U.S. Shale Isn’t As Strong As It Appears

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Yves here. We’d taken our eye off the shale/oil and gas beat for a bit because the cutback in the amount of drilling in the US has made fracking a somewhat (only somewhat) less contentious political issue. The widespread assumption was that rigs would be put back on line once oil prices rebounded. But even with shale gas players supposedly lowering their breakeven costs, it appears oil prices would have to rise to a sustained level of over $50 per barrel for meaningful capacity to be put back into production.

By Nick Cunningham, a Vermont-based writer on energy and environmental issues. You can follow him on Twitter at @nickcunningham1. Originally published at OilPrice

The extraordinary cost reductions achieved by North American oil and gas companies have likely reached their limit, and any boost in profitability for much of the U.S. shale and Canadian oil sands industries will have to come from higher oil prices, according to a new report from Moody’s Investors Service.

Moody’s studied 37 oil and gas companies in Canada and the U.S., concluding that although the oil industry has dramatically slashed its cost of production in the past three years and is currently in the midst of posting much better financials this year, there is little room left for more progress.

“After substantially improving their cost structures through 2015 and 2016, North American exploration and production (E&P) companies will demonstrate meaningful capital efficiency to the extent the West Texas Intermediate (WTI) oil price is above $50 per barrel and the Henry Hub natural gas price is at least $3.00 per MMBtu,” Moody’s said. In other words, WTI will need to rise further if the industry is to improve its financial position.

The report is another piece of evidence that suggests the U.S. shale industry is perhaps struggling a bit more than is commonly thought. U.S. shale has been portrayed as nimble, lean and quick to respond to oil price changes. And while that is largely true, strong profits remain elusive, despite the huge uptick in production.

Shale drillers have substantially lowered their breakeven prices, but further reductions will be difficult to achieve, Moody’s Vice President Sreedhar Kona said in a statement.

“Higher than $50 per barrel WTI essential for a meaningful return on capital,” Moody’s said.

The findings are important for a few reasons. First, it suggests that if WTI remains stuck at about $50 per barrel, U.S. shale drillers might be forced to reign in their ambitions, because they won’t generate enough cash to reinvest in growth. Second, shale drillers might actually worsen their financial position if they pursue growth. Spending more to produce more—while that could lead to more oil sales—might not necessarily be the wisest strategy.

For similar reasons, Jim Chanos, short-seller and founder of Kynikos Associates, has made some headlines shorting Continental Resources. He argues that shale companies simply have to spend too much to keep production going. Shale drillers “are creatures of the capital markets,” he told Bloomberg. “Because the wells deplete so quickly, they constantly need to raise money to replace the assets. And this is the crux of the story.”

Another significant observation is that the shaky financial position for some shale drillers also suggests that the downside risk to oil prices might not be as serious as once thought. The oil market has tried to assess how quickly shale production would come roaring back. Reports that shale companies were posting juicy profits at very low oil prices has likely factored into heady projections for shale output. The EIA has repeatedly projected that shale output would average 10 million barrels per day next year (although they have revised that down recently to just 9.8 mb/d).

But that might be overly optimistic if a long list of shale companies are not posting “meaningful” returns on capital.

“The market may well discover it has been asleep at the wheel and far too relaxed about shale keeping a ceiling on prices forever,” Ben Luckock, a senior executive at oil trader Trafigura, told an industry conference in Singapore last week. Bloomberg surveyed a bunch of oil traders and energy executives at the conference, and the general sense was that oil would trade between $50 and $60 per barrel, up from an informal consensus of between $40 and $60 last year. While there are many reasons for the newfound bullishness, more modest expectations about shale growth is certainly one of them.

In a separate report focusing on larger integrated oil companies, Moody’s came to a similar conclusion—that the substantial improvement in the financial position of the oil industry over the past year is poised to slow down. All of the highly-touted cost reductions and efficiency gains have already been “realized.” Moody’s lowered its outlook for these large oil companies in 2018 from “positive” to simply “stable.”

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  1. PlutoniumKun

    The article touches on this, but a key aspect of shale oil is that, as the analyst Arthur Berman has repeatedly pointed out – as drillers have been focusing on the geological ‘sweet spots’, the likelihood is that shale drillers will need more, not less capital as time goes on to just maintain output, and that output is likely to drop off quite severely once the relatively easy to extract shale oil is exhausted.

    Shale oil is really a sideshow which has been elevated to a major source of production by access to cheap capital. Its no solution to a long term decline in conventional reserves. Leaving to one side the political risks in the Middle East, etc., I think there is a significant possibility of a major jump in oil prices sometime over the next few years. It seems so many investors and economists have very short memories.

    1. A1

      Art Berman missed a bunch of things. One, the shale frontier is huge. Two, as technology improves, the sweet spots become more numerous. And Three, the cheap cost of money does not appear to be going away.

      The anti shale folks are an interesting bunch because they are emotionally tied up in legacy oil and gas production, both the techniques used for production and the companies. The people who know anything about shale are busy doing, not longing for a by-gone time.

      1. PlutoniumKun

        Art Berman is a geologist, he knows perfectly well the physical extent of the shale deposits. It is economists, not geologists who make extrapolations based on limited knowledge of science. Technology does improve the ability to extract oil from less promising deposits, but as Berman points out, there are basic physical laws at work, and one is that more and more energy needs to be expended as the geology becomes less suitable. Eventually, a point of no return is reached.

        And you haven’t had much dealings (as I have) with shale exploration companies if you think they are ‘doing’. They are retreating from most of the most promising areas outside the US (most notably Poland) as they simply haven’t been able to get economic returns. Most of the majors are pulling back from shale, its still a get rich quick industry, nobody is in for the long haul. And the Fed is tightening money. There is simply no evidence of a flood of new investment to match what happened 5 years or so ago, and shale requires a constant infusion of capital to keep going.

        1. Lyle

          Majors with in many cases large legacy lease (and in some cases outright ownership of) land in the Permian Basin are not pulling out but continuing to invest. Partly this is because the old leases require far less in the way of royalties You do have to go on a basin by basin analysis as things differ from basin to basin. In particular the infrastructure for gathering etc is already in place in the Permian Basin since it has been producing for over a century.

          1. bob

            You’re regurgitating sales pitches.

            “Majors with in many cases large legacy lease (and in some cases outright ownership of) land in the Permian Basin are not pulling out but continuing to invest. ”

            It’s pretty well understood and agreed upon that shale is pulling back. If you have evidence to the contrary, you should cite that. If you chose to show that in basin terms, great. Show it.

            Not pulling out…continuing to invest. There are three options- Less investment, equal investment, more Investment. Your statement argues less is not happening, and then blurs the lines to make the case for equal and more. They are mutually exclusive. Pick one of three, not two of three.

            “Continuing to invest” can meet the criteria of all three of the above. They could be continuing to invest, but with less overall investment. They could be investing at the same rate. They could be investing at a higher rate.

            All of which would be continuing to invest.

            The term sounds impressive, and means absolutely nothing. It’s bullshit.

      2. FluffytheObeseCat

        The ‘shale frontier’ and increasing ‘sweet spots’ with improving techniques are real, but mainly in an international context. I.e. Nobody to my knowledge has come back for a second crack at the Monterey after it proved to be refractory to fracking techniques. Most of the best U.S. plays have been identified at this point.

        Some of the reduction in expense in the great west Texas fields is geographically constrained, and may not be reproducible in other regions or other nations. I.e. They’ve been able to use local sands for propants, and it is used there now instead of higher silica, highly uniform sand from the upper Midwest. Shipping costs plummeted with this move, so much that the lower quality of local sand doesn’t matter. There are engineering limits to how low they can go with sand quality, however. And many regions with fine shale potential have deficits of either propant sand or water access, or roads. Paved highways made U.S. shale oil possible. Pipelines and LNG port facilities will keep it going. All 3 are at least partly gifts from the general public. Who donate the right of ways and permits needed to effect these developments.

        Texas fried bs about how “those who can are out doing!” takes real engineers and drillers only so far. Eventually, the guys who do the real work need a viable resource. One that is proximal to critical materials. And infrastructure.

      3. George S

        This sounds like the technocratic cornucopianism that often overlooks the squalor of oil & gas communities. Yes, there are jobs, and good-paying ones, but in the bargain you get poisoned air and water, crime and prostitution, the abuse of women, and other social ills of boom-bust economies. And the bust comes, eventually.

    2. nonsense factory

      The historical notion of growth in oil demand being inseparably linked to overall economic growth is now in question. If economies can grow without the need for oil to fuel the transportation sector, then there goes oil demand. And then oil prices will stay low – too low to recover investments in hard-to-produce oil, such as tar sand oil.

      Back in 2008, recall the projections of $200 a barrel for oil, after it hit a high of $140? It quickly became clear that the previous historical notion, that of oil being ‘inelastic’ – i.e. that demand would not be affected much by oil prices – was proved false. When the price got high enough people switched to alternatives – and now, as the price drops, why switch back to dirty polluting fuels? Electricity costs per mile of for EVs is about a third of that for equivalent gasoline in the U.S., and the ratio is better than that in Europe.

      Look at China, as well – what will the ban on production of fossil-fueled vehicles do to global oil demand? What will a shift to electric vehicles in Asia and Europe do to oil demand? Yes, the United States under Trump is trying to sabotage renewables and electric vehicles – but even if that effort is successful, the domestic US market isn’t enough to drive global demand. Thus, to drive up prices, a very large fraction of the oil market would have to shut down. But who is going to shut down and take the losses in that scenario? So it looks like oil prices have nowhere to go but down.

      Once upon a time, stone tools were valuable trade items – but that didn’t come to an end due to a lack of stones. They were replaced by better technologies.

  2. hman

    as long as there is a contango market for them to sell into they will make money and keep a cap on prices by doing so.. imho..

  3. lyman alpha blob

    …strong profits remain elusive, despite the huge uptick in production.

    And is the reason why this is occurring really so hard to understand?!?!? Profits remain elusive because of the huge uptick in production.

    My extended family are dairy farmers who have milked the same number of cows for decades. My dad, who has never participated in any economics classes, discussions, etc gets pretty animated when discussing the practice of some farmers to increase herd size and start milking more cows in response to an uptick in prices which inevitably drives prices right back down. If you produce more than people need, they won’t buy it – pretty simple. Works the same with oil.

    Last I checked, oil storage tanks were full to the point that tankers were picking up the slack, floating around full of oil with no place to unload. China had built entire cities during its boom, many of which now sit largely unoccupied. Clearly demand there has fallen off. And yet oll companies race to drill in the arctic, drill shale, frack natural gas, drill frack drill frack as fast as they can and hope for the best.

    Is this really the best way to run an economy? It really seems like idiots are in charge of just about everything these days.

  4. Pwelder

    Cunningham is telling you something important, IMO. There is still a lot of complacency about the US oil supply based on cornucopian expectations from the Permian – which will be a great producer, but not as great as you might think if you’re listening to the money-raising pitches from operators in the region. One of many under-appreciated issues: The work force that you would ordinarily look to for an expansion of production in West Texas has a boatload of alternative opportunities re-building the Gulf Coast.

    Shale oil production will be less than you expect. And so,

    The price of oil will be higher than you expect. And so,

    The rest of the economy will be weaker than you expect.

    Sorry about that.

  5. Expat

    One of the major problems with shale is the huge debt overload incurred in the Glory Days. Early drilling was very costly and a large Ponzi-like structure was built up. I imagine those debts linger with oil at 55. Newer production is much cheaper but not much lower than 50 per barrel for Bakken and Eagle Ford. Bakken. Bakken is worth about 42 a barrel. Doesn’t sound great to me.

    If oil prices rise (how or why is beyond me), then shale reacts very quickly. New wells produce fast even if they deplete quickly. If we get a price spike over 60, shale will reflood the market.

    Oh, and shale is not some new, miracle source of oil. It is old but it was simply not economically exploitable for a long time. So, commenters like A1 might treat legacy, old-school oil and gas folks like myself as outdated dinosaurs, but shale drillers have neither re-invented the wheel or even figured out a new way to slice bread.

    There is an old saying in the gas business which sort of applies to shale: Find gas once, you get promoted. Find gas twice, you get fired.

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