The Two Sides of Shale Oil

Sep 01, 2015

Between the middle of 2014 and early 2015, the average price of Brent crude fell from $115.7/bbl to $45.19/bbl, a decline of about 60% . Closer to the end of August 2015, the price had further declined to the level of the $40s . According to the U.S. Energy Information Administration (EIA), the U.S. is set to produce 9.36 million barrels per day through 2015, an increase of about 7.5% over 2014. However, the prediction for 2016 by the U.S. EIA indicates annual crude oil production of 8.96 million barrels per day. Is the forecast decline in 2016 an indicator that shale producers in the U.S. could come under pressure?

Shale will decline   Shale will be resilient
Oil price has dropped from over $100 a barrel last year to $57 today   The Saudis misjudged or underestimated the growth of the shale industry leading up to 2014, from 2005
Over half a trillion dollars of capital invested so far, mainly through junk bonds   US shale frackers are not high-cost; they are mostly mid-cost
Austerity rife among shale producers   Frackers could potentially induce cost savings of upto 45% within 2015 itself, supported by strategies such as switching tactically to high-yielding wells and using smart drill-bits with computer chips to seek out cracks more efficienctly
The top 60-odd shale firms are making a return of roughly zero on the swollen stock of capital they employ   Even in the event of drying up of funds, the fact remains that the technology and infrastructure will still be there. This means that each rise in oil price will be capped by a surge in US output
About half of shale firms, owing $85 billion of debt between them, have distressed balance-sheets   The possibility for "clean fracking" in China exists, through the use of the plasma pulse technology
If prices do not rise, rapid industry consolidation is very likely, concomitant with short-term losses among banks and investors   The US oil industry may exhibit greater staying power, even as leading oil producers groan under rising current spending
Source: The Economist; Telegraph Media Group

Between the middle of 2014 and early 2015, the average price of Brent crude fell from $115.7/bbl to $45.19/bbl, a decline of about 60% . Closer to the end of August 2015, the price had further declined to the level of the $40s . According to the U.S. Energy Information Administration (EIA), the U.S. is set to produce 9.36 million barrels per day through 2015, an increase of about 7.5% over 2014. However, the prediction for 2016 by the U.S. EIA indicates annual crude oil production of 8.96 million barrels per day. Is the forecast decline in 2016 an indicator that shale producers in the U.S. could come under pressure?

With the pressure on the oil price continuing unabated, there is some empirical evidence that it is having an impact on shale producers. The number of rigs in America has been declining steadily since oil prices started to fall. From 1,609 rigs in October 2014, the number of shale rigs fell to about 674 by August 25, 2015 . Independent oil companies in the U.S. are already under a combined debt bill of $235 billion . The downward volatility in oil prices has made investing in shale a highly risky proposition for banks and investors. In October 2015, American banks will reevaluate drillers’ lines of credit. These evaluations are largely based on the value of reserves. Downward pressure on international oil prices means that many shale drillers, especially smaller ones, could be cut off from critical funding.

However, there are arguments that shale production will continue to prove resilient, especially on the back of productivity gains. Some analysts point out that the marginal cost of oil from the American shale plays in North Dakota and Texas have fallen from $70 per barrel to about $50-$60 . There are more optimistic estimates that indicate breakeven prices of about $40, or even $30, in some shale areas. The media in the U.S. has reported that drilling is “[…] still cost-effective down to prices of $10 per barrel to maintain many existing wells across the United States, which is why drillers have not shut in production.”  In an environment of low oil prices, shale drillers have been compelled to adopt new technologies and continuously optimize cost structures. 

The resilience of shale will be closely tied into impending supply and demand dynamics. Though the U.S. shale oil production amounted to only 5 million barrels per day by the close of 2014, i.e., around 6% of global production and consumption; its emergence in the middle of the industry cost curve meant that it has accounted for over 50% of the increase in world supplies since 2010 . In its June 2015 meeting, the Organization of the Petroleum Exporting Countries (OPEC) decided to keep its member countries' collective target of 30 million barrels a day unchanged over the following six months in order to defend market share in the face of rising unconventional oil output. OPEC’ strategy of not seeking production cuts to underwrite the global oil price will hit American shale producers hard. For instance, in early August 2015, the CEO of Pioneer Natural Resources Co., a leading independent energy producing company in the U.S., stated:  "If oil prices go to $40 and stay at $40 for the next 18 months, we'll most likely slow down. But as long as our hedge positions and the (futures) strip occurs, there's no reason at this point in time to slow down." 

Thus, a sustained low oil price environment in the neighbourhood of $40 or below may cause serious disruptions among many U.S. shale producers, who may find it unfeasible to deploy additional capital. However, OPEC may find itself faced with a persistent headwind as well. This is due to the fact that the shale technology and infrastructure would be on continuous standby, given the large sunk costs, to take advantage of any increase in global oil prices. Each episode of increase in global oil prices could be met with almost instantaneous production ramp up on the part of shale producers. Moreover, OPEC will likely find it difficult to sustain a consensus over long time periods, given the fact that OPEC countries like Iran and Venezuela have budgetary oil price break-even prices that are markedly north of the $100 mark. 

Figure: 2014 OPEC Members Oil Break-even Prices
Figure: 2014 OPEC Members Oil Break-even Prices.jpg
Source: WSJ

The international supply and demand scenario is undergoing a period of pronounced turbulence. The case of the key Chinese economy, following unexpected devaluation of the Yuan and the tremors in the Chinese capital markets in August 2015, is a cause of concern for many oil producing nations. Elsewhere, in Europe, too, the recovery is extremely lax and automobiles are getting more and more fuel efficient. Thus, the portents for a reduction in demand for crude oil are getting enhanced.  Conversely, the recent nuclear deal between Iran and the major world powers may lead to a quick lifting of sanctions, allowing Tehran to pump more crude. Iran is determined to take back its lost market share of over 1 million barrels per day that it lost due to biting sanctions imposed in 2012. 

Thus, in the global oil market place, a plethora of players have developed that has injected much unpredictability into the system. The current search is for a new equilibrium in terms of oil price that can satisfy multiple players. Despite multiple forecasts as to what that price is; it is only the market and the unpredictable interactions between multiple players within it that can finally provide the answer. The fate of shale will depend upon finding a niche in that evolving balance.