DEPLETION: THE FORGOTTEN PART OF SUPPLY AND DEMAND

By Matthew R. Simmons, Simmons & Company International

While there are hundreds of published forecasts on the supply and demand for oil, some
extending all the way to the year 2020, the industry has no published estimates as to the
average decline rate, or depletion of the existing supply base. Any knowledgeable
observer of the oil and gas industry knows that all hydrocarbon reservoirs ultimately
begin a production decline. Many small fields only maintain peak production rates for a
short period of time before steep decline begins. Yet no one produces reliable field by
field decline estimates, let alone even makes a guess at the current blended rate of for
the worldwide production base of oil and gas.

The issue was not particularly serious for years when a high percent of the world’s oil
and gas production was coming from giant fields years away from beginning to
experience any decline. And, when the world had tens of million barrels per day of shut-
in capacity, decline rates were only relevant to the owners of a particular field.

Today, the world of oil and gas is quite different. The amount of shut-in capacity is, at
best, only three to four million barrels per day, less than 5% of present demand. An ever-
increasing percent of the world production base now experiences high decline rates,
particularly if a massive amount of added development and workover activity is not done
to slow these declines. Moreover, a large number of the giant older fields which anchor
the world’s hydrocarbon production base have now started to decline.

As a result, it is becoming impossible to accurately predict the supply side of any oil or
gas forecast without dealing with the issue of depletion. And the rapid use of all the new
forms of oil field technology has tended to increase the decline rate of many fields, once
peak production has been achieved.

WHAT DEPLETION IS ALL ABOUT

All oil and gas wells exhibit declining oil and gas production over time, commonly called
“depletion.” As a well produces, the reservoir pressure typically drops, causing the

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production to decline. In many cases, artificial lift (gas-lift, rod pumps, electrical
submersible pumps, etc.) can extend the life of the well, but the production rate will
eventually decline below an economic limit and the well will be shut-in and permanently
plugged.

Wells producing from reservoirs with an active reservoir pressure maintenance program
also experience production declines once the injection fluid (usually water) reaches the
producing well. In many cases, the total liquid produced from these wells will remain
constant, but oil content declines as the fraction of water being produced
increases. The oil production declines because the amount of water in the reservoir
near the producing well(s) continually increases. This increasing water saturation
impedes oil flow into the producing well. The water does not completely sweep the oil
and as a result, a significant portion of oil is left behind in the reservoir.

In the early 1900’s, the goal for many companies was to produce the oil out of the
ground as quickly as possible; a term we call ‘blowdown’ production. As many wells as
possible were drilled, sometimes 10 wells per acre, which damaged the reservoirs and
significantly reduced the ultimate recovery. In these cases, the individual well and total
field rates were extremely high and declined off very rapidly in this ‘blowdown’
production mode. At the height of the development of the East Texas Field in the early
1930’s, there were 12 wells drilled on 1/5 of an acre in Kilgore, Texas!

Eventually, regulatory authorities limited the number of wells drilled to typically fewer
than 16 per square mile (or 1 well per 40 acres). Usually the number of wells initially
allowed was far less than this and as the reservoir produced, the well density could be
increased as dictated by the effectiveness of the current well spacing and recovery
mechanisms. In this development scenario, the reservoir is developed over time with
new wells almost continually being drilled and adding to the overall field production. This
ongoing development activity masks field depletion as the new wells all or partially offset
the decline form the older wells. The Prudhoe Bay Field on Alaska’s North Slope
illustrates this.

Prudhoe Bay is a classic example of depletion. First, there is sufficient production history
to illustrate depletion. Second, high quality production data is available for the life of the

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field. Third, Prudhoe Bay’s operators have applied “best in class” reservoir management
practices. Graph 1 shows the monthly oil, gas and water production history from
Prudhoe Bay since start-up.

Graph 1: Prudhoe Bay Field Production History

10,000,000
10%/Year

Gas

bo 1,000,000
pd Oil
or
mc Water
f/d
100,000
ay

10,000
1977 1980 1983 1986 1989 1992 1995 1998
Source: PI/Dwights, Simmons & Company International

Oil production was constant at 1.5 mmbopd from 1980-1989, which was the maximum
allowable volume for Prudhoe Bay into the Trans-Alaska Pipeline System. Prudhoe Bay
reservoir pressure is partially maintained through a water flood in the “oil rim” and gas
injection into the reservoir gas-cap. Even though field production was flat, the number of
wells gradually increased during this same time period and both gas and water
production increased. Individual wells exhibited declining production, offset by new wells
being drilled and completed.

The production data is graphed on a semi-logarithmic scale, even though it tends to

visually ‘mask’ the severity of the decline rate, because this is a standard technique in
the E&P industry. After 1989, total field-wide production began to decline, falling from 1.5
mmbopd to 0.6 mmbopd in 1998. This is a 10% per year depletion rate. However, during
the last nine years, over 575 new wells were brought on line which partially offset decline
rate. Graph 2 shows the production profile for all Prudhoe Bay wells drilled and
completed before 1989. The decline rate of only the wells drilled before 1989 nearly
doubles to 18% per year. During the same time frame, the average producing gas to oil

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ratio increased from 2,700 to 13,000 cubic feet of gas per barrel of oil, and the producing
water to oil ratio increased to almost 2:1 (two barrels of water produced for every barrel
of oil) from 0.5:1.

Graph 2: Prudhoe Bay Production From Wells Drilled Prior To 1989

10,000,000
18%/Year

Gas

1,000,000
bo Oil
pd
Water
or
m 100,000
cf/

10,000
1977 1980 1983 1986 1989 1992 1995 1998
Source: PI/Dwights, Simmons & Company International

The depletion rate at Prudhoe Bay, ranging from 10% per year to 18% per year, is
driven by the activity level. In addition to drilling new wells, the Prudhoe Bay Field
operators increased gas injection capacity from 4 billion cubic feet per day to 8 billion
cubic feet per day during the early 1990s. Since the produced gas is re-injected,
increasing the gas handling capacity allows for higher field-wide oil production rates,
partially offsetting depletion.

As Simmons & Company has delved deeply into the depletion issue, we created two
new oil & gas terms: “gross depletion” and “net depletion.” We define gross depletion as
the depletion rate with no drilling activity; in the Prudhoe Bay example, the gross
depletion is 18% annually. The net depletion is the depletion rate with on-going and
future drilling activity; in the Prudhoe Bay example the net depletion rate is 10%
annually. It is important to note that the gross depletion case is not a ‘do nothing’ case.
Workovers of existing wells and the implementation of secondary or tertiary recovery
techniques are captured in the production profiles, which tend to offset base production
decline. Thus, a true ‘do nothing’ scenario at Prudhoe Bay (just basic maintenance)
would have a production decline significantly higher than 18% annually.

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Several factors influence the levels of net and gross depletion rates. They include the
maturity of the field or basin, including reservoir rock and fluid properties, availability of
existing infrastructure, recovery mechanism, and the aggressiveness of the development
program (which is a function of oil price).

Preliminary analysis of many other basins that we are currently studying shows
that gross depletion rates in the range of 15% to 20% per year are typical!

THE DIFFERENCE BETWEEN GROSS & NET DEPLETION IS A LOT OF DRILLING

It should be clear from the Prudhoe Bay example that the difference between gross and
net depletion is a lot of added drilling and work-over activity. In order to accurately
forecast oil supply, at least from all non-OPEC sources, the base or “gross” level of
depletion must be known and the planned level of added drilling activity level accurately
anticipated.

For many OPEC producers, depletion is also becoming a very significant supply issue.
Senior oil executives at Venezuela’s PDVSA have estimated that PDVSA needed to
increase their 1997 oil production by 1.2 million barrels per day to effect a net increase
of 350,000 barrels per day as their gross depletion rate “using up” the additional 850,000
barrels per day. OPEC producers like Saudi Arabia and Kuwait still have the luxury of
enjoying flat production from some of their large fields, though recent reports from both
countries indicate that both Ghawar and Burgin, the world’s two largest oil fields are now
beginning to encounter serious water problems and are starting to experience field-wide
production decline.

The following graph shows the trend of quarterly non-OPEC supply and international rig
count since 1993. Even though the rig count was high in the first half of 1998, the
production volumes started to flatten out – even though all the rigs in the world were
working!

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 Trends of non-OPEC Crude Oil Supply and International Rig Utilization

47 850

Non-OPEC Oil Supply

International Rig Count
45 800
Oil Production, mmbopd

# Of Active Rigs
43 750

41 700

39 650

37 600
93
93
93
93
94
94
94
94
95
95
95
95
96
96
96
96
97
97
97
97
98
98
98
98
1Q
2Q
3Q
4Q
1Q
2Q
3Q
4Q
1Q
2Q
3Q
4Q
1Q
2Q
3Q
4Q
1Q
2Q
3Q
4Q
1Q
2Q
3Q
4Q
Source: IEA, Baker Hughes, Simmons & Company International

WHAT HAPPENS TO DEPLETION WHEN OIL PRICES COLLAPSE

The recent collapse in the price of oil has started to cause severe reductions in capital
budgets by majors, independents and national oil companies. The rig count has
decreased significantly in the fourth quarter 1998 and we expect this trend to continue
into first quarter 1999. The result of drilling fewer wells will be less new wells completed
and produced. This will almost certainly cause the incremental new production volumes
in 1999 to be less than the underlying production declines; at least in many of the non-
OPEC areas of supply. This reduced drilling activity will result in a decrease in non-
OPEC production in 1999. The severity of this decline will be a function of what
projects are dropped as budgets are cut and the current decline rates in each producing

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area. To the extent the cuts are primarily limited to exploratory drilling, it moderates the
impact on 1999 supply. But, it then has a profound impact on production rates in 2000
and beyond. If budget cuts force operators to slow development activities or bring them
to a halt in some fields, then production declines move toward the “gross” depletion rates
of 15 to 20% or higher in some areas.

THE IMPACT WHICH TECHNOLOGY HAS ON DEPLETION

Some counter or even dismiss the depletion argument by saying that technology has
made it easier add new production volume. While we agree that incredible technology
advances in the upstream sector of the E&P business have been made over the last
decade, adding new production volumes is not easier. A recent study by Simmons &
Company of depletion trends in the U.S. Gulf of Mexico (GOM) showed that decline
rates were increasing for recently drilled oil and gas wells as shown in the following
figures.

Decline Rate Trends In Louisiana GOM Shelf

Source: PI/Dwights, Simmons & Company International I

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 50%

40%
Effective Decline Rate, %/yr

30%

20%

10%

0%
1

96
-7

-7

-7

-7

-7

-8

-8

-8

-8

-8

-9

-9

-9

19
70

72

74

76

78

80

82

84

86

88

90

92

94
19

19

19

19

19

19

19

19

19

19

19

19

19
Wells Completed During Time Period

In fact, 80% of the gas production form the GOM shelf (less than 250 meters water
depth) is from wells drilled after 1991! Thus, drilling new news is a critical component of
maintaining production volumes.

It should be no surprise that exploration and development opportunities diminish over

time in a mature basin. We believe that the broad application of 3-D seismic and
horizontal drilling technologies in the early 1990s may have actually accelerated the
decline rates. 3-D seismic allowed the geologists and geophysicists to ‘see’ smaller
structures that were previously not readily visible on conventional 2-D seismic.
Horizontal drilling technology allowed many of these smaller reservoirs to be developed
from existing platforms with fewer wells, creating an illusion that technology was making
it easier to exploit oil and gas on the GOM shelf. However, once the ‘low hanging fruit
had been picked’, the 3-D seismic technology was driving exploitation of smaller
(marginal) reservoirs.

The following graph showing the reserve distribution illustrates that smaller reservoirs
are found as a basin matures. The graph shows reserve distributions for three separate
water depth increments in the GOM shelf (less than 100’, and 100’ to 300’, and between
300’ and 1000’).

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The data show that the reserves are found early in the life of a basin. In the GOM, we
treat different shelf water depths as different ‘basins’ as technology allowed deeper
exploration and development. The first commercial discovery in the Offshore GOM (up to
100’) was in 1947 and 50% of the reserves were discovered in the first 10 years. The
first commercial discovery for water depths between 100’ and 300’ occurred in 1956 and
50% of the reserves had been discovered in the first 14 years. Finally, the first
commercial discovery in water depths between 300’ and 1000’ occurred in 1965 and
50% of the reserves were discovered in the first nine years.

GOM Shelf Reserve Distribution as a Function of Discovery Date

0.9

0.8 up to 100' water

depth

0.7
Cumulative Frequency Reserves

300' to 1000'
0.6 water depth

0.5

100' to 300'
0.4
water depth

0.3

0.2

0.1

0
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1
Fields, Cumulative Frequency, by Date

Source : Minerals Management Service, Simmons & Company International

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On the GOM shelf, technology has allowed the commercial exploration and development
of smaller reservoirs!

DEPLETION IS A SERIOUS SUPPLY ISSUE

The industry has clearly not taken the issue of depletion seriously. Some have tended to
scoff even at the mere concept, let alone its impact, as being synonymous with the world
running out of oil. Nevertheless, it is a serious supply issue. It is now impossible to
predict with any degree of reliability what the future rates of oil and gas production are
likely to be without first understanding field by field depletion rates. The International
Energy Agency (IEA), for instance, has already missed its fourth quarter 1998 estimated
rate of non-OPEC supply by 4.1 million barrels per day. This must be the largest revision
to their published forecasts in their 25-year history. While their analysts tend to dismiss
these supply revisions as one-time events, they are most likely driven by depletion rates
in too many parts of the world now equaling to exceeding the rate of any supply addition.

To put the issue in its most staggering context, the world now produces approximately
110 million barrels per day of oil and gas (BOE.) If the gross rate of depletion is a mere
10% per annum over the next 11 years, then 83 million barrels per day of added
wellhead oil and gas production is needed to merely cope with flat demand. If demand
for oil and gas grew by only 1% per annum over this same period of time, then the new
supply additions need to total another 12 million barrels per day.

Whether such rates of expansion are even physically possible given the limitations on
rigs and manpower, particularly after the 1998 oil price collapse, is a serious long-term
energy issue that needs at least an intelligent debate.

At the least, the oil and gas industry must pay attention to depletion rates. The industry
badly needs to begin developing supply studies, which clearly incorporate intelligent
estimates of depletion. Otherwise, all future supply estimates will likely be overstated.
Perhaps the IEA’s “supply miss” of 1998 is merely a harbinger of all future supply
forecasts because depletion was badly ignored.

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