The 2010 – 2014 rapid increase of US shale oil production to about 5.5 million b/d has been a game changer in the oil industry. Although still amounting to only a small fraction of global production, it was responsible for most of the growth in non OPEC supply during this period. The speed and magnitude of this increase was such that within a few years it disturbed the global oil supply and demand balance. In 2014 Saudi Arabia, facing a prolonged period of oversupply (also due to downward revisions of expected demand), decided it was in their best interest to defend market share and rein in high cost oil production. This resulted in the current low oil price world.
US shale oil production exploded because of a unique set of circumstances (a “perfect tailwind”). A knowledgeable and low cost service industry, extensive geological knowledge (more wells have been drilled in the US than in the rest of the world taken together), a legal and regulatory system supportive to the oil industry, a prolonged period of high oil prices and the availability of funding at attractive conditions to the industry all contributed. At present, non US shale oil production is minute compared to US shale oil production (something unlikely to change in the short term).
The aim of this paper is to give a concise overview of the US shale oil industry, from a geological as well as a financial point of view, and to describe how the industry is adapting to the current low oil price world. A red thread is that the financial state of the industry is much worse than the impressive production figures would lead us to believe.
Shale oil geology and fracking
Hydraulic fracturing (in short: fracking) is a well stimulation technique that involves the creation of fractures upon pressurising the fluid in the wellbore. Subsequently, hydrocarbons can flow through these fractures to the wellbore. First experiments took place in the US as early as 1947. Fracking of gas wells in tight sandstones was already commonplace in the US from the 1970’s onwards. For shale wells the first commercial application was pioneered by Mitchell Energy for gas production from the Barnett Shale in Texas in the 1990’s. It was only from about 2010 onwards that shale oil production took off in earnest, initially in the Bakken and later in the Eagle Ford and Permian. To this day these are the three main US shale oil provinces. Although usually referred to as shale oil, the tight (i.e. low permeability) formations that yield oil upon fracking can be mudstones, silts, dolomites or tight sands (tight oil being the more appropriate term).
Shale oil has different characteristics compared to conventional oil. Firstly, shale oil requires continuous drilling as the production of a well declines rapidly (with typically about 50 – 60 % of production during the first year of production).
Secondly, shale oil requires the drilling and fracking of many wells that are very similar in design. As with other industries that involve oft repeated processes, it has become very efficient at doing so. It is more similar to the manufacturing industry than conventional oil.
Thirdly, conventional oil is mostly about finding oil in the first place. With shale oil, it is not so much about finding oil but rather about finding those places where the oil can actually be produced at commercial rates (oil in the Bakken for instance was already discovered in the 1950’s). Within a single play the EUR (estimated ultimate recovery) per well is highly variable. The key to success is the definition of sweet spots, with systematically higher oil recovery. Even within a single sweet spot area well performance is highly variable, however. So far the industry has not been very successful in predicting sweet spots. As a result, it takes many wells before the location of sweet spots (which may be the only places where commercial production can take place) can be inferred with some confidence. Hundreds of wells are needed to properly evaluate; upon which many thousands of wells are needed to produce.
For each play, different areas have highly variable break even oil prices. For the Bakken, for instance, the break even oil price ranges from about $ 25 – 100 per barrel (at current cost levels). For the larger companies the average breakeven price currently ranges between about $ 40 and $ 70 per barrel. Ranges for the other plays are not markedly different. The best areas with a break even oil price below the early 2016 $ 30 per barrel price are very small, however (about 1 % of the total Bakken area), are already starting to deplete and could be depleted in approximately 5 – 10 years at current production rates. Intense drilling at increasingly smaller distance implies that wells increasingly interfere with each other. Within a few years further technological advances need to sufficiently lower the breakeven price in the next best areas. This is quite possible – but by no means a given.
Throughout the years, the shale oil industry has seen impressive gains in efficiency and productivity. Two different sets of factors come into play here. The first set of factors relates to our increased geological knowledge (resulting in a better delineation of the most productive areas) and increased efficiencies and knowledge in drilling (longer horizontal well productive sections, faster drilling) and fracking (larger number of fracs per well, larger fracs). It seems that these factors, which should be sustainable in the long term (even in a future high oil price world), had reached a plateau by 2014.
The second set of factors relates to the current low oil price world in which companies are making an all out effort to survive. This involves a much more increased focus on the most highly productive areas (whilst suspending activities in all other areas), the continuation of these more limited activities with only the best performing rigs and fracking crews and the overall decrease of service industry costs and rig rates. The majority of advances in the last 2 years seem to come from this second set of factors. Upon a prolonged period of cut throat competition between service providers this second set now seems to have reached a plateau as well. EIA monthly drilling reports suggest that the added production per Bakken rig is about to reach a plateau.
The steep rise in US shale oil production has been a major technical achievement from what has now become a mature industry. The steep part of the learning curve seems to have been climbed. Cut throat competition between service providers over the last 2 years has significantly reduced cost. After an all out effort to survive, the US shale oil industry is now as competitive as it can possibly be (at least in the short term – even for a mature industry further technological breakthroughs in the long term cannot be ruled out).
Most US shale production comes from smaller, independent companies that lack the financial robustness of the larger companies that dominate conventional oil production. Compared to these larger companies they rely to a greater extent on bonds and asset backed lending and to a lesser extent on equity. US corporate bonds in the energy sector rapidly increased to about $ 800 bn (an increase that abruptly stopped in late 2014). The rapid increase in shale oil production would not have been possible without the easy money that was readily made available during the 2010-2014 period.
Virtually all US shale producers are currently cash flow negative. Even in the 2010 – 2014 high oil price world, however, most US shale oil producers were already cash flow negative. Apart from higher costs and lower well recoveries at the time, this was primarily caused by the money that was spent on acquiring leases and building infrastructure.
For costs, a distinction needs to be made between full cycle cost (which also includes the costs of acquiring leases) and half cycle cost (including drilling and fracking costs but excluding leases). As long as oil prices stay above half cycle costs there is an incentive to keep on drilling, in order to minimise losses.
Adapting to a low oil price world
The resilience of the US shale oil production in 2015, following the dramatic fall in oil price, has surprised many analysts. It declined later and less than expected. From a peak of 5.6 mb/d in March 2015, shale oil production had fallen by no more than 0.6 mb/d by the year end. For the main plays production has been the most resilient for the Permian and the least resilient for the Eagle Ford. No massive wave of company bankruptcies has materialised.
On the technical side, there has been an increased focus on the best producing areas. Activities in poorer producing areas have been much reduced or stopped. Rigorous cost cutting has taken place throughout the industry. A significant part of the 2015 shale oil production had been hedged (for approx 50 % of production of smaller companies, for prices anywhere in between $ 60 and 100 per barrel). Hedging contributed to over 30% of revenue in US shale oil in 2015. Hedging of 2016 production at attractive prices is much less prevalent.
For many producers, in order to minimise losses, it still makes sense to drill (as long as the oil price stays above half cycle costs). In some cases, producers are forced to drill in order to keep their leases. For some companies with lower quality assets (half cycle cost greater than oil price) it makes sense to stop operations entirely. These companies (known in the industry as “zombies“) are trying to survive without any drilling or fracking of new wells, just waiting for the oil price to recover.
The key factor in the resilience of US shale oil production has been the continuation of funding, however. No additional money is flowing into the US shale industry but the existing money has not (and cannot) been taken out. During the last round of loan extensions and associated reserves re-determinations in October 2015 banks were only able to cut funding limits by a small amount (although interest rates may have risen substantially). Bankruptcies and asset fire sales are in no one’s interest in the current low oil price world. Hence the tendency to be rather lenient regarding loan extensions. Both shale oil producers and their financiers are trying to sit out the current low oil price world. Covenants for the extension of funding are being re-negotiated with minimal publicity.
Overall the financial state of the US shale oil industry is much worse than the resilience of production would lead us to believe. Few bankruptcies have materialised so far but share prices have gone down significantly (often by as much as 90%). The yield of the Bank of America Merrill Lynch US energy high yield bond index has climbed to close to 20%. The average high yield US energy bond has slid to 56 cents of the dollar.
Easy money enabled the rise of the US shale oil industry in the 2010 – 2014 period. It kept it alive in the following low oil price world in 2015. Now, what will happen next?
Oil prices have been close to $ 30 per barrel during the first two months in 2016. The short term outlook is highly uncertain. Global supply is only expected to become in line with demand in 2017/2018 as the drastic investment cuts in non shale oil take time to materially affect supply.
Oil prices this low will further contribute to making 2016 a much more difficult year for shale oil producers than 2015. Hedging at attractive prices is no longer possible. More companies will suspend activities. The drop in the rig count has picked up again and the 2016 drop in shale oil production could be as large as 1 million barrel/day.
Shale oil producers and their financiers are trying to sit out the current low oil price world – something that is becoming increasingly more difficult. Financially more robust larger oil companies and private equity are waiting for bankruptcies, looking to pick up the shale oil producers’ core assets in sweet spots at rock bottom prices (much more attractive than taking over financially distressed shale oil producers and having to pay off their debts in full).
The key question is whether the next phase of loan extensions and reserve redeterminations in April 2016 will be as lenient as the preceding one in October 2015. It is in the financiers’ interest to continue and aim for a soft landing once oil prices pick up. But will regulators let them? And even if regulators let them: will the current situation start to undermine trust in financial institutions? Bankers may stress that the importance of the energy industry has been diminished and that these loans are backed by assets. These assets are worth much less in the current low oil price world, however. Worldwide the level of debt of the energy industry stands at a record high of 2.5 tn $ (at a time that the value of assets backing these loans stands at a record low). The day of reckoning may be postponed but one day it will come.