Amy Myers Jaffe Explicates the Shale Oil Revolution

I think the most important fact that a lot of the analysis [on Middle East conflict] somewhat failed to see in thinking about of our energy future is a fact—one that I have been saying like a broken record and even wrote a book about, something that even the oil industry itself loses sight of—the oil industry is a cyclical industry. The oil industry has been going through booms and busts since the 1800s, and those booms and busts are connected, in great measure, to the general business cycle—both in the US and the global economy. I’ll give you the two-minute summary of the last go-round for the latest boom cycle, though I know we are all familiar with it after having lived through it so recently.

We had tremendous growth in the global economy in the 2000s, and that meant we needed more energy, which in turn helped create rapid growth in demand, and that demand push helps raise the price. People see the rising oil prices and get the “price signal” to drill. But there’s a time lag between the time you think the price is rising, when it is time to invest, and the time when new projects actually come online. As we wait for the fruits of this new investment to hit the market, the price of oil keeps going higher. Finally, the rise in the price of oil gets to the point where it’s so high it creates economic dislocation. The burden of high energy costs sets us into the cycle where oil demand starts to fall. In fact, oil demand goes down just about the time as new supplies are coming online. The price of oil collapses, and we’re back in the same place. The bust cycle begins anew.   

So when I would talk about this boom and bust cycle in 2005 and 2007, people would heckle me off the stage because it looked like the price of oil was going to be high forever. I think it’s important to go back and reanalyze the intellectual framework for believing the price of oil would be high forever. We imagined, incorrectly, that we were running dry of oil. We were told that there was a permanent shortage of natural gas in the United States and Canada. The markets moved into a euphoria that drove prices unrealistically high, and now we have to step back and think about what it meant. In light of the understanding that the idea of geological shortage and permanently high prices was always wrong, we now need to go back and revisit the intellectual framework regarding the ease of implementing a transition away from fossil fuels because our prior understanding was based on the idea that fossil fuels were going to be increasingly scarce. We now know once again that oil is a cyclical commodity and therefore scarcity won’t be the obvious driver.

In 2005 we started to invest $6 billion a year as a nation subsidizing biofuels. And we did that until 2011, a really long period of time. You might ask yourself, are we really actually any further along on the cellulosic biofuels puzzle? If you look at the recent prices in the RIN credits on a national level, we are clearly not as far along as maybe we thought we’d be, and I think the RINs problem has presented the fallacy well. However, focusing only on that side of the puzzle—did we spend enough on R&D, did we spend enough on the right kind of R&D, did we pick the right kinds of biofuels for research, did we have the right people doing that research?—if we focus only on that, we miss 50 percent of the puzzle. The other 50 percent of the puzzle is that innovation was happening in spades in the private sector. It wasn’t a matter of public and social investment policy. The price of oil and gas was high, and that meant that everyone with an extra dollar was willing to invest it in oil and gas. And guess what? Innovation did not just happen from our social and public spending in clean tech. Innovation happened in the competing fuel, in oil and gas.

So there was this premise that somehow—and I think a lot of people in the environmental movement felt the same way—if we could just have this price-level playing field, if the price of oil were $100 or $200 a barrel, then that would enable renewable energy, and the energy transition would happen naturally. That thesis happened to coincide with a bunch of people in countries that are members of the Organization for Petroleum Exporting Countries (OPEC), seeing the massive oil demand growing in China and the developing world would give them the opportunity to constrain supply in the world and get this higher price they need to try to quell the inevitable social instability that was taking place in their countries. And so you got this confluence of influences.

In places like the United States and in Europe, we weren’t feeling like flying across the globe to diplomatically seek a lower oil price because we thought it would enable a transition to alternative fuels. You had the Arab world with simmering discontent and leaders there thought they could quell this discontent by just having a lot of oil money sloshing around—which, again, turned out to be incorrect. And at the same time, we all moved away from the idea that oil is a commodity and prices are set by market forces in the long run. We forgot that over and over again history has shown us that when prices move too high, gravity will set back in and there will inevitably be a supply boom and a price correction.

When the Middle East producers held the price above $70 dollars artificially over the last decade—which they really did despite what they might have said about market forces—by not investing in more oil and restraining output at particular times of the year to create inventory drawdowns that would create a periodic sense of scarcity. By doing all those things, it led to the investment community getting confused that those things meant we were in a scarce time geologically. That meant that everybody with a shovel could go out and look for oil and gas in the most obscure places, and the most extreme and unconventional resources could be successful at making money. It created the euphoria within the investing community, which began to think that even if it was going to cost them $200 a barrel to exploit an oil source, it was worth doing because the price was going to be high forever.

What actually happened is truly significant, and it’s significant beyond the resources and beyond the words “shale” or “fracking.” This is about an explosion in technological breakthroughs. We need to move beyond the rhetoric about “fracking” and understand that these oil companies that we speak about negatively are companies filled with thousands and hundreds of thousands of science people. We don’t think about ExxonMobil as a science company, but they are. Starting with George Mitchell, the man who saw we could get to the technology to produce oil and gas from what I call the “source rock,” we can produce oil not the way we have for decades, but in new ways that will allow infinitely more supply.  

For those of you that don’t follow oil and gas closely, I’m going to grossly oversimplify. In the olden days, we would have to drill through the ground and many layers of rock to find a pocket of oil. Imagine a little pond of oil that was caught in between layers of solid rocks—that is what the industry calls a trap. We came up with all kinds of technologies that do that better. Ways to shoot seismic so we could better see where the trap was, and then we came up with better technologies so we could distinguish that the thing in the trap was actually oil. We kept improving and got to the point where we could find these traps with oil deep in the ocean. And George Mitchell had a different vision—he was a man of physics, and he believed that you could produce oil and gas, not from these traps or pools of oil, but from the actual rock where it was formed. I use the word “rock” for those laypeople in the audience so you can picture it visually, but rock is not actually the correct technical term. Shale is one kind of rock-like material from which the industry has, of late, had success in producing oil and gas. But that same technology can squeeze oil and gas out of any kind of material under the ground, and people are working on the science of going beyond the shale to other kinds of source rock.

What this means is that as a society, we are going to have to make decisions not on the basis of scarcity. Once we can produce oil and gas from the source rock, it is not in the time frame of our generation that we will “run out” of oil. Because of this technology innovation, and because the Middle East has made this error in economic judgment in holding the price of oil at about $100, and because of all the conflict in the Middle East, geology is not going to offer us the easy out. We will have to make decisions about social values and future generations. We will have to make the hard choices ourselves.

The bottom line is we have so much oil and gas for the future that any discussion of climate change or alternative energy or foreign policy must be taken in that context.

For the next two to three years, we will still have to worry about what happens in Saudi Arabia, but eventually, with unconventional oil and gas, we will have enough oil and gas for the normal boom and bust cycle to reassert itself and for the price of oil to fall, as has already happened in natural gas. Citibank is predicting an additional 4 million barrels per day of oil supply in the United States, and that’s not counting progress in unconventional oil in the rest of the world. Now there are a lot of oil and gas people who will say that the overall forecast of Citi is way too optimistic. Shale will be “hard to do.” But every time companies move to a different place in the US to exploit the shales—eventually they are figuring it out. You have all heard of the Bakken in North Dakota, and now more and more of you are hearing about the South Eagleford in Texas, which is going to be producing one million barrels a day soon. But you haven’t even heard about the Permian basin yet. The players down in the Permian say that it could become a two-million-barrels-a-day play. And Citi is projecting 4 million barrels a day overall by the early 2020s, but they aren’t considering the Permian as the main significant production area in their data, so even their forecast could be incorrectly pessimistic. 

One of the things we’re facing in terms of social dislocation is that this oil from source rock can be produced on almost every inch of this country. As Americans, we’re used to using as much oil as we want. We feel comfortable having 350 million cars on the road and using them as much as we want. And we feel comfortable doing that, quite frankly, speaking as a person who raised her children in Texas, because all the pollution and after-effects that come from that industrial process of producing that oil we are using in our daily lives, are limited to Texas and Louisiana, and so therefore, the rest of the country feels that that’s alright. 

But all of a sudden, now that the oil production for our country can be all around our country, people are saying, “I don’t want to have industrial activity near my farm in Pennsylvania or where I live in upstate New York, so we have to do something!” And we do have to do something because we don’t want to drill a hole in every inch of the United States. But the reality is that given the breakthroughs in the oil industry, we could actually drill a hole in every inch of the United States and have plenty of oil and gas at a really low price, if you want to maintain a fossil fuel-based American lifestyle. 

This, to me, is the real challenge of the transition: understanding that we could continue with business as usual, and we cannot count on the high price of fuel in the business as usual as constraining us. What we know now is that however much public money that we will invest socially in other kinds of fuel, we’re going to have the same amount of capital poured into oil and gas because it is so available, and the financial reward of producing oil and gas will continue to be high, especially given the unrest in the Middle East. There is so much money to be made selling this oil because the world will use it. The momentum of that is huge and will be difficult to overcome.

For those of you who are skeptical that there will be a lot of oil produced in the United States, one only has to look at the experience of the last ten years in unconventional natural gas. That the price collapse and supply surplus have already happened in natural gas is easier to see. Oil people try to comfort themselves by saying, “Well, when the price of natural gas goes down, people will stop drilling.” First, that hasn’t happened yet: it happened that the surplus was starting to get clearer in Texas, so some companies did stop drilling, but a lot of that drop is just capital moving out of Texas to the Marcellus in Pennsylvania because the Marcellus itself is also so prolific. Injections to storage of natural gas continue apace because there’s so much natural gas coming from Pennsylvania that producers in Texas are being forced to put their own natural gas into storage because they cannot find enough buyers. Therefore, analysts are predicting an additional collapse in natural gas prices this fall. When we do the long-term supply simulations, which we’ve done with my research team first at Rice and now at UC Davis, the modeling forecasts show that you don’t run out of shale gas resource in ten years—you don’t run out of US Shale gas resources even if you start exporting them as liquefied natural gas. There’s so much resource that the computer tells you that you can stay between $4 and $6 per mcf for natural gas in the United States for thirty years or longer. And my intuition is that based on history, we might not see an average price that high because the technology to produce natural gas from places that aren’t the top tier sweet spots might improve over time, and so we won’t see production from expensive, $8-per-mcf natural gas reservoirs as the forecasts currently predict.

So what does that tell us about the oil market? To tell you what it means about the oil market, I’d really have to be psychic. There are so many things that could happen geopolitically that it makes it very hard to talk about these under-the-ground realities and seem convincing, because the above-the-ground things really influence the short-term prices more than any other factor. There’s no shortage of conflicts in the Middle East to hold up the price of oil in the short run. The war in Syria is not only a proxy war between Saudi Arabia and Iran, but a proxy war between Saudi Arabia and Iran, with Russia backing one team and the US sort of semi-trying to support the other. In sum, Syria is a conflict with a complex number of players with a complex number of global parties backing them and who have complex interests. If you think that Iraq has turned out messy, multiply that by a million, and that’s Syria. 

On top of that, we don’t know what’s going to happen in Venezuela in the transition in the aftermath of the death of Hugo Chavez. We don’t know what’s going to happen long-term with the policies on oil and gas in Russia. But most importantly, we also don’t know what the long-term stability is going to be like in the oil producing regions of Saudi Arabia. Last summer, a religious leader named Nimr al-Nimr was arrested by the Saudi government. The news wasn’t broadcast around the world, but interestingly, Nimr Al-Nimr is on the record as saying that the two to three million Shiite Saudis who live in the oil producing region should secede and become their own country. Analysts point out that Saudi Arabia has so much money that the Arab Spring style protests are not happening there at all. That is incorrect. I could show you videos to the contrary. It’s just not being picked up by CNN. And it’s certainly not being picked up by Al Jazeera because Al Jazeera is controlled by governments that don’t want this to happen in Saudi Arabia. They’re not putting it on television, but that doesn’t mean it’s not real.           

I can’t tell you how long instability in the Middle East is going to hold the price of oil up. But I can give you a historical perspective. The time frame in between the first Egyptian revolution in 1952, when Gamal Abdel Nasser forced out the king of Egypt—and there was the related Suez Canal oil crisis in 1956—and the time where all those 1950s social movements brought about the last Arab socialist regime change was when Muammar Qaddafi overthrew the king of Libya in 1969. That is a 17-year period. 

Between these revolutions, many of you might not remember that there was a ten-year war between Egypt and Saudi Arabia over Yemen. Or people also don’t remember that the 1979 oil crisis didn’t actually happen because the Shah of Iran fell from power; it happened because thousands of Iranian protesters were being shot in the streets in Iran night after night and the oil industry workers decided to go strike in sympathy with the protesters. That is what cut off the oil exports of Iran and caused the 1979 oil crisis. The shah fell from power after the oil was cut off. This kind of event could happen in any country in the Middle East.

So it’s hard for me to talk definitely about the long-term picture for the price of oil because I have all these geopolitical events as the backdrop. It is simply hard to know how all this conflict will turn out and when.

Even with all this turmoil, though, I’m going to spend my last two minutes talking about how the price of oil is going to fall. I know it’s not going to fall in the next week because of the terrible situation in Syria. But if we could be successful in negotiating a cease-fire in Syria and a peaceful transition for Egypt and other countries, then the second peace would break out, and there would be a giant drop in the price of oil. The higher the price of oil goes in the short-term and the longer conflicts hold the market up, the greater the fall in prices will eventually be. The market already recognizes this fact in the oil futures exchange. The future price of oil is already less expensive than the immediate market premium that we’re seeing this month because of the political risk. We already see a sharp discount in the long-run oil price. Speculators are recognizing the supply wave that is coming.

This futures differential between today’s price and prices a year from now is a sign that we are already seeing a beginning of the repeat of the cycle that we saw after ’79 through the 1980s. There are three components that can usher in a long-term downward correction in the price of oil. The first component is that high prices encourage new drilling technology innovation. Last time around, the innovation centered around offshore drilling platforms. We were able to dramatically lower how cheaply we could drill offshore. And North Sea production, which was about 600,000 barrels a day at the time that the 1979 oil crisis happened, mushroomed in the course of just a few years. Every London bank, every rich person in England who had a nickel, put their money into North Sea financial oil trusts. North Sea production went 4 million barrels a day in the space of a very short number of years. Same thing is happening now. The colossal improvement in drilling technology for tight oil will eventually produce a supply bubble comparable to the 1980s. As oil prices rose in the 2000s, consumer countries have correctly responded to the threat from the Middle East and the threat from high oil prices. Governments have put in strong measures for energy efficiency, strong measures for conservation, and strong measures for oil substitutes. We have the market-oriented substitution from natural gas, which is happening on its own without a lot of government intervention. That substitution also deteriorates the demand for oil. But efficiency is a dramatic cure for high oil prices. When you look at the energy charts for the United States, the line for demand in the US is falling, and that decline could accelerate.           

The black line in this picture is the history of oil prices from 1979 – 1998. The red line is oil prices from 1998 to today. If you look at the price peak in 1980, you can see how long the price downturn lasted. You see the blip in the Gulf War here in 1990 but the down cycle was long. 

If you look at the red line upward 2000s oil price line as an economist, you have this blip here where the curve looks like it might be turning down. I look at that and it is hard for me to believe we haven’t turned the corner and that the line is going to go up for ten years. It’s hard for me to believe we’re not about to be in a long-term downturn that matches the black line from the 1980s. Indeed, I have a paper just completed with Mahmoud El Gamal, who is an econometrician. He applied wavelet analysis to this issue of the cycles. We show, by looking at the general business cycle and oil cycle together, that we are about to engage in, in the next three to five years, a major downturn in the cycle, barring a major war in the Middle East that destroys infrastructure. 

It is in the context of a possible oil price downturn, then, through which we may have to work on a energy transition. The energy transition we are considering for the next ten or twenty years could easily have to take place over a period of time where oil prices are falling. We therefore have the possibility that we will need to refashion our thinking on alternative fuel in the context of a structural decline in oil and gas prices. Oil scarcity will not be the force driving a shift to alternative energy. Climate and energy policy initiatives will have to take into consideration the possibility of oil and gas surpluses and lower fossil fuel prices.