Why Is The Shale Industry Still Not Profitable?

Yves here. We’ve been writing skeptically off and on about the shale industry’s claims that of rising productivity that will solve their profitability problems. A new report indicates that shale players’ claims that they have made progress on this front are based on very narrow and unduly flattering definitions of productivity.

By Nick Cunningham, a freelance writer on oil and gas, renewable energy, climate change, energy policy and geopolitics. He is based in Pittsburgh, PA. Follow him on Twitter: @nickcunnigham1. Originally published at OilPrice

Echoing the criticism of too much hype surrounding U.S. shale from the Saudi oil minister last week, a new report finds that shale drilling is still largely not profitable. Not only that, but costs are on the rise and drillers are pursuing “irrational production.”

Riyadh-based Al Rajhi Capital dug into the financials of a long list of U.S. shale companies, and found that “despite rising prices most firms under our study are still in losses with no signs of improvement.” The average return on asset for U.S. shale companies “is still a measly 0.8 percent,” the financial services company wrote in its report.

Moreover, the widely-publicized efficiency gains could be overstated, at least according to Al Rajhi Capital. The firm said that in the third quarter of 2017, the “average operating cost per barrel has broadly remained the same without any efficiency gains.” Not only that, but the cost of producing a barrel of oil, after factoring in the cost of spending and higher debt levels, has actually been rising quite a bit.

Shale companies often tout their rock-bottom breakeven prices, and they often use a narrowly defined metric that only includes the cost of drilling and production, leaving out all other costs. But because there are a lot of other expenses, only focusing on operating costs can be a bit misleading.

The Al Rajhi Capital report concludes that operating costs have indeed edged down over the past several years. However, a broader measure of the “cash required per barrel,” which includes other costs such as depreciation, interest expense, tax expense, and spending on drilling and exploration, reveals a more damning picture. Al Rajhi finds that this “cash required per barrel” metric has been rising for several consecutive quarters, hitting an average $64 per barrel in the third quarter of 2017. That was a period of time in which WTI traded much lower, which essentially means that the average shale player was not profitable.

Not everyone is posting poor figures. Diamondback Energy and Continental Resources had breakeven prices at about $52 and $37 per barrel in the third quarter, respectively, according to the Al Rajhi report. Parsley Energy, on the other hand, saw its “cash required per barrel” price rise to nearly $100 per barrel in the third quarter.

A long list of shale companies have promised a more cautious approach this year, with an emphasis on profits. It remains to be seen if that will happen, especially given the recent run up in prices.

But Al Rajhi questions whether spending cuts will even result in a better financial position. “Even when capex declines, we are unlikely to see any sustained drop in cash flow required per barrel … due to the nature of shale production and rising interest expenses,” the Al Rajhi report concluded. In other words, cutting spending only leads to lower production, and the resulting decline in revenues will offset the benefit of lower spending. All the while, interest payments need to be made, which could be on the rise if debt levels are climbing.

One factor that has worked against some shale drillers is that the advantage of hedging future production has all but disappeared. In FY15 and FY16, the companies surveyed realized revenue gains on the order of $15 and $9 per barrel, respectively, by locking in future production at higher prices than what ended up prevailing in the market. But, that advantage has vanished. In the third quarter of 2017, the same companies only earned an extra $1 per barrel on average by hedging. Related: The Unstoppable Oil Rally

Part of the reason for that is rising oil prices, as well as a flattening of the futures curve. Indeed, recently WTI and Brent have showed a strong trend toward backwardation — in which longer-dated prices trade lower than near-term. That makes it much less attractive to lock in future production.

Al Rajhi Capital notes that more recently, shale companies ended up locking in hedges at prices that could end up being quite a bit lower than the market price, which could limit their upside exposure should prices continue to rise.

In short, the report needs to be offered as a retort against aggressive forecasts for shale production growth. Drilling is clearly on the rise and U.S. oil production is expected to increase for the foreseeable future. But the lack of profitability remains a significant problem for the shale industry.

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  1. Chauncey Gardiner

    Interesting data. However, it has become hard for me not to question if traditional financial performance metrics play a meaningful role in decisions regarding domestic shale oil development and production.

    1. PlutoniumKun

      Indeed – oil shale* has been a mystery to me – I was convinced 2 years ago that it was all going to crash ignominiously as it was clear it was a huge loss-maker (and so, for that matter, did the Saudi’s, who did everything they could to break it). All the evidence suggested that they couldn’t produce oil at prices below $60, and maybe even not that low consistently. But its a notoriously opaque industry as so many operators are small and are not listed so nobody really knows their financing situation.

      I suspect that so much money has been put into it that nobody wants to pull the plug on the weakest companies for fear of what might be found. At the moment, they seem to be breaking even or making small profits, but I would guess its very vulnerable to any disruption, such as an unexpected drop in oil prices or a rise in interest rates. Although I think for the next 12 months at least, oil prices are far more likely to rise than drop. But then again, I’ve been consistently wrong in my predictions about shale oil and gas for a few years now, so what do I know?

      *yes, I know, the correct term is ‘tight oil’, ‘shale oil‘ is technically speaking a different process, but the terms are generally interchangeable).

      1. Synapsid

        Plutonium Kun,

        The majority of these companies aren’t even breaking even but the few who do get the headlines. The article doesn’t mention the shale-industry debt level: $265 billion is a recent informed estimate. That isn’t being payed off; I don’t expect it ever will be.

        Oil shales are a wholly different creature and they don’t have a place in a discussion about LTO/shale oil production. Oil shales are what Canada has so much of; they’re rocks containing kerogen, a heavy gunk that can be turned to oil by heat. In other words, they contain no oil, just a precursor of it. What is produced from the rock, bitumen, is too thick to flow through pipelines and needs to be diluted by much lighter (less viscous) condensate–which, in fact, is increasingly what is being produced, and shipped out of the country, by the shale-oil industry. Some has been sent to Canada for years, to be used as diluent so the bitumen can be sent to the US by pipeline.

  2. Principe Fabrizio Salina

    It’s a bit more complicated. There is a difference between shale oil, oil shales and tight oil. In the case of shale oil, the reservoir rocks are the same source rocks. Tight oil may be any rock formation characterized by low porosity and low permeability. All these terms are used somewhat loosely. I would agree that the shale revolution was funded with a credit card, to a large extent. Thank you Ben and Janet.

  3. jackiebass

    Fracked Shale gas has a long term productivity problem. Most of the production is early on and drastically declines. To even maintain production new wells have to be continuously fracked.

  4. joecostello

    One must say its more than amusing to see a Saud bank take down shale, and certainly revealing nothing new.

    But one would want the same institution to look at the House of Saud’s oil field operations and give at least one real number, say whats the marginal cost for a barrel in the desert these days? Seems something simple as that would be possible with the much anticipated Aramco IPO.

    Shale is the poster child for the great debt boom of the last decade, its a subsidizing of the cheap oil economy with cheap money, and the present global system is based on cheap oil and cheap money, it dont go without it.

    1. jefemt

      re joecostello comment:

      “….and the present global system is based on cheap oil and cheap money, it don’t go without it.”

      Bumper sticker of the decade.

  5. rd

    As far as I can tell, shale oil is unusual in that the fairly fast start-up and relatively short-duration of the wells makes it a “free market” animal which can be turned on and off very quickly based on market and financing conditions. The break-even cost varies greatly by location for a wide variety of reasons https://www.forbes.com/sites/rrapier/2016/02/29/the-break-even-cost-for-shale-oil/#32ede0bf40d4

    As a result, there are wells that can be drilled at nearly any price, so rising and lower prices are not an on-off switch, but more of a dimmer switch.

    The current investor hunger for bonds means that there is an endless supply of money available for rational plays. A well can be drilled with oil flowing at a pre-sold guaranteed price fairly quickly, so everybody can be happy – the bond holder gets paid, the oil company gets their revenue, and the driller gets paid. Since the oil company is doing much of the work using borrowed money, a small profit is highly leveraged so they can still afford their Cadillacs. This is a very different business than massive capital-hungry oil sands mines, refineries, pipelines etc. where it can be a decade or more before any revenue flows from a proposed project.

    Even environmental regulations just raise the threshold cost for profitability a bit, but usually don’t preclude new wells unless there is an outright ban like New York State. That is unlikely to occur in places like Texas and North Dakota.

    So this is one of the few places in resources where it actually looks like those nice little charts in Econ 101/102 with theoretically frictionless markets with perfect knowledge of costs, investment returns, and revenue from product sales. So oil prices pop a bit, futures get locked in, bonds get sold, and the well gets drilled. If prices drop, some rigs are moth-balled and workers are laid off, so the holding costs for the oil company drop rapidly to just the cost of leasing the rights for future wells.

    Rising interest rates and slumping bond demand, especially for junk bonds, are probably the biggest threat to shale oil.

  6. Jim Haygood

    ‘recently WTI and Brent have showed a strong trend toward backwardation’

    Indeed. Nearly three years out, the Dec 2020 WTI future sells for $54.72, versus $65.56 for the front month Mar 2018 future.


    Crude was likewise backwardated in 2004, when it first punched through $40 in the wake of Viceroy Bush’s conquest of Iraq [/sarc] then kept on rolling all the way to $140.

    Backwardation produces a positive roll yield for long positions, whereas contango [out year prices higher than today] drains returns for longs.

  7. John

    Or are they just using the Amazon business model? Never make a profit. Just skim it all before it comes to the profit stage. And you don’t even have to pay taxes. I bet some individuals are getting filthy, filthy rich off of shale.

    1. rd

      You have to pay bond-holders who just demand cash flow, not profit. You have to pay the subcontractors out of cash flow. Many of the corporations are very closely held, so the value can be extracted many ways without a profit ever declared, much like real estate.

  8. JamesG

    Seriously, it depends on how you define “profitable.”

    For example if airlines sold all their tickets at the price they sell to “standby” passengers the airline would lose money. But if the low price to standby passengers covers the direct variable costs (mainly the cost of fuel to fly a single passenger) and contributes something to the fixed costs then the airline is better off if it fills the seat by selling the cheap ticket than if the seat remains empty.

    The same factor works in oil production. If shale contributes “something” to fixed costs then producing shale oil is better than not producing it. The oil industry has always run low-producing wells which make sense if they contribute something to reduction of overhead.

    Shale oil people are not stupid. If they are increasing production they are not deliberately reducing their profits.

    (It was forever ago but, yes, I was once an oil company accountant.)

    1. oh

      JamesG, your comment only applies to wells already drilled and in production. Only fools will get in now and pour big $$ into drilling new wells to ‘lose 10 cents on the dollar hoping to make it up by volume’.

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