, the second-largest producer in OPEC, worries energy observers with its erratic international behavior; its own financial turmoil; and its control of the strategic Strait of Hormuz, through which much of the world's traded oil passes daily.

There are, of course, those who believe that our ability to meet our future energy needs will be far easier than I've posited here. But I remain convinced that the process is riskier and more subject to potential failure than the optimists' whistling-past-the-graveyard approach would indicate. At the very least, the world could be subject to spot shortages of crude and a decided upward bias to energy prices in the years to come.

I hope these concerns will lead Foolish investors to pay careful attention to the vital energy sector. My favorite names for consideration include the three international producers mentioned above, along with big oilfield service companies Schlumberger (NYSE: SLB  ) and Halliburton (NYSE: HAL  ) .

For related Foolishness:

Fool contributor David Lee Smith does own shares in Schlumberger, but not in the other companies mentioned. He welcomes your questions or comments. The Fool has a disclosure policy.


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