May 8, 2014
Do You Remember Gadzooks??
June 2, 2014


Ever since oil prices bottomed in 2002, people have wanted to believe that new supply would reduce prices. Over the past decade, they’ve talked about increased Iraqi and Libyan oil; there has been the promise of tar sands and Brazilian pre-salts and now they’re talking about shale oil. Yet, despite all of this talk, world oil production has plateaued for years.

The simple truth is that much of the world’s easy oil has now been exploited. The world isn’t running out of oil any time soon, but we will need much higher prices to bring new supply online. Nothing illustrates this better than last month’s announcement of yet another delay at Kazakhstan’s massive Kashagan oil field. Let me copy a few paragraphs from an article published in Quartz on the latest delay. (read the full article here)

“In another crisis at a giant but star-crossed oilfield, Kazakhstan’s Kashagan will be shut for at least two years while specialty pipelines are made to resist the unforeseen impact of toxic gas, according to a source close to the project.

In recent weeks, word has dribbled out that Kashagan—one of the largest supergiant oil finds of the last half-century—may lie dormant through the summer (paywall) and perhaps longer. But this is the first concrete report that the gravity of the problem means that Kashagan will produce no oil through at least 2016 and possibly 2017.

The costly new lines—probably with a nickel alloy—will replace two 55-mile pipelines, one for oil, one for gas. Already, $50 billion has been spent, and the rework means a delay in billions of dollars in cashflow expected by Kazakhstan itself and major oil companies including ExxonMobil, Shell, Eni, and France’s Total. Kashagan contains an estimated 13 billion barrels of recoverable oil reserves…

…The problem is poisonous and corrosive hydrogen sulfide, or H2S. Some 17% of the natural gas contained within the oilfield is comprised of H2S. That has meant the use of pipelines that resist the H2S corrosion. The Kashagan consortium has said that cracks appeared in the pipeline, a result of the hardness of the steel and the exposure of H2S to water.

The source close to the project said that the cracks appear “instantaneously” when the H2S is exposed to moisture.

Barry Hindin, a corrosion engineer at Battelle Memorial Institute, told Quartz that to best resist H2S the pipeline should be made of a nickel-based alloy, but that such steels can cost 10 and even 15 times that of ordinary pipeline. ”


Just look at how complex the problems related to these mega-projects are—mistakes in engineering can cost tens of millions and delay billions in cash flow. With oil at $100 a barrel, prices just aren’t high enough to justify the investment in many of these projects. At the same time, investors are learning that shale oil wells have higher decline curves than expected, which substantially reduces the economics on many of these projects.

Over the past few months, I’ve heard some very smart people speculate that oil prices will decline as new supply comes online—mainly related to shale oil. This just isn’t the case. If prices decline, it won’t be on the supply side—it will be demand related.

The oil bull market started over a decade ago and is a trend that you can bet on for decades into the future. Every time a Kashagan gets deferred by two years, it will force producers to re-assess their oil price assumptions for investment, and possibly choose not to make the investment. Don’t let people convince you that oil prices are going lower, they aren’t—they’re likely going much higher. If someone wants proof of this, have them do a bit of reading about the decade-long fiasco named Kashagan.

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