The Economy

Shale Oil: In a Bind

Will falling oil prices curb America’s shale boom?
Economist StaffDecember 9, 2014
Shale Oil: In a Bind

This year’s Christmas parade in Lindsay, in the heart of Oklahoma’s oil country, featured the Stars and Stripes every 10 yards, 11 horses with riders in Santa hats and a rifle salute by veterans. But the highlight was a thundering, bright red oil tanker covered in fairy lights and owned by Hamm & Phillips, an oil-services firm with local roots that has ridden the shale boom in the state and across America.

That energy revolution is the envy of the business world. Abundant oil and gas have been extracted from underground rocks by blasting them with a mixture of water, chemicals and sand — “fracking,” in the jargon. As well as festive spirit, the firms responsible embody an all-American formula of maverick engineers, bold entrepreneurs and risk-hungry capital markets that no country can match.

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hail_shaleYet now that oil prices have fallen by almost 40% in six months, these firms’ mettle is being tested. Across America shale-shocked executives will spend Christmas overhauling their strategies to cope with life at $70 per barrel, even as investors dump their firms’ shares and bonds. Executives at Lukoil, a big Russian firm, now sniff that shale is like the dotcom bubble — a mania that is being cruelly exposed.

Oil-price slumps usually lead to cuts in energy firms’ investments. Production eventually falls, helping prices to stabilize. In 1999, after the Asian crisis, global investment in oil and gas production dropped by 20%. A decade later, after the financial crisis, investment fell by 10%, then recovered.

This time some of the pain will be taken by the big integrated energy firms, such as Exxon Mobil and Shell. After a decade of throwing shareholders’ cash at prospects in the Arctic and deep tropical waters to little effect, they began cutting budgets in 2013. Long-term projects equivalent to about 3% of global output have been deferred or cancelled, says Oswald Clint of Sanford C. Bernstein, a research firm. Most “majors” assume an oil price of $80 when making plans, so deeper cuts are likely.

But much of the burden of adjustment will fall on America’s shale industry. It has been a big swing factor in supply, with output rising from 0.5% of the global total in 2008 to 3.7% today. That has required hefty spending: shale accounted for at least 20% of global investment in oil production last year. Saudi Arabia, the leading member of OPEC, has made clear it will tolerate lower prices in order to do to shale firms’ finances what fracking does to rocks.

Even the gods of shale disagree about the industry’s resilience. The boss of Continental Resources, Harold Hamm (whose fortune has dropped by $11 billion since July), has said he can cope as long as the oil price is above $50. Stephen Chazen, who runs Occidental Petroleum, has said the industry is “not healthy” below $70. The uncertainty reflects the diversity of activity. Wells produce different mixes of oil and gas (which sells for less). Transport costs vary: it is cheap to pipe oil from the Eagle Ford play, in Texas, but expensive to shift it by train out of the Bakken formation, in North Dakota. Firms use different engineering techniques to pare costs.

Two generalizations can still be made. First, in the very near term, the industry’s economics are good at almost any price. Wells that are producing oil or gas are extraordinarily profitable, because most of the costs are sunk. Taking a sample of eight big independent firms, average operating costs in 2013 were $10-20 per barrel of oil (or equivalent unit of gas) produced — so no shale firm will curtail current production. But the output of shale wells declines rapidly, by 60-70% in their first year, so within a couple of years this oil will stop flowing.

Second, it is far less clear if, at $70 a barrel, the industry can profitably invest in new wells to maintain or boost production. Wood Mackenzie, a research consultancy, estimates that the “break-even price” of American projects is clustered around $65-70, suggesting many are vulnerable (these calculations exclude some sunk costs, such as building roads). If the oil price stays at $70, it estimates investment will be cut by 20% and production growth for America could slow to 10% a year. At $60, investment could drop by as much as half and production growth grind to a halt.

fractured_balance_sheetThe industry’s weak balance sheet is also a vulnerability, says Michael Cohen of Barclays, a bank. Most firms invest more cash than they earn, making up the difference by issuing bonds. Total debt for listed American exploration and production firms has almost doubled since 2009 to $260 billion (see chart at right), according to Bloomberg; it now makes up 17% of all America’s high-yield (junk) bonds. If debt markets dry up and profits fall owing to cheaper oil, the funding gap could be up to $70 billion a year. Were firms to plug this by cutting their investment budgets, investment would drop by 50%. In 2013 more than a quarter of all shale investment was done by firms with dodgy balance sheets (defined as debt of more than three times gross operating profits). Quite a few may go bust. Bonds in some smaller firms trade at less than 70 cents on the dollar.

All this suggests looming investment cuts that within a year will slow growth in American shale production to a crawl and perhaps even lead to slight declines. A few firms have trimmed their budgets already. More are expected to announce cuts in January. “Frontier” projects — on the fringes of existing basins or in places where little commercial production has taken place — are vulnerable, including Oklahoma. Most firms will hunker down in the Bakken, the Eagle Ford and the Permian Basin, where they have scale and infrastructure. Even in the Bakken, applications for drilling permits fell by almost 40% in November.

OPEC’s wishes may seem to be coming true over the next year. But adversity will eventually make shale stronger. It will prompt a new round of innovation, from cutting drilling costs through standardization to new fracking techniques that increase output. Dan Eberhart, the boss of Canary, a Denver-based oil-services firm, says the industry has already “pressed fast forward” on saving costs.

And if and when prices recover, new wells can be brought on stream in weeks, not years. America’s capital markets will roar back into life, forgiving all previous sins. “There is always a new set of investors,” says the boss of a one of the world’s biggest natural-resources firms. He predicts a shale crash — and a rapid rebound.

© The Economist Newspaper Limited, London (December 6, 2014)