The New Economics of Energy
For the last few years, we have been living through an oddly quiet revolution in the energy business. As pundits ponder the potential of electric cars and renewable energy sources, oil and natural gas production is booming, largely due to innovations such as deep water drilling, hydraulic fracturing ("fracking"), and horizontal drilling. This is reshaping the geopolitics of energy, making energy superpowers out of Canada, the U.S., and Australia (see p.12). In the U.S. alone, natural gas and oil production are up about 30% from their respective lows in 2005 and 2008, according to The Economist - and a Wall Street Journal analysis says that last year the U.S. surpassed Russia to become the biggest producer of oil and gas combined.
Although the energy industry has often taken the lead in adopting new technology, its approach to supply chain logistics has been, until recently, relatively old-fashioned.
New technology is creating a host of opportunities in the energy business - but that doesn't mean all of them will pay off. Even as the energy business expands, some projects will fail to make a profit. In fact, the very boom in production that has sparked so many projects is making some of them look like busts. In October 2013, former Royal Dutch Shell CEO Peter Voser said he regretted the company's investments in shale oil and gas exploration. In April, Bloomberg View wondered, "Is the U.S. Shale Boom Going Bust?"
As in all booms, the current energy revolution brings risk as well as opportunity. The truth is that the energy business is living through the best of times and the worst of times. The same technology that makes it possible to extract oil and gas from deep water wells and shale deposits could produce enough energy to drive down the very prices those projects depend on. Right now, oil prices are making much shale oil extraction profitable, while declining gas prices are threatening some gas projects.
Until recently, energy companies drilled for "easy" oil and gas. But the supply of fossil fuel is increasingly complicated to access. As production from traditional wells declines, more oil and gas is coming from shale deposits, deep water drill sites, and other unconventional sources. Most of these projects wouldn't have been practical until relatively recently. And the demand for fossil fuel probably won't decline anytime soon: Any reduction in overall energy use in Europe would be offset by Asia, and renewable energy is unlikely to replace much fossil fuel in the near future.
But deep water and shale projects remain expensive in terms of operations and also need adequate emergency response plans for far-afield rigs. Based on the costs involved, these projects only remain profitable as long as the price of oil or gas stays over a certain amount. Ken Medlock, Senior Director of Rice University's Baker Institute Center for Energy Studies, has been researching breakeven prices for U.S. shale gas wells and has concluded that "some wells are profitable at $2.65 per thousand cubic feet, others need $8.10...the median is $4.85."
But due to the boom in commercial rigs flooding the market with large amounts of natural gas the price in the U.S. is falling: Since 2008, it has declined significantly, from more than $8 per million British thermal units (MMBtu) to $4.22/MMBtu as of July ($ per thousand cubic feet are roughly equal to $ per MMBtu). In Europe, the price was over $10/MMBtu even before the conflict in the Ukraine. If those prices fall below a certain figure estimated by experts to be around $2 per MMBtu, production sites can become unprofitable and even result in the closure of a project.
With prices in flux, operations costs come under pressure - making logistics a crucial part of a profitable project. Especially since, for instance, the costs for shale gas production sites in prospective areas around the world vary widely. A well in the Haynesville Shale in the U.S. state of Louisiana may cost about $8 million, but the same well in Poland would cost $14 million to $16 million. According to experts like Ken Medlock, this is because shale gas development in Eastern Europe is still a young industry and a company would need to import equipment, fracking crews, etc.
Interestingly, the oil and natural gas markets, which once had fairly similar dynamics, have become completely different.
Since oil is relatively easy to transport, prices tend to move worldwide, and they have stayed relatively steady at more than $100 a barrel. Gas is more complicated. If natural gas cannot be transported by pipeline, it must be cooled into liquid form, moved by ship, and regasified upon arrival in port. This means that gas prices can differ significantly by market depending on the distance the gas has to travel in order to reach the end-consumer - and the recent production boom in the U.S., combined with the lack of exports thus far, has sent prices in very different directions worldwide. The volatility in the market for natural gas as well as the high costs for deep water oil drilling have resulted in energy producers focusing on their logistics expenses, both because they account for a significant share of costs compared to traditional projects, and because other investments can't be adjusted as easily. That means optimizing transport, not only to save money, but also to minimize both environmental impact and the time and wages wasted when employees have to wait for equipment. This usually requires a consolidated logistics operation that gives companies visibility across their entire supply chain.
Although the energy industry has often taken the lead in adopting new technology, its approach to supply chain logistics has been, until recently, relatively old-fashioned. "The oil and gas business is very advanced technologically, but I don't know if logistics has ever been a main priority for upstream until quite recently," says Steve Harley, President, DHL Energy Sector. Even now, energy companies tend to focus on acquiring extraction rights, and most industry service providers specialize in transporting drilling equipment, not in running consolidated logistics operations.
"We can bring our experience in hub operations to the energy industry and make sure they're run to optimum efficiency," Harley says. That often means regional hubs to manage, store, and ship inventory from different suppliers. It also means borrowing strategies from other logistics-intensive businesses. Several oil companies have visited DHL's automotive operations to get ideas about how to improve their own logistics - and several have adopted a DHL Control Tower system to coordinate logistics from a single point, with considerable success (see p.10). Although the two businesses are very different, "you could compare the complexity of some offshore energy platforms to a company that has a very large number of vendors supplying components to a single manufacturing site," Harley says. "We can do that very well through systems we already have that can be adapted and applied to this industry to take account of additional transport modes such as helicopters and supply vessels."