The Middle East is the oil industry’s Goldilocks Zone. Just as in astronomy there is an ideal band for life, depending on the distance from the sun and the potential presence of liquid water, there are ideal conditions in the world of hydrocarbons as well, conditions that include a long process of sedimentation of organic material in an environment free of oxygen and the availability of large geological traps to contain the oil and gas.
These conditions manifested themselves in the Middle East when, during the Jurassic era, the region was near the Equator and bordered by the Tethys Ocean.
There has been evidence of oil since ancient times. The perennial fire at Kirkuk in Baba Gurgur, which translates as “Father of Eternal Fire” in Kurdish, has been burning for 4000 years and is mentioned in the Stories of Herodotus. Oil’s historic presence can also be seen in the use of bitumen on the walls and streets of Babylon, perhaps even at the base of the Tower of Babel, and from the presence of hydrocarbon seepage on both sides of the Gulf.
But the result of prospecting in the region was not a foregone conclusion. While in Iran, the oil potential was ascertained at the beginning of the century, with Iraq following in 1927 in Baba Gurgur itself, the prospects for discoveries further south seemed limited. British engineers who probed the region considered the Arabian Peninsula free of crude oil, unsuited to the genesis of oil, so much so that they bet they could drink every drop of oil found south of Basra.
Some, however, had a different perspective: Frank Holmes a New Zealand army major, believed in the existence of a large oil field running from Kuwait along the coast of the Arabian Peninsula. Holmes, who trusted his nose more than geological maps of the time, was not entirely mistaken. His searches led to the discovery of the large oil fields of Bahrein and Kuwait. But he failed to discover the big oil field he had imagined, called Ghawar, in Saudi Arabia. This is the largest deposit in the world, with a length equivalent to the distance between Milan and Venice. On its own, it accounts for 5 percent of global production, and there are many gems in the Gulf in addition to Ghawar. Following a line that runs along the Arabian Peninsula there are hundreds of giant oil and gas fields that make this region the hydrocarbon Eldorado.
There is another planet in the oil galaxy where ideal conditions exist for the generation of oil and gas: the United States, and in particular Texas. Here too, the evidence of oil is ancient—the Spanish conqueror De Soto wrote about the use of bitumen in the canoes built by the natives as well as their use of crude oil as a medicine.
But expectations for significant discoveries in Texas, during the first American oil boom in Pennsylvania and California, were smaller. Only the perseverance of another amateur geologist with a name worthy of a Tolkien novel, Patillo Higgins, led to the discovery of the enormous wealth in what would become the capital of American crude oil. In 1901, the Spindletop well produced a gusher, a scenic but uncontrolled and dangerous eruption of crude oil. The event brought the price of oil down from 2 dollars to 25 cents a barrel, and the field, which produced 100,000 barrels per day (bpd), half of all U.S. production, was cannibalized by thousands of rigs and was exhausted within a few years.
Discoveries were subsequently made across the state, moving from East (another giant, East Texas and another price drop) to West. One of the biggest deposits in the world was discovered here in 1923. The well, which did not initially seem very promising, was named Santa Rita 1, invoking the saint of impossible cases.
The West Texas field actually revealed a series of geological strata which, like a giant millefeuille, cover an expanse between Texas and New Mexico of about 500 km in length and 400 km in width and which are defined as the Permian basin.
The Permian is at the cornerstone of what is today the American tight oil revolution, which has brought the declining oil industry back to new production records. In fact, now that the traditional deposits (the creamier layers of the millefeuille) have been exhausted, fracking is allowing extraction of the crude oil contained in the hardest layers, which had been uneconomical for decades.
According to the USGS, the government agency that estimates the potential of American mining, the Permian contains up to 46 billion barrels of oil, 20 billion NGLs and 280 Tcf (trillion cubic feet) of gas, doubling the total amount known in the U.S. and rivaling the top deposits in the Gulf.
Therefore, Texas, which was producing 1 million bpd just ten years ago, is now producing 4 million. If it were part of OPEC, it would be the third largest producer after Saudi Arabia and Iraq. U.S. tight oil production, which includes contributions from oil fields in North Dakota and New Mexico, amounts to 6.7 million bbl/day, more than half of all U.S. production.
This second oil planet, however, is also the most destabilizing factor for the oil market, as the operating rules of this particular world are vastly different from the industry’s traditional procedures. The U.S. oil system is the full expression of the animal spirit of American capitalism. It is based on a parcelization model with thousands of operators coexisting side by side, from Exxon to the so-called strippers who produce a few dozen barrels of oil a day from the yards of their own homes.
Historically, production has been governed by the Rule of Capture, a principle derived from English Common Law that applies equally to all captured natural resources, whether oil or game animals. Just as a wild pig is the property of whoever catches it, the oil found underground is owned by whoever extracts it. Hence the race to produce oil, including by positioning the well on the boundary with your next door neighbor in order to “capture” the adjacent crude, thereby maximizing production and avoiding the risk of losing it. This is essentially a Far West like scenario, with everyone against everyone else, making orderly management of production impossible and often causing overexploitation of the oil field due to the drive to produce without limits with little concern for the long term.
Today, there are still thousands of American oil producers, and disciplined production is not one of their virtues. While no longer exposed to the risk of “capture,” since tight oil comes from low-permeability rocks where flow is more difficult, growth is taking place in a frenetic and disorderly fashion and prices can collapse due to overproduction. This leads to the slowdown of production activities and a fall in output that causes a new oil price hike, until a new rebound, oversupply and collapse cycle begins again.
In 2016, output fell to 400,000 bpd due to a reduction in activities after the price of oil dropped below USD 30 a barrel. Two years later, when the price bounced back to over USD 70, production rose to 1.2 million bpd and a new slowdown is currently underway. American tight oil is an animal that moves at a frenetic pace and is capable of accelerating and slowing down in the space of a few months. And the activities are on a unique and unequalled scale. In the Permian alone, an average of 5,000 wells is drilled every year, on top of the already existing 180,000. This figure makes the 18,000 oil wells in the entire Middle East pale in comparison.
The unequal number of oil wells in the two regions conceals a further difference that makes the U.S. model structurally fragile. Tight oil wells have an average output capacity of 500 bpd, which rapidly declines, with production falling by 50 percent within the space of a year. They are basically like a giant, seemingly inexhaustible, matchbox, but one that requires ongoing replacement activities. It is estimated that 60 percent of the wells drilled annually in tight oil regions are designed to offset declining output.
These low productivity levels and high decline rates will set a physical limit to American output growth. When the number of new wells that need to be drilled in a year exceeds the number of drilling sites or drilling capacity, growth will stop. As with all oil fields, production always follows a parabolic trajectory. The light from the matchbox will grow fainter and fainter. For the time being, we are still far from the inflection point, but according to the most authoritative sources, like the International Energy Agency, American output is expected to come to a plateau from the middle of the next decade.
In the other planet, the Gulf, where production is controlled by a handful of national oil companies in joint ventures with a number of foreign companies, operating conditions are very different. The massive scale of crude oil production (the Arabian Peninsula alone accounts for 20 percent of global output) and the productivity of individual oil wells, often in the region of 10 to 20,000 bpd, and their low annual decline rate (4-5 percent), make management planning easier and more stable. The fields in this region continue to produce for decades and even centuries. To give an idea, four out of the five discovery and appraisal wells in Ghawar are still in production after almost 70 years of activity.
A further key factor in the region is its role as an oil reserve in case of crisis. A few countries (Saudi Arabia, Kuwait and the UAE) maintain a spare production capacity that gives them the ability to raise output quickly and offset possible supply shocks. Today this buffer, which amounts to 3 percent of global demand, means that 3 million bpd can be put into production within 90 days and sustained for an indefinite period. Without these supplies, and in case of shocks, one should expect American drilling to offset any shortfalls. But bottlenecks in drilling and fracking activities are likely to occur. Prices would probably rocket, and falling demand would effectively become the balancing factor in the market.
In conclusion, despite the strong focus and emphasis placed on American oil output, the world of oil will continue to revolve around the major reserves of the Middle East. The revival in U.S. production is an important but temporary phenomenon. It gives a perception of abundance but does not eliminate the risk of oil price spikes. It requires an ongoing effort to develop what is a fragile and ephemeral production capacity. The other side of the galaxy, the traditional Arabian Peninsula, will continue to be key for guaranteeing the continuity of production, at a lower cost, and could still have major surprises in store in terms of new discoveries as exploration has been limited in the last forty years.
We are binging on fast food, on hamburgers and Coca Cola. This is a practical and quick way to build up calories. But it is not a balanced diet. It won’t be long before we return to something more traditional.