Since mid-2011, the U.S. has been experiencing a "shale revolution," in which domestic energy production has increased significantly thanks to advances in exploration and drilling technology. The scale of this revolution and its impact on global supply and demand — and the potential impact of even newer technological breakthroughs, such as cloud computing, artificial intelligence and machine learning — may be larger than many investors recognize.
Financing the exploration and production segment of the energy industry remains a viable path for investors. However, the complexities of the modern energy industry present challenges — especially as renewable energy sources, like wind, water and solar continue to grow and impinge on demand for carbon-based energy sources.
Nevertheless, this shale revolution is poised to reshape our view of U.S. energy independence and, ultimately, the contours of our increasingly modern global economy.
A Fundamental Shift in Prices
We are already experiencing a fundamental shift in how crude oil is priced in the market. For example, consider the case of West Texas Intermediate (WTI) crude oil versus Brent crude oil, which is extracted from the Brent oilfield in the North Sea.
The U.S. contract for WTI specifies a grade of oil that is "light and sweet," less viscous and sulfurous than the grade specified by the Brent contract. Based on the cost of refinement, Brent should trade at a discount to WTI. However, since around 2010, Brent has actually traded at a premium because the U.S. and Canada have been successful in the development of their shale resources. As such, Brent is no longer priced in the market as a spread off of WTI.
Increasingly, supply and demand volumes are becoming a local dynamic. Because of the shale revolution, we may be entering a period of time where the risks to the U.S. economy from geopolitical unrest in the Middle East may be reduced. The U.S. is currently on track to become the largest producer of crude oil by the end of 2018. In the future, such unrest might have more of an impact on international demand for U.S. exports rather than exposing the U.S. to an energy supply shock. This would represent a profound change in energy markets, and it is largely attributable to new technologies that have made the extraction and production of oil and natural gas more efficient and cost-effective.
The Impact of Technology
Technological advancements and cost reductions in natural gas production, energy deposit exploration and drilling infrastructure have made it easier for energy companies to "farm the cube" — a term used among energy companies to describe efforts to capture all of the potential energy opportunities from a cubic section of the Earth. While challenges remain, the benefits of these technologies have made energy production more efficient and could point toward additional efficiencies in other areas.
Hydraulic fracturing, commonly referred to as "fracking," is a technique that uses pressurized liquids to fracture shale deposits, which allows oil or natural gas deposits that were previously inaccessible (or that would have been cost prohibitive to access using conventional methods) to rise through the cracks.
The impact of fracking on energy markets is significant. For instance, it's said that the Marcellus shale, which lies beneath Pennsylvania, could contain enough natural gas to power all U.S. homes for 50 years.1 Access to deposits such as these will radically transform energy markets. Prices will be dictated more and more by local exploration and production costs and will be less reliant on the output of OPEC and other low-cost producer countries.
Seismic imaging has been a tool available to drilling companies for many years, but technological advancements and falling costs have made it more effective than ever. Similar to sonar, seismic imaging emits acoustic waves into the ground and uses the echoes to create a "picture" of what lies beneath. This provides companies with information they can use to more accurately direct their drilling efforts, reducing the costs associated with exploratory drilling — and thereby increasing the profitability of the well.
While three-dimensional seismic images have long been available, drilling companies have historically relied on somewhat less accurate two-dimensional seismic images derived from a single vibration source, due to costs. But that is changing. Not only is the three-dimensional technology more attainable, companies can now utilize four-dimensional analyses that show changes in the flow of fluid beneath the surface over time.
Additionally, energy companies are beginning to use artificial intelligence to analyze seismic imagery, using it to develop oil field models with a level of accuracy and efficiency that human engineers simply cannot match. This data can be used to guide decisions not only about which drilling locations will be the most productive, but about which drilling techniques may be best suited for the situation.
Mobile Drilling Rigs
The increased value of shale energy deposits due to fracking and the improved geographical data provided by technologies like seismic imaging could lead to other efficiencies as well. For instance, it may become more cost effective to mount drilling rigs on mobile tractors so they can be moved in one piece rather than disassembled. If drilling companies are assured that there are more energy deposits available to them and can feel confident that they know precisely where those deposits are, the additional capital required to mobilize their drilling rigs in this fashion may be worth the cost.
Energy companies have long collected data about their drilling operations, but advances in cloud computing are allowing them to offload the cost of storing and maintaining that data while enhancing its usefulness. Recently, Chevron entered into a partnership with Microsoft, using the latter's Azure cloud computing platform and machine learning tools to analyze the vast amount of data gleaned from thousands of individual oil wells. The hope is that the output of this analysis can guide company decision-making regarding exploration, logistics and oil well management — increasing efficiency and safety while driving down costs.2
One way in which cloud computing and machine learning might assist energy companies is preventative maintenance. Each of Chevron's oil wells is equipped with a fiber optic cable that sends more than a terabyte of data into the cloud each day. Chevron can use machine learning to scour the data in the cloud in search of patterns that indicate equipment failure, for example, sudden increases in temperature or pressure or decreases in performance. Once identified, these patterns can be used to anticipate potential failures and bring them to the attention of engineers who can address them before they can negatively impact production.3
Opportunities and Challenges
Nowhere have these new technologies had a greater impact than in the Permian basin of Texas and New Mexico, which the U.S. Department of Energy calls "the nation's most prolific oil-producing area." The geology of the Permian basin is such that the ancient, inland sea that produced the fuel-rich sediments took a long time to evaporate. Over time, the land folded over itself as the earth moved, which resulted in many layers of shale deposits. Before the advent of fracking, these deposits would have been far too expensive to exploit, and without improvements in seismic imaging, it would have been difficult for energy companies to peer through these layers of rock to identify the most viable and most profitable sections of shale.
So today it should come as little surprise that the increased efficiency and production in the Permian basin has led to a bottleneck in the existing pipeline infrastructure. There's simply too much for the pipeline system to handle. The Department of Energy believes that these bottlenecks won't clear up until sometime in 2019. We might expect lower U.S. oil prices sometime next year as a result.
The Emergence of Stable Energy Markets
As U.S. reliance on imported oil is reduced, investors may be able to take solace in knowing that geopolitical risks, which have long been a major factor in introducing volatility that affects future oil prices, may be diminished. In the stock market, more stable earnings from energy companies could lower stock-price volatility while also potentially increasing the multiple that investors are willing to pay for those earnings. Future disruptions in the Middle East may cause the price of Brent crude oil to spike, but it is likely that local supply and demand dynamics will prevail and materially blunt the impact of a serious event. Beyond fossil fuels, the rise of renewable energy sources could have a similar influence, as markets stand to benefit in efficiencies driven by competing sources of energy.
Consumers and businesses will also enjoy the stability of global energy prices, which can lead to better decisions around future spending. If the U.S. government sees increased tax revenue from a more robust economy, energy technology and competitive forces in our private sector could be seen as an underlying contributor.
It is worth noting, from a public policy standpoint, that the jobs in the energy industry in the U.S. cannot be outsourced to a foreign country. The more efficiencies that energy technology can introduce into the exploration and production process, the more likely we are to see increases in the associated labor force. Furthermore, this may allow the Fed to more easily maintain its mandate of price stability over time.
Expect More Technology-Driven Efficiency Gains
Further investment in technology, such as cloud computing, artificial intelligence and machine learning, will garner additional gains in the efficiency — and thus the cost — of energy production. This will lead to a better balance of production levels that meet economic demand and greater price stability over the longer term.
For those interested in tapping into the potential of these new technologies, private equity investments can provide exposure to the next wave of advances. Venture capital firms are dedicated to identifying, nurturing and capitalizing on the next big thing, with a track record of success in discovering new companies that have substantial growth potential. A skilled private equity manager with knowledge of the energy market could be a significant help to an investor looking to navigate the complexities of this fast-changing market and provide an opportunity to take advantage of the ongoing revolution in energy.