Deepwater Oil Production- the Key to the Supply Equation Puzzle

I came across this commentary by Rikard Ekstrand in FPA Capital's 3rd Quarter Shareholder Letter. It makes a nice analysis of future oil supply. (There is also an analysis of Circuit City included in the shareholder letter)

The energy sector is by far our largest investment area. We discussed the rationale for our energy investments in the September 2006 Shareholder Letter.We will expand on that discussion here by providing our thoughts on the deepwater segment, which is vital for future production levels. Before discussing deepwater oil, let’s sum up the current demand and supply equation for oil. Over the last four decades, worldwide oil consumption has virtually doubled from 45 million barrels per day in 1970 to 86 million barrels today. When comparing this to discovered oil volumes, the picture becomes bleak. Harry Longwell, a former Director and Executive President of Exxon Mobil Corporation, backdated discoveries to the time the find was made and built a chart that showed that global discoveries peaked around 1960, or almost five decades ago. This was when we were in the beginning phases of using 2D seismic technology. 3D seismic came a few decades later and now we’re using visualization technologies and real-time data when drilling. The diamond drilling bore technology came in the 1960s and revolutionized the oil drilling industry. Despite these large technological advances, global discoveries have declined from close to 60 billion barrels per year in the peak years of the 1960s to around 10 billion barrels today. Thus, after five decades of significant improvements in technology and understanding of where oil is, we are now finding a fraction of what we found five decades ago.

Due to this declining discovery trend, we are now relying on old fields for the majority of our supply. Eighty percent of global oil production today comes from fields discovered before the 1970s, according to 13D Research. How fast these older fields are depleting is of paramount importance. To appreciate the impact of depletion, the U.S. is one of the best case studies. Depletion of the U.S. oil reserves was first signaled by the drop in yield to exploration in 1940, as measured by barrels per foot drilled. But with enhanced technology, oil production kept growing for another 30 years despite a deceleration in yields. Then the inevitable happened; production peaked in 1970 and it has declined ever since. The decline rate has been slowed by incremental production in new areas such as Alaska and the deepwater Gulf of Mexico, without which the decline would have been much steeper and more serious. The U.S. is a good precursor for what is happening in the global arena. The world is now consuming approximately three times the volume of crude it is finding each year. Put another way, at current levels of oil consumption, we are using up and not replacing two thirds of our daily consumption. This is why we have focused our investment on oil drilling companies. Exploration and thereby drilling for oil must increase to keep production levels from declining over time, and this leads us to deepwater oil.

Deepwater oil is defined as oil found at depths greater than 400 meters, or 1200 feet. Remarkable technological achievements have extended the range of drilling from shallow waters to deep waters over the last decade and a half. This has allowed the mapping of where deepwater oil is in the world. It turns out that there are three main regions where it is prolific, the U.S. and the Mexican Gulf of Mexico, Brazil’s Campos Basin near Rio de Janeiro, and Africa’s Angola and Nigeria. The total proved and probable deepwater and ultra-deepwater resource today is 78 billion barrels according to data from Bank of America, of which 44 billion is proved according to IPC Petroleum Consultants. It is this large resource base that is allowing deepwater production to double from production levels of more than 4 million barrels per day in 2006 to over 8 million barrels by 2011, according to estimates from Bank of America and Wood Mackenzie, a consultant to the global oil industry.

However, by 2011, this data points to a sharply slowing and then flattening deepwater growth profile. The reason for this is that a proven resource base of 44 billion barrels is unable to support peak production in excess of 8 – 10 million barrels per day for any length of time since depletion rates would get too large. For example, 8 – 10 million barrels per day, or 2.9 – 3.6 billion barrels per year, of deepwater production implies a 6.6 – 8.3% depletion rate on a proven resource base of 44 billion barrels. The U.K. for example, an offshore province, has a depletion rate of 7.7% — according to Colin Campbell, a retired petroleum geologist who specializes in depletion — and its production peaked in 1999, or eight years ago, at lower depletion rates than currently.

The only sustainable way to get higher deepwater oil production is to prove up the probable barrels and to make substantial new discoveries. Extrapolating the falling deepwater discovery trend suggests that another 5 – 15 billion barrels of smaller finds can be made, according to Colin Campbell. Adding these possible barrels to the 34- billion-barrel probable reserves gives us 40-50 billion on top of the proven 44 billion. In order to continue growing deepwater production beyond the 2011 forecast, we would need to prove up and bring these barrels to production in the near future. However, the reality is that by the time these potential barrels are brought to production, declines in existing deepwater fields, and onshore fields, will eat up a
lot of these gains. Time will tell if substantially more can be found and economically produced in the deep waters around the world. We believe the impact on oil prices will be significant if we don’t find substantially more than the current discovery trend is suggesting; therefore, we remain of the opinion that, in the next decade, oil prices will likely be substantially higher than they are today.

Of course, this does not take into account the demand side of the equation. The general opinion is that future oil demand will soar as the rest of the world begins to develop. But technology can increase efficiency and reduce our demand for oil, easing the pressure from the lack of new supply. See this video by Amory Lovins- We Must Win the Oil End Game.