Investing In Oil: A History

Investing In Oil: Barrels Of Oil, Miles Of Mud
A Daily Reckoning White Paper Report
by Byron King

The evidence was right there. On its first day of operation, Aug. 27, 1859, Edwin Drake’s well in the small town of Titusville, Pennsylvania, had produced all of 25 barrels of oil from the depths of the earth, albeit the very shallow depth of 69 feet.

It took over a week for James Townsend, who lived in Connecticut and was the promoter and fund-raiser of the drilling project, to learn from his man on the spot, Edwin Drake, about the successful oil well. A nervous Townsend informed almost no one, out of fear that the Drake well was a fluke and would dry up within a short time after the initial success.

Despite the caution of Townsend and Drake, other local speculators began to do what speculators have always done. They approached neighboring landowners with offers to take out leases. With the legalities out of the way, they commenced to put down new wells on lands near Oil Creek.

Overall, the drilling efforts started relatively slowly. Most people still had to overcome the deeply entrenched preconception that it was preposterous to obtain oil from a hole in the ground. But Drake had been successful and had proved the concept. Others attempted to imitate his effort.

Investing In Oil: Catch The Fever

By November of 1859, the first of what would eventually become a forest of drilling derricks began to poke through the treetops south of Titusville. By the winter of 1860, the sounds of men and machines making depth began to echo in the valleys. Most of these early drillers and operators were local folk, or members of an industrious and close-knit fraternity who had grown up in and around the salt well or oil-skimming business.

By the spring of 1860, many people near and far were catching catch oil fever. Their hearts nurtured the hope to mirror the success of Col. Drake. And to a man (and an occasional woman), it was safe to say that the oil prospectors wanted to strike it rich in the process. As is the case in all eras, investment followed hope.

Over the next year, into 1861, an entire investment industry began to spring up along the eastern seaboard to pool funds for the purpose of drilling oil wells. By the spring of 1861, the investment model was pretty much established. A promoter would obtain a lease, and then move to raise funds among mostly well-heeled investors to drill a well on a leased property.

It was a fairly simple business model. Then as now (well, maybe not now…), in an economy in which capital was scarce, investors tended to involve themselves in a business, perform their due diligence, and be careful about those in whom they placed their faith to make a well and return the investment…and then, in April 1861, South Carolina seceded from the Union, followed by other Southern states. The Civil War began…

Investing In Oil: A New Business

When the Civil War started, no one on either side, North or South, knew how much it would cost. In total, after four years of fighting, the Union government increased its expenditures by a factor of 15. Under the governance of Abraham Lincoln, the United States spent well over $15 billion (equivalent to over $300 billion today) to fight the war.

This was an immense sum that the federal government could not even begin to raise through tariffs and imposts. So to generate the funds necessary to conduct the war, the federal government almost immediately commenced to borrow $3 billion by selling bonds. Also during the course of the war, the federal government printed almost $1 billion in paper currency, or “greenbacks,” that was unbacked by gold or silver.

This newly inked federal paper flooded into the national economy as the government purchased all of the goods and implements required to wage war, not to mention pay the troops to do the fighting. As the new federal paper moved through the economy, much of it found its way into the embryonic oil business.

Federal greenbacks had encountered Drake’s well. This combination spawned a form of behavioral psychology that grips the masses of investors once a mania has set in. People saw that there was money to be made in oil wells, and many of them decided to buy into the business, for the most part sight unseen.

The goal of most people was, as is almost always the case, to buy at whatever price was quoted, in the hope of selling even higher. The buying frenzy turned to boom, as shares of stock and the underlying leases flipped and flipped, and flipped again. Drilling wells was almost secondary to the process for many participants, and could even lead to…”problems” if the well was dry. As with all booms, the speculative process eventually begat a selling panic, which is the natural and inevitable consequence of an investment mania.

Still, with investment being channeled into the field, oil started flowing from the ground. The petroleum was flowing from below, and in unprecedented quantities. Yes, there was a market for the refined illuminant. But the problem rapidly became what to do with the substance once it arrived at the surface of the earth, and how to transport it to the refineries. There were simply not enough containers in which to store the oil that was bubbling up from the ground.

Producers began to ransack barns and cellars and trash heaps throughout western Pennsylvania, up into New York, and over into Ohio. They were looking for anything into which they could pour the oil. The list included old barrels that had formerly held flour, whiskey, turpentine, pickles, hog fat, vinegar, and molasses. Old kegs, whether they had held nails or beer, found new lives. Even wash tubs and rain barrels disappeared from households as these items were begged, borrowed, sold, or stolen into the oil patch.

These impromptu oil containers were inappropriate and woefully inadequate in both number and quality, but they were the best that people could find in an agrarian landscape. It was a cruel trick that Mother Nature was playing – yielding her oil to the drillers, and then taking it back as it leaked out onto the ground from unsuitable containers.

Other industries arose almost instantly to meet the needs of this new business of producing oil. Whether the petroleum was ultimately to move by railway or river dock, someone had to haul these barrels of oil from the wells to a shipping point. And soon the countryside was jammed with literally thousands of burly fellows, with their wagons and horse teams, loading and hauling these kegs and barrels of oil. For a price, of course. And the more remote the well, the prettier the price to be charged.

At first, the wagoneers were local farm boys, but soon the demand for labor and the money to be made attracted workers from neighboring counties, and then from other states.

As the Civil War unfolded after the events of April 1861, and particularly after the U.S. government began to call for men to join or muster into the Union Army, a remarkable number of drivers named John Smith, or something comparably bland, began to appear on the scene. These were city fellows escaping the draft, or bounty jumpers who had taken an enlistment bonus and then left an army camp in the dead of night. If a man sought anonymity and wanted to avoid the prying eyes of the outside world, driving a wagon rig loaded with oil barrels in Venango County was the place to be.

The farm trails and dirt paths in and around Titusville and Oil Creek soon became all but impassable. The wheels of the heavily laden wagons ground deep ruts into the soil. Where the roads were covered with wooden planks, the weight of the wagons rapidly smashed even 10-inch-thick lumber into splinters.

The ruts almost immediately filled with water and turned the rights of way into seas of mud. The oil, leaking or spilling from the precious barrels and pouring out from the wagons, turned the mud into a gooey brown muck that caked the wagon wheels and slowed movement even more.

From the outset, oil well operators were looking for ways to move their product at lower cost and with less loss in transit than by using leaky barrels and hauling their barrels in wagons over bad trails. The idea of using a pipeline was not new, wooden lines having been used to move water and even natural gas in some parts of the United States since Colonial times.

Investing In Oil: Pipelines And Investment Boondoggles

Operators commenced to build pipelines in early 1862, but it took several years of experimentation and trial-and-error development before iron pipelines and associated pumping rigs came into common use in the oil fields. Part of the delay was due to vandalism and sabotage of oil pipelines by numerous teamsters, who objected to losing their difficult but good-paying jobs to technological innovation. (Note: These teamsters of old are not to be confused with members of the modern Teamsters Union, who everyone knows do not as a rule engage in acts of vandalism.)

Classical Austrian economics teaches about the concept of “malinvestment.” In short, this is so-called investment that never should have occurred, funded with credit creation that exceeds the natural patterns of growth in an economy. Malinvestment often serves to diminish the wealth of a society, because it represents capital that is allocated in a way that reduces the overall productivity of an economy.

This is as good an explanation as any for what was going on in the Pennsylvania oil patch during the Civil War. Too many fiat dollars led to too many investment boondoggles, too many oil leases, too many oil wells, and too much production. Drillers produced oil at rates far beyond the ability of the economy to absorb. Oil prices fluctuated from an early $50 per barrel to about 10 cents within one six-month period. And the derrick-floor solution to low prices was, sad to say, more production.

Investing In Oil:Oil Is Where You Find It

In the past two decades, oil exploration has evolved from drilling the “bumps,” to utilizing the theory of plate tectonics to help reformulate an overarching strategy for the search. In the modern world of petroleum exploration, plate tectonics provides useful models to explain the nature of ancient deposition environments, burial of sediments, subsidence of basins, thermal histories of rock masses, hydrocarbon generation, deformation of structures, uplift of mountain masses, and eventual erosion and exposure.

In the present, just as in the past, oil is exactly where you find it. And that’s we are going to discuss the Maritime provinces of eastern Canada, where the St. Lawrence River spills out into its eponymous gulf.

Specifically, we are going to take a bird’s-eye view of current exploration efforts in and around Nova Scotia, New Brunswick, and Prince Edward Island, as well as the southeastern part of Quebec. Formally, entire area is called the Acadian region.

During the Pleistocene Epoch (about 1.8 million to 10,000 years ago), nearly all of Canada was covered by vast ice sheets that extended far into what is now the northern United States. As these ice sheets moved southward, they profoundly modified Canada’s landscapes, creating many thousands of lakes and extensive deposits of sand, clay, and gravel that cover the bedrock in many places.

A glance at a map shows a very extensive and irregular coastline, characteristic of glacial sculpting, in the Acadian region, along the Gulf of St. Lawrence and the Atlantic Ocean.

It is not entirely obvious to the untrained eye, but geologically, the Canadian Maritime region is the northern continuation of the Appalachian Mountain system that runs more or less parallel to the Atlantic Coast of the United States. The western side of the Appalachians just happens to include northwest Pennsylvania, where Col. Drake once set great events into motion.

The rocks underlying this Canadian Acadian area were deposited in a Paleozoic sea, about 500-250 million years in the past, similar to the strata of northwest Pennsylvania and western New York. Including most of the Paleozoic and thereafter, these Acadian rocks have been subjected to about 500 million years of successive folding, faulting, and relative movement by geological forces acting chiefly from the east, the direction of the present Atlantic Ocean.

The Anticosti Basin , named after Anticosti Island, of Ordovician to Silurian age (510-415 million years old), underlies the northern part of the gulf. The Magdalen Basin , of Pennsylvanian to Permian age (350-250 million years old), underlies the south. Together, the Anticosti and Magdalen basins cover an area approximately the size of New Mexico.

Current exploration efforts to the north, in the Anticosti Basin, are focused on the Trenton-Black River formation, an extensive formation of marine shale and limestone/dolomite that extends as far south as West Virginia and west into the Michigan Basin. The TBR contains zones of structural and chemical alteration, where the rocks are fractured and chemical changes have greatly increased porosity and permeability.

The TBR has become a major drilling target for natural gas, and some oil, in the northeast United States in recent years, in New York, Pennsylvania, and West Virginia, particularly in conjunction with modern reservoir stimulation methods.

The sedimentary history, as well as the burial and thermal history of the Anticosti Basin, provides it with what is called an “oil window,” meaning that there is strong potential for oil or gas to be present. The potential oil- and gas-bearing zones lie within long structural features that tend to be several miles in length and a few thousand feet wide.

These features are characteristic of the type of faulting associated with regional uplift, attenuation of the Earth’s crust, and sea floor spreading of plate tectonic theory. Outside of the fractured and chemically altered zones, the TBR is bordered by relatively impermeable limestone, which acts as a seal for any buried and entrapped hydrocarbons.

There is a fold and thrust belt of rocks along the eastern margin of the Anticosti Basin and along the western coast of Newfoundland. Shallow wells drilled along this trend in the 1800s and early 1900s produced small quantities of oil that were used locally.

Oil seeps and other bitumen stains are present on rocks at many localities along the coast. In the 1990s, several wells were drilled in this area to test carbonate reservoirs. One well at Port au Port was a moderate success, producing over 5,000 barrels on a seven-day production test.

The southern Gulf of St. Lawrence is underlaid by the Magdalen Basin, which holds a sedimentary column up to six miles thick. This is similar to what one finds in the Permian Basin of West Texas or in some areas of the Gulf of Mexico. Recent drilling has revealed zones of rock saturated with natural gas, evidence of larger reservoirs awaiting the driller’s bit.

There is an offshore structure called East Point (drilled by FINA in the 1970s), already designated a significant natural gas discovery, which contains an estimated 80 bcf of gas in place (GIP). Standing alone, this is too small an offshore project to develop at current prices, but the extent of the reservoir is not known, and it has never been fractured or otherwise stimulated, which could hold the key to producing significantly larger volumes of gas.

Other exploratory drilling in the Magdalen Basin has located sandstone reservoir rocks that are, while variable in quality, very porous and potentially significant sources for hydrocarbon entrapment. The source rocks in the basin, from which oil or gas would have originated during the past many millions of years, are mainly coals and gas-prone shale of Upper Pennsylvanian age (350-290 million years ago).

Using a plate tectonic model, these Pennsylvanian-age rocks are related to the North Sea Coal Measures, across the Atlantic Ocean basin, whence originated much of the natural gas found in the southern North Sea. Conservative estimates of the methane resources in the Magdalen Basin are 76 tcf, but other estimates go as much as eight times higher, 600 tcf.

In the 1880s, there was some early exploration for oil and natural gas in New Brunswick. A few wells hit gas in some sedimentary structures of Pennsylvanian age, but not in great quantity, and the gas found local uses, because there were no pipelines to transport it to distant markets.

New exploration concepts using plate tectonic models, as well as improved seismic processing, drilling technology, and enhanced recovery methods, are very promising in these two almost-unexplored Canadian sedimentary basins.

Both historically and more recently, many exploratory wells have encountered hydrocarbons in the Anticosti and Magdalen basins, demonstrating the existence of a hydrocarbon system that involves generation from source rocks, migration into host rocks, and entrapment at an impermeable barrier. The evidence is that the source rocks are excellent and indicate significant quantities of oil in the Anticosti Basin and gas in the Magdalen Basin.

To the north, in the Anticosti Basin, new prospecting concepts are evolving based on new knowledge of what is called hydrothermal dolomitization, associated with deep faults in the very basement rocks of the continental mass. An extensive network of faults and associated structural deformation occurs throughout Anticosti Island and the adjacent offshore regions.

Depending on the amount of identified and recoverable reserves, as well as on the production rates, both the onshore and the offshore regions of the Anticosti Basin could become major oil-producing areas.

To the south, in the Magdalen Basin, new prospecting concepts are evolving from a modern understanding of what is called salt diapirism, which is related to deeply buried salt beds similar to what one finds in the Gulf of Mexico or southwestern Iran. The deformed salt beds of the Magdalen Basin are extensive in area, underlying approximately 13,000 square miles, nearly the same area as Saudi Arabia’s Ghawar oil field (but alas, without the thick pay zones of that Middle East supergiant.)

Despite its proximity to the industrially developed regions of Canada, and certainly to the vast markets of the United States, exploration in the Gulf of St. Lawrence region is still at a “frontier” stage. It is not overstating the case to say that the biggest and best of the oil and gas prospects in this region are still waiting to be explored and drilled.

The good old days of just drilling the “bumps” are over. But just as in the days of Col. Drake, the oil and gas is out there somewhere. Somebody has to look in all the right places, drill a hole in the ground, and set up a well. If you have not figured it out yet, discovering and producing hydrocarbons on the back end of Hubbert’s Peak is going to be a lot harder than it was in the first half of the ride. And it has never been easy. You can lose your shirt.

Where in this world of ours is another oil boom in the making? You could do worse than to keep an eye on the Maritime Provinces of eastern Canada.

And who, figuratively at least, are the next Col. Drakes of the coming oil boom in eastern Canada? There are a number of oil-exploration firms heavily involved in the Anticosti and Magdalen basins. They have been conducting seismic work, performing ground mapping, leasing up the best acreage of prime oil patch, and drilling test holes “out yonder, where the wildcats live,” to coin a phrase. When the big-time drilling starts in the next few years, you will either be in on the action or on the outside looking in.

This is as good an explanation as any for what was going on in the Pennsylvania oil patch during the Civil War. Too many fiat dollars led to too many investment boondoggles, too many oil leases, too many oil wells, and too much production. Drillers produced oil at rates far beyond the ability of the economy to absorb. Oil prices fluctuated from an early $50 per barrel to about 10 cents within one six-month period. And the derrick-floor solution to low prices was, sad to say, more production.

I am in the process of performing some due diligence with respect to the companies that are working and exploring in and around the Gulf of St. Lawrence. I am arranging a visit to the area to meet with some of the key people involved in the largest plays. And even more fun, I am going to go out in the field and kick some of those Paleozoic rocks.

Investing in Oil: More Oil For The Lamps of China

The title above is a play on an old advertising slogan of the Standard Oil Trust, first used in the 1890s. The business logic a century ago was “What if we could sell our oil to every person in China?”

Today we wonder…what if they bought it?

What prompts the question is a recent slew of articles in reputable publications about China’s quest to secure oil supplies from a worldwide production base. Chinese internal demand for oil outstripped its own domestic production in 1993. China has been a net importer ever since. Chinese demand for oil is growing at double-digit annual rates. China is the world’s second-largest oil-consuming nation, after the United States.

In the past decade, Chinese oil companies have established themselves in Sudan, producing over 400,000 barrels per day for export back to China. This despite Sudan’s ongoing civil war and well-publicized human rights abuses.

China has asserted historical claims to the South China Sea and its significant petroleum potential, to the point of claiming essentially all of the continental shelf beneath those waters based on long-ago Chinese explorations of remote islands. Chinese territorial claims bump up against the territorial claims of neighboring nations such as Vietnam, Brunei and the Philippines.

Chinese companies have made deals for oil concessions in and around Indonesia and Malaysia. Chinese companies have made deals with Russia for development in Siberia. China is on the verge of inking a deal with Canadian interests for access to the oil sands of Athabasca.

Chinese firms have recently signed contracts with Venezuelan interests to invest in that country’s oil regions. Chinese concerns are prowling the coastlines of Argentina and Brazil and the backwoods of Peru and Colombia seeking to join consortia to produce oil and ship it home.

Not long ago, China’s Sinopec, a major oil company, even expressed an interest in acquiring Unocal, a U.S.-based international explorer and producer. Unocal’s portfolio includes a wide variety of oil-producing properties in the United States, as well as significant interests overseas, most notably in Indonesia. In addition, back in the 1970s and 1980s, Unocal was a leader in developing technology related to extracting oil from oil shales.

According to a recent article in The New York Times, Chinese oil companies are aggressively seeking potential deals. Chinese firms are attempting to outmuscle big international oil companies, which is not all that difficult, because Western firms tend to be beholden to Wall Street demands for short-term growth in certain key index numbers. Chinese companies, however, can count on substantial government financial assistance. The Chinese government, through its state-owned banks, can dispense government aid to secure development deals, as well as offer the chance to take advantage of generally lower costs for oil-related development technology from firms in China.

The Times quoted an expert witness who testified to the U.S. Senate Energy Committee that Chinese companies “tend to make uneconomic bids, use Chinese state bilateral loans and financing, and spend wildly.” And why shouldn’t they? China is accumulating a vast treasure chest of U.S. dollars based on its $150 billion annual trade surplus with America. The funds have to go somewhere. The witness continued, “Chinese investors pursue market and strategic objectives, rather than commercial ones.”

“Rather than commercial,” that is, by Western ways of measurement. Perhaps the Chinese are not so much interested in the Western concept of “return on investment,” taught in every business school and used as the measure of the merit for almost all projects under modern economic theory. Perhaps the Chinese are simply interested in securing access to petroleum because they see it as being in their long-term national interest. There is a difference.

Investing In Oil:The Chinese know

The world is a big place, but it does have its own set of dimensions and limits. There is only so much continental landmass on the surface of our blue and green sphere. The rest is oceanic basin. The continents hold most of what geologists refer to as the Earth’s sedimentary basins, and that is where the petroleum is. Well, sometimes that is where the petroleum is; you have to drill and find it. The Chinese know this.

The fortunate explorer discovered oil or gas in such locales as the Devonian sands of Pennsylvania; under the Permian salt domes of the North Sea; or in the Jurassic limestone of Ghawar, Saudi Arabia. For the past 145 years or so, the Western world has been blessed with many fortunate explorers. And the Chinese know this.

During the past 145 years, the geologic and general scientific community has located and identified just about all of the sedimentary basins that the Earth’s crust holds. Most of the basins have been drilled and explored to a relatively high degree of development. The best estimate is that about 90% of all the petroleum that is out there has already been discovered. And about half of that oil has been produced and consumed. And the Chinese know this as well.

There might be a few big discoveries out there, waiting for the driller’s bit. But just a few, and not a big number at all. The amounts of petroleum waiting to be discovered will be relatively big for the fortunate few who make the discoveries, but relatively small in the larger scheme of things, most notably world oil demand. It is a safe bet that there will be no more Ghawar fields, the Vermont-sized monster in Saudi Arabia. And the Chinese know this, too.

In a world in which petroleum production increased every year, due to the opening of new exploration frontiers and a worldwide trend of successful discoveries, there was enough oil to go around. The world was a happy place, wasn’t it? Well, happier than if the situation had been otherwise. The price of oil might have fluctuated a bit due to market forces, or due to political-economic events such as the oil shocks of the 1970s, but the production trend was always upward. Now, however, some of the smartest geologists in the world think that the previous situation is about to change. And there are some very smart geologists in China.

No, the world has not “run out” of oil, but the rate of production growth has stalled, and informed speculation is that worldwide production is about to begin a slow, irreversible decline. The Chinese know this. They are seeking the oil for the lamps of their nation. We live in interesting times.


Byron King
for The Daily Reckoning

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