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Page added on January 11, 2015
U.S. Oil Shales: Still Growing Fast
Summary
- How long would it take for the U.S. oil production to go in decline?
- Why have shale operators waited for six months since the beginning of the oil price correction to reduce drilling?
- What are breakeven oil prices for U.S. shale plays?
- What are the implications for the price of oil?
It has been six months since crude oil prices started a straight-line, uninterrupted decline. All the key price benchmarks have now dropped to or below $50 per barrel level:
- OPEC Reference Basket: $45.74 per barrel (1/8/2015 price);
- Brent: $50.11 per barrel (1/9/2015 settlement);
- WTI: $48.79 per barrel (1/9/2015 settlement).
Given the magnitude and longevity of the economic signal, should one anticipate that supply contraction is now imminent and a bounce in the price of oil may be around the corner?
While admitting that trying to predict the direction of oil price is a futile task, a different oil price scenario appears to be more probable from a structural standpoint.
A case can be made that in the absence of a policy-driven production cut by Saudi Arabia (and its closest OPEC allies), the oversupply pressure on the oil price may sustain itself for at least several more months. Moreover, such pressure may increase in the near term, before the inflection point in the supply and demand balance is reached, perhaps by mid-2015. It may take several more months thereafter for the accumulated excess volumes to be absorbed, clearing the path for a meaningful oil price recovery.
North American shales represent one of the most flexible supply categories that will likely lead the economically-driven production slowdown. As such, the flattening of the U.S. oil production trajectory may serve as an indicator of the likely turn in the oil price cycle.
I would dare to estimate that, barring a further significant decline in the price of oil, U.S. oil production will continue to grow at a high pace for another several months, before flattening during the summer.
Rig Data Shows Drilling Activity Just Starting To Roll Over
The key reason for the continued U.S. production growth in the first half of 2015 is that no tangible reduction in drilling activity has occurred yet.
Given that the most important shale oil plays – including the Bakken, Eagle Ford, Niobrara and portions of Permian – are already in pad development mode, the spud-to-sales times in those plays can be three months or longer (a six-well pad in the Bakken, for example, may take over four months to be placed on production after the first well is spud). In other words, April production volumes will likely reflect January rig activity levels that remain high. In addition, in some cases, operators have significant backlogs of wells waiting on completion that may contribute to new production for another few months, even after drilling rigs have been released.
The following graph from Helmerich & Payne’s (NYSE:HP) presentation shows that drilling activity in U.S. oil shales started to roll over less than a month ago (the recent decline depicted by the blue line on the graph below). The oil-focused rig count is still above 90% of the peak achieved during last summer.
(click to enlarge)
(Source: Helmerich & Payne, January 2015)
Of note, the greatest declines have occurred in the least productive mechanical and SCR rig categories. Those rigs typically work without long-term contracts and often drill less prolific wells.
(click to enlarge)
(Source: Helmerich & Payne, January 2015)
The point can be illustrated by Helmerich & Payne’s fleet utilization. As one can see from the graph below, the number of the company’s active rigs declined by only 11 units in the past two months, from 298 to 287. This represents a decline of less than 4%. The company’s idle and available AC drive FlexRig count in the U.S. now stands at 26 rigs.
(click to enlarge)
(Source: Helmerich & Payne, January 2015)
Let’s make no mistake, the U.S. onshore drilling for oil is going to take a steep nosedive. However, the implementation of spending cuts by operators will not be instantaneous and may take several months to run its course.
Helmerich & Payne expects to see another 40 to 50 FlexRigs become idle during the next 30 days and additional rigs to become idle beyond 30 days (H&P has already received early termination notices related to four long-term rig contracts). This suggests that the total reduction in the contractor’s active U.S. FlexRig count as of early February will be less than 20% from the recent peak level.
Assuming that Helmerich & Payne’s rig fleet can be used as a proxy for drilling activity in the most prolific shale oil plays, the real slowdown in production growth from U.S. unconventional oil plays may not occur until the April-June 2015 timeframe. For the second half of 2015, even relatively recent U.S. oil production forecasts would probably require revisions to reflect the change in the macro environment and across-the-board spending cuts. In the first half of 2015, on the other hand, U.S. oil production momentum is likely to carry on. Growth rate early in 2015 will likely be comparable to Q4 2014, i.e. at relatively high, ~0.3 MMbbl/d per quarter.
(click to enlarge)
(Source: EIA.)
Why Are Producers Not Reacting Quicker?
While the current oil price correction is already six months old, the economic signal to operators to reduce drilling activity emerged only recently. For the vast majority of producing areas (in terms of volume contribution), drilling remained economic until six weeks ago, when OPEC announced on Thanksgiving Day that no production cut would follow. Prior to that time, the incentive to U.S. shale producers to make major, urgent reductions to the pace of drilling was not there.
To illustrate this point, the following slides from a presentation by North Dakota Department of Mineral Resources may be helpful. Lynn Helms, DMR’s Director, estimates that breakeven wellhead price for new drilling in the Bakken’s most prolific areas – in Dunn, McKenzie, Williams and Mountrail Counties – is in the $29-$41 per barrel range. It is important to note that these core areas currently account for the majority of drilling activity and the majority of the existing production in North Dakota. Out of 166 rigs currently active in the Bakken, 148 are drilling in those four counties. Factoring in the local basis differential, currently at ~$16 per barrel, these estimates would correspond to ~$45-$57 per barrel Nymex WTI price.
The “shut-in” price for existing production in the Bakken is estimated at ~$15 per barrel at wellhead, or ~$31 WTI Nymex price per barrel.
(click to enlarge)
(click to enlarge)
(Source: North Dakota DMR)
Perhaps the most relevant estimate provided in the presentation is the price that would be required to sustain North Dakota’s oil production at the current 1.2 MMbo/d level. That price appears to be in the $60 per barrel range. However, the presentation suggests that even at $55 per barrel, the 1.2 MMbo/d production would likely be sustained over the next two years, before a slow decline sets in.
Assuming that the basis differential contracts to a more normal $8-$10 per barrel level, the WTI price that would be needed for sustained production is in the $65-$70 per barrel range.
(click to enlarge)
(Source: North Dakota DMR)
While it is difficult to verify what cost structure and well productivity assumptions stand behind the calculations, the estimates appear consistent with what leading operators in the Bakken – including Continental Resources (NYSE:CLR), Whiting Petroleum (NYSE:WLL) and EOG Resources (NYSE:EOG) – have indicated in the past month.
Due to the wide basis differential, the Bakken is in fact not the lowest-cost producing oil shale in the U.S. The Eagle Ford in its core areas often offers stronger economics at the same WTI price. For example, EOG’s breakeven price in the Eagle Ford (as measured by a 20% minimum rate of return) is below $50 per barrel of WTI for prolific areas, based on my estimate.
(click to enlarge)
(Source: EOG Resources, November 2015)
The fact that leading shale operators see above-threshold returns in their core plays at relatively low commodity prices (as low as $40-$50 per WTI barrel) is one of the reasons why the industry did not respond with a slowdown in drilling activity and continued to move at full speed until December.
The other reason is of course the natural lag between the price signal and the industry’s response. Operators need time to establish confidence that the price drop is real; to formulate and get approved new operating plans; and to implement drilling activity reductions within natural operational constraints.
The “Oil Glut” May Begin To Develop
The continued high production growth rate and the widening contango in the front part of the futures (which creates an incentive to store) spell bad news for crude oil inventories.
While U.S. commercial crude oil stocks are below the December 2013 peak level (the graph below), the lack of sufficient seasonal drawdown in the past few weeks raises a concern that crude oversupply may be intensifying. Gasoline inventories are also at high levels by historical standards, whereas distillate inventories are low.
(Source: EIA.)
Implications For The Oil Price
Barring a significant further drop in the price of oil, the supply response is not going to be instantaneous. The industry may need several more months to respond with necessary adjustments. In the meantime, the oversupply situation may persist, becoming increasingly manifest in inventory statistics.
Although the “oil glut” scenario should not be taken for granted, it cannot be ruled out either. If inventory build continues at an above-average pace, the contango in the front end of the futures curve would likely widen further (and possibly much further), depressing producer price realizations in the short term. The sub-economic prices should at some point lead to voluntary production curtailments. Production curtailments are the most effective mechanism of quick supply and demand rebalancing.
One should not rule out that curtailments may at some point come from Saudi Arabia (and would likely be driven by the Kingdom’s confidence that sufficient capacity destruction and new mega-project postponement have been assured).
The scenario where curtailments occur woudl likely lead to a V-shape oil price trajectory.
Does this logic prescribe that further decline in the price of oil is unavoidable? Not necessarily, in my opinion. The oil price decline to date has already been very deep and triggered adjustments on the supply side. Furthermore, low oil and fuel prices will likely stimulate consumption, which should help rebalance the market. Having said that, the oil price slump may extend over several months. This scenario would likely correspond to a U-shape price pattern.
9 Comments on "U.S. Oil Shales: Still Growing Fast"
SugarSeam on Sun, 11th Jan 2015 8:44 pm
RE: break-even price, aren’t those just capital costs? As Berman recently stated, they “don’t begin to reflect all of their costs like overhead, debt service, taxes, or operating costs so the true situation is really a lot worse.”
Also, he said, what investor is interested in merely “breaking even?”
SugarSeam on Sun, 11th Jan 2015 8:48 pm
in any event, hooray! It’s U-shaped, not V-shaped!!! We’re safe ’til Autumn!! Keep shopping!!
Perk Earl on Mon, 12th Jan 2015 12:22 am
The time period at the bottom of that ‘U’ will be when the weak hands get shaken out, like LTO.
If demand could not support higher oil prices, and price has dropped accordingly, then overall world oil production will be less on the other side of that ‘U’, then we will have dipped below peak oil.
If demand cannot increase post ‘U’ shaped oil price high enough to increase supply to a higher peak, we may permanently be on our final descent. “We’d like to ask that all passengers please buckle up at this time.”
rockman on Mon, 12th Jan 2015 6:11 am
Good timing for this post. I’ll save a copy and we’ll revisit its numbers in 6 months. Not worth debating at the moment IMHO.
Bandits on Mon, 12th Jan 2015 6:54 am
This is a direct copy of a post by Slow Rider over at Gail’s Blog.
Jim Rickards in the Daily Reckoning says the financial problems with $50 oil are worse than the 2007 subprime crisis:
“Rickards.Posted Jan 8, 2015.
Oil below $50 is more than low enough to do an enormous amount of damage in financial markets. Losses are all over the place. We don’t know necessarily where they are right now. But I guarantee there are major losers out there and they’re going to start to merge and crop up in unexpected places.
The first place losses will appear are in junk bonds. There are about $5.4 trillion dollars – that’s trillion – of costs incurred in the last five years for exploration drilling and infrastructure in the alternative energy sector. When I say alternative I mean in the fracking sector.
A lot of it’s in the Bakken and North Dakota, but also in Texas and Pennsylvania. That’s a lot of money. It’s been largely financed with corporate and bank debt. These companies issued some equity, but it’s mostly debt.
Here’s how it works. Suppose I’m an oil exploration company. Let’s say I borrowed a couple hundred million dollars to drill for oil using fracking technology. The bank — the lender, bond investor or whoever — says: “Well, Jim, you just borrowed $200 million. How are you gonna pay me back?”
And I’d say: “Well, I’m going to sell my oil at $80 a barrel.”
To which the bank says: “How do I know that’s true?”
Oil below $50 is more than low enough to do an enormous amount of damage in financial markets…
So I go to Morgan Stanley, JP Morgan or Citibank and I buy what’s called a swap contract. It’s a kind of derivative. Citibank or whoever basically agrees to pay me the difference between $80 and the actual price of oil.
So if oil goes to $50 and I have a swap contract with Citibank that guarantees me $80, they have to pay me the $30 difference. That way, I’ve locked in the $80 price.
That’s not a free lunch. Oil producers give away the upside. If crude prices go to $150 they might have to pay the lenders the difference. But oil companies try to protect their downside.
Oil companies are protected because when oil goes to $50 because they can call up the bank and say: “Hey, bank, send me the other $30 a barrel because we have a deal.” And the bank will have to send it to them.
Through the derivative contract the loss now moves over to the bank. It’s not the oil company that suffers the loss, it’s the bank. This is the case with the global financial system today — you never know where the risks end up.
So the first iteration is that some of the oil companies – not all of them — have shifted their risk over to the banks by doing these derivative contracts.
You might be saying to yourself: “Aha, so the banks are going to have all the losses.”
Not necessarily. The banks are just middlemen. They might have written that guarantee to an oil company and have to pay the $30 difference in my example. But the bank may have also gone out and sold the contract to somebody else. Then it’s somebody else’s responsibility to pay the oil company.
Who could the somebody else be? It could be an ETF. And that ETF could be in your portfolio. This is where it gets scary because the risk just keeps getting moved around broken up into little pieces.
Citibank, for example, might write $5 billion of these derivatives contracts to a whole bunch of oil producers. But then, they may take that $5 billion and break it into thousands of smaller one or ten million dollar chunks and spread that risk around in a bunch of junk bond funds, ETFs or other smaller banks.
When many oil producers went for loans, the industry’s models showed oil prices between $80 and $150. $80 is the low end for maybe the most efficient projects, and $150, of course the high end. But no oil company went out and borrowed money on the assumption that they could make money at $50 a barrel.
So suddenly, there’s a bunch of debt out there that producers will not be able to pay back with the money they make at $50 a barrel. That means those debts will need to be written off.
How much? That’s a little bit more speculative.
I think maybe 50 percent of it has to be written off. But let’s be conservative and assume only 20 percent will be written-off. That’s a trillion dollars of losses that have not been absorbed or been priced into the market.
Go back to 2007. The total amount of subprime and Alt-A loans was about a trillion. The losses in that sector ticked well above 20 percent. There, you had a $1 trillion market with $200 billion of losses.
Here we’re talking about a $5 trillion market with $1 trillion of losses from unpaid debt — not counting derivatives. This fiasco is bigger than the subprime crisis that took down the economy in 2007.
I’m not saying we’re going to have another panic of that magnitude tomorrow; I’m just trying to make the point that the losses are already out there. Even at $60 per barrel the losses are significantly larger than the subprime meltdown of 2007. We’re looking at a disaster.
On top of those bad loans, there are derivatives. Right now, some of the producers are kind of shrugging, saying: “We went out and borrowed all this money on the assumption of $80, $90, $100 oil. But we also sold our oil production forward for a couple of years at $90. So we’re fine.”
That’s not true in every case, but it is true in a lot of the cases.
But the problem with derivatives is that you don’t know where the risk ends up. I don’t know where it is, and neither does the Federal Reserve, neither do the bank regulators. The banks might know their piece of it, but they don’t know the whole picture. That means we have to keep digging and digging.
The losses out there are larger, potentially, than the subprime crisis. The losses could actually be bigger than the sector’s borrowings because you can create derivatives out of thin air. And as I say, they could be in your portfolios.
There’s still time to call your investment advisors or broker to see whether you have any of this risk buried in your portfolio. You might not, but even if you don’t it may be time to take a little more defensive posture. That could be a little more cash or other hedges. That way when things start to collapse around you — even if you’re not taking a direct hit — you’re not collateral damage.”
– END –
Davy on Mon, 12th Jan 2015 8:16 am
Bandit, great re-post of a great post. I wonder how long the central banks through repression, debt liquidity efforts, and rinse and repeat extend and pretend will mop up the puke? We know that is what was done with all the moldering paper in the past before diminishing returns hit their efforts recently. How low can they go with their limbo dance?
Bandits on Mon, 12th Jan 2015 8:22 am
Yes Davy it was a terrific post. Scared me and I didn’t think there was much left that could.
Amvet on Tue, 13th Jan 2015 9:53 am
Bandits, Do you know what the typical leverage is in the US. I have read that loaning out 9 times more than they have is standard??? A problem and the house of cards falls in.
Davy on Tue, 13th Jan 2015 10:14 am
AMV, take a look at the way China makes loans and its rehypothecation scandals. Leverage is pretty standard the world over but especially exciting in China.