Severe Drought Adds to Costs for US Oil and Gas Producers

Severe Drought Adds to Costs for US Oil and Gas Producers

The current drought in the US — the worst since the Great Depression — will raise crude oil production costs by the end of the year if the dry conditions persist, experts say, potentially squeezing refinery margins and pushing up the price of refined products.

Chris Faulkner, chief executive of Breitling Oil and Gas, says drilling costs could rise between 8% and 12% as water shortages impact hydraulic fracturing (fracking) — a process that releases oil and gas trapped in “tight” rock formations, but one which also uses large quantities of water.

Fracking has helped fuel a boom in US oil production, pushing output above 6 million barrels per day to levels last seen in 1998.

However, the process uses several million gallons of fresh water per well, and with two-thirds of the contiguous US currently hit by mild-to-severe drought, the cost of water has sky-rocketed.

We used to get water for 40¢ or 50¢ per barrel, Faulkner said. But as aquifers dry up, local farmers are less willing to sell water they need for crops, forcing oil and gas producers to haul in water from much further away. The cost of water has tripled to $1.20/bbl as a result.

It’s just now starting to affect production, Faulkner said. But if this continues, it’s going to be impacting the price of crude, it’s going to be impacting refining [margins], and it’s going to be impacting gasoline, he said.

The drought also could drive up gasoline prices via the rising cost of ethanol, which is distilled from corn and which by law accounts for 10% of the gasoline that motorists put in their tank. The US Department of Agriculture says the drought has affected 88% of the nation’s corn crop, and front-month corn futures have risen to record highs around $8 per bushel ( OD Jul.23’12 ).

The high cost of corn recently led independent refiner Valero to shut down two ethanol production units, according to sources close to the company.

Refineries currently are meeting the blending requirement by running down stocks of cheap ethanol acquired during a recent supply glut, but those will only last so long.

“Eventually, that inventory will run out and the newly produced ethanol will translate to higher gas prices,” one major refiner said.

Refining expert Andy Lipow said it will take longer for the drought to affect crude production than it has for it to push up corn and ethanol prices.

We still have significant inventory of crude, and there’s adequate supply throughout the world, he said. US commercial crude oil stockpiles currently stand at around 380 million barrels.

However, in some areas where hydraulic fracturing is prevalent, local and state governments have already imposed water restrictions on the oil and gas industry.

For example, the Susquehanna River Basin Commission has banned water acquisition for fracking operations in several Pennsylvania counties, affecting Breitling, Exxon Mobil, Chesapeake and other companies active in the Marcellus Shale natural gas play ( NGW Jul.23’12 ).

“Conversations have changed from, ‘You’re contaminating my water’ to, ‘You’re using up my water,'” Faulkner said of his dealings with residents in some areas where Breitling operates. And Faulkner sympathizes with such concerns. “[Water] is a precious commodity, not only in India and China but here, too.”

Meanwhile, upstream companies are experimenting with ways to recycle the water they use for fracking, including investments in desalinization. However, these processes are expensive and could drive up the cost of oil production, which in turn could make refined products more expensive.

The drought also has disrupted the transportation of crude and refined products by river barges. The Mississippi River’s water level has dropped precipitously, slowing barge traffic to a crawl.

It affects barge traffic, Lipow said. You have to load less on your barges to lessen your draft.

The National Weather Service says it expects drought conditions to last until Oct. 2012, but Faulkner said he has heard reports that they might extend “well into 2013.”


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