Liebreich and Blanchard: Thinking about energy – the lure of laziness

By Michael Liebreich, Chairman of the Advisory Board

and Charles Blanchard, Head of Gas Analysis

Bloomberg New Energy Finance


Forecasting oil prices, as I have noted before, is hard. You build huge data sets of supply curves and stocks; you create complicated demand models; you overlay geopolitical analysis at the deepest level of granularity you can afford; you mine big data for the impact of speculation and trading. And then you explain to your boss why you are right and the market is wrong.

Most people just use simple heuristics. According to Wikipedia, a heuristic is “a mental shortcut that eases the cognitive load of making a decision.”

In any industrial transition, lots of formerly reliable heuristics have to be scrapped. One of the most exciting developments of the past five years is the debunking of the assumption, which has served for many decades, that renewable energy is always expensive. It is simply not true any more.

The problem is that once you get used to a heuristic, and it has worked well for you, it can be hard to ditch. A key area of research in behavioural psychology is the extent to which people use simplistic heuristics to make very momentous decisions, and decisions that would yield to analysis. As we see from the news, engineers at VW relied a little too much on the heuristic that no one ever checks what emission control software actually does.

Heuristics about energy are not only useful, but also serve as tribal markers, so that when analysis points to a conflicting conclusion, people are tempted to reject it and stick with the heuristic. A case in point: last quarter renewable sources supplied over 25 percent of the U.K.’s electricity, at a subsidy per household equivalent to two cappuccinos per week. Any sensible person would herald this as good news – a quarter of the country’s power demand removed forever from the reach of Russian gas producers – yet the government and its allies in the press continue to rail against “expensive subsidies”. It is simply easier to keep saying this than to accept the reality of affordable clean energy.

Related to that is a heuristic that says that as renewable power penetration goes up, so it gets more and more expensive to integrate. When New Energy Finance started in 2004, conventional wisdom was that no grid could cope with more than 5 percent variable renewable generation. Over time, that figure went up to 10 percent, then 15, and so on. If your business model is based on the idea that there is a saturation point beyond which renewable energy cannot be integrated into the system, I would suggest you think again.

There is another heuristic that holds thrall across traditional and clean energy folk, and that is the idea that the cost of fossil fuels must inevitably rise over the long term.

The most strident proponents of this view are, of course, the Peak Oil crowd, whose simple model of depleted reserves leading to unaffordable prices and societal breakdown was all the rage a few years ago. They have been strangely quiet since the arrival of unconventional oil and gas, but they should be pressed on whether they have changed their views on prices – views that, it is now clear, distracted and misinformed the debate.

Less apocalyptic versions of the ever-more-expensive-fossil-fuels heuristic abound. According to REN21, no fewer than 145 countries now have policy frameworks in place to support the uptake of renewable energy – ranging from feed-in tariffs to reverse auctions, portfolio standards to tax rebates – and almost none of them have sunset clauses. People, so the thinking goes – will never object to endless renewable energy and energy efficiency subsidies, because they see traditional energy sources getting more and more costly. What if this thinking is wrong?

To be fair to Transitionistas, they are not the only ones who subscribe to the mirage of ever higher future fossil fuel prices. In 2008, Goldman Sachs was warning us of $200 oil; Alexey Miller, chairman of Gazprom, was predicting $250; the late Matt Simmons, rock-star banker to the oil industry, went for $300; and Patrick Artus (still gainfully employed as the chief economist of Natixis) used his crystal ball to come up with a forecast of $380 by 2015 – or maybe he missed a decimal point!

Even after last year’s price crash, Abdulla El-Badri, secretary-general of OPEC, has been warning of $200 oil. Almost every mainstream oil analyst is still expecting oil prices to head back towards the $80 to $100 range as U.S. unconventional production falls away. Indeed the whole Saudi strategy of opening the spigots and regaining market share is based on the assumption that after a period of painful oversupply, prices will rebound towards at least $75 a barrel, which we are told most OPEC countries consider fair.

This is dangerous stuff. The history of the oil and gas industry is the opposite of long-term price increases, punctuated by periods of low prices. In real terms the history shows long-term price declines, punctuated by periods of high prices.

The expectation that the current oil price crash forces U.S. unconventional producers out of the market – perhaps after a year or so as their existing wells deplete – which will drive prices back up nearer to $100 than to $50, misses one of the most important stories of the last year: how those U.S. oil and gas companies have been pushing down costs. The surprising fact is that in the U.S., oil and gas unit costs have come down about as rapidly as solar power costs over the past five years. As Charlie Blanchard, head of Bloomberg New Energy Finance’s gas practice would say, do not ever think that Texans, Oklahomans and Louisianans are lazy hee-haws, sitting on their butts, waiting for oil to spurt out of the ground.

A recent presentation by Range Resources1 shows that over the past five years the average length of the horizontal “laterals” drilled in the Marcellus shale in southwest Pennsylvania has increased by 114 percent; at the same time, drilling cost per unit length of lateral has reduced by 71 percent and completion cost by 42 percent.

It is not just that costs are going down – output is going up. The number of operating rigs in the US is down more than 40 percent from the peak, but production per rig has increased ninefold since 2010.

Of course, all this is down to fracking, or “well stimulation” as it is known in the business. Fracking has been around for a while, but it was not until Mitchell Energy combined fracking with horizontal drilling that anyone was able to extract large quantities of gas from shale.

By virtue of a wonderful force called gravity, sediment is laid down on the Earth’s surface horizontally, so most productive hydrocarbon formations are oriented horizontally. When you drill vertically (the old-fashioned way), the amount of reservoir that you can access with fracking is limited by the thickness of the productive layers. By steering your bit and drilling horizontally, you access a far larger resource-rich area.

Improvements in technology and productivity did not stop there. The longer the lateral, the more oil or gas you can access from one location, so lateral length is going up. Down-hole, operators experiment with different and new chemicals, changing proportions of water and sand, and with agents that would increase or decrease viscosity: more viscous is better for getting the sand into the fractures and holding them open – less viscous is better for blasting apart the rock in the first place. Operators are using micro-seismic equipment to verify what is working and what is not. Up-hole, new rigs are able to use the pressure of wellbore mud to rotate the drill bit, eliminating the need for drill pipes. The latest rigs are powered, so they can literally get up and walk from one part of the pad to another.

Blanchard has challenged the rest of the Bloomberg New Energy Finance team to show him anything in their sectors as cool as a 400-ton machine drilling a hole 12,000 feet down, 10,000 feet across, and then getting up, walking 50 feet away and doing it again. A 6-megawatt offshore wind turbine is pretty cool too, but they get Charles’ point.

So renewables are not the only sector of the energy industry aggressively driving costs down and output up. It used to be a good result if a well produced 3 million cubic feet of gas a day during the first few days of production. Now, 20-30 million cubic feet a day is commonplace, and a new record was recently set in Pennsylvania of 73 million cubic feet a day.

Up to this point, fracking has been a U.S.- and Canada-centric phenomenon. BNEF does not expect it to spread overnight, but spread it will.

There are two ways for fracking to go global. The first will be as more LNG facilities are built and U.S. gas is exported. Construction is well under way at Cheniere Energy’s $11 billion Sabine Pass export terminal, which will soon have 3.2 billion cubic feet per day of export capacity. Starting as soon as December 2015, Train 1 will be complete and US LNG exports will begin. A couple of months later, Train 2 begins. By end-2018, three other facilities in different locations will have begun operations, and the U.S. will have emerged as a major global exporter.

In the longer term, more and more countries will start producing their own gas – both conventional and unconventional. With sanctions being removed, Iran is likely to increase exports from South Pars, part of the same gas field as Qatar’s huge North Dome. Meanwhile, a study by the US Energy Information Administration in 2013 found that technically recoverable resources in shale oil worldwide are some 345 billion barrels, with shale gas at 7,299 trillion cubic feet.

Anyone operating in the energy sector today would be wise to assume the following new heuristics:

First, the world will never run out of oil or gas. The Earth’s crust is saturated to varying degrees with hydrocarbons. In the vast sedimentary basins that stretch diagonally through North America, cover much of Russia and North Africa and dot every other region, there are enormous deposits. If they are not producing oil or gas now, it is only because of political, security or economic reasons. And then there are the world’s offshore shelves and basins.

Second, the cost of extracting oil and gas may increase over time, but never to such an extent that it chokes off its own demand. Of course the most easily accessible reserves are exploited first, or most profitably. And yes, the industry will continue its relentless march to lower-permeability reserves, deeper water, more viscous tars, sub-salt resources, and so on, but the application of technology and capital means these resources are ever more cheaply exploited. This week Shell announced that it is abandoning its Arctic plans; it remains to be seen if it will revive them if the oil price spikes back up.

Third, the end-game of any transition to clean energy will not be accompanied by high oil and gas prices – in fact the opposite. So much oil can be extracted at a marginal cost of $20/barrel or less, and gas in some places as cheaply as at $0.25/MMBTu, that it would be naïve to expect producers to hang up their drill-bits until those prices are reached. We are already seeing this in the case of coal: the end-game of thermal coal is accompanied by a prolonged price decline to zero, not a price surge as the industry shrinks.

As a result, the transition will be characterised by an era of unprecedented oversupply and competition between clean and fossil energy. This is the thinking behind the Age of Energy Plenty I described in my keynote at the Bloomberg New Energy Finance Summit this year . The recent revelations of dieselgate may accelerate this trend, as concerns about air quality in cities bear down on demand for oil.

Which brings me to my final new energy heuristic. There are only two ways for clean energy to win. Either demand for ample, cheap fossil fuels is choked off by legislation, driving up costs at the point of use via taxes, carbon prices or regulation – call it the Paris COP21 plan. Or else clean energy competes with fossil in the market and beats it on price, service, resilience and performance.

Demand-choking legislation versus the animal spirits of innovation. I know which one I think is going to win.

1 Range Resources Company Presentation, 28 July 2015

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