The financial state of the US shale oil industry is much worse than the still impressive production figures would lead us to believe, writes energy expert Jilles van den Beukel, a former geophysicist with Shell. Shale oil producers and investors have managed to postpone the day of reckoning, but the fundamentals of the industry make a shake-out inevitable.



To assess the prospects of the US shale oil sector, it is important to understand that shale oil is fundamentally different from conventional oil production in important ways.

Firstly, shale oil requires continuous drilling as the production of wells 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. Like other industries that involve oft repeated processes, the shale oil industry has become very efficient at this. It is more similar to the manufacturing industry than conventional oil.

The steep rise in US shale oil production, and subsequent drastic cost reductions, have no doubt been a major achievement, but the US shale oil industry now seems as competitive as it can possibly be, at least in the short term

Thirdly, whereas conventional oil is mostly about finding oil in the first place, shale oil is 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 1950s. Within a single play the EUR (estimated ultimate recovery) per well is highly variable. The key to success therefore is finding the sweet spots, with systematically higher EUR’s. 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 sweet spots (which may be the only places where commercial production can take place) can be located with some confidence. Hundreds of wells are needed to properly evaluate the play. Subsequently many thousands of wells are needed to produce.

As a result, in 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 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

The best areas with a break-even oil price below $30 per barrel are very small, however (about 1% of the total Bakken area) and are already starting to deplete. They could be depleted in approximately 5-10 years at current production rates. [Intense drilling at increasingly smaller distances implies that wells increasingly interfere with each other.] This means that further technological advances are needed to sufficiently lower the breakeven price in the next best areas. It is quite possible that this will happen – but by no means a given.

Productivity gains

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 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 likely that these factors (which should be sustainable in a potential 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.

After 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, and subsequent drastic cost reductions, have no doubt been a major achievement, but the US shale oil industry now seems 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).

Financial

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 due to the money spent on acquiring leases and building infrastructure.

With regard to 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 US shale oil production in 2015, following the dramatic fall in the oil price, has surprised many analysts. Production 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. As regards the major plays, production has been the most resilient in the Permian and the least resilient in 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.

Shale oil producers and their financiers are trying to sit out the current low oil price world – something that is becoming increasingly more difficult

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. No additional money is flowing into the US shale industry but the existing money has not been (and cannot be) 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 in some cases they were able to raise interest rates 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 on 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?

Looking ahead

Oil prices have been close to $30-$40 per barrel during the first 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 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 greater than the 0.6 million barrel/day 2015 drop.

It is in the financiers’ interest to continue and aim for a soft landing once oil prices pick up. But will regulators let them?

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 try to reassure us, claiming that the importance of the energy industry to the overall economy has diminished and that moreover these loans are backed by assets. These assets are worth much less, however, in the current low oil price world. Worldwide the level of debt of the energy industry stands at a record high of $2.5 trillion 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.

Editor’s Note

Jilles van den Beukel worked as geologist, geophysicist and project manager and lastly as Principal Geoscientist for Shell in many parts of the world. In March 2015, he resigned to become a freelance traveller and author. This article was first published on his blog Jilles on Energy and is republished here with permission from the author.