In spite of Saudi Arabia's best efforts Shale oil is winning. We look at how shale industry evolved and the path ahead.

STEVE AUSTIN | 2017/06/07

Some wars are fought on the sidelines. They too are full of ideas, intrigue and bravado. Some backfire thoroughly. The Saudis took a brunt of it in their war with shale.

In the US, after the peak oil production of early seventies, the oil industry went into a limbo. It even looked like the US would be an importer of oil forever. Yet, thing did change. What revived the energy scene was the arrival of shale gas on the horizon. It was boom time. After 2008, the oil industry grew at a phenomenal rate. Then came the anti-climax. Saudi Arabia wary of shale oil exerting influence on the global market devised a cunning strategy to end the dominance. The Kingdom just flooded the market with more crude leading to increased exports. More supply of any commodity brings down the prices, after all. Oil wasn't a glorious exception, either.

Oil prices plunged. In 2014, oil prices fell to as low as $27 per barrel and the foundations of shale industry did shake. The breakeven point for shale producers was just above $70 a barrel because of expensive drilling. The rig count too fell from 1, 600 to 400 in quick time. Oil companies filed for bankruptcy and Saudi Arabia had pulled off a crouched coup- almost. The shale industry had, indeed, run into a brick wall built by Saudi Arabia.

However, the shale industry withstood the tremors and how. Cost cutting, innovation, increased recoveries and prudent management showed the resilience of shale industry. The break-even cost fell to as low as $45 a barrel. In synch with market realities, Shale oil returned with a vengeance. And, Saudi efforts to strip away and undermine the emergence of US in the oil field reached a massive road block.

Why not? Comparison between shale and conventional oil sources heaves out a clear winner in shale. Oil exploration is as expensive and time consuming as can be. After billions of dollars and years, at the end of explorations, some wells throw up just a few thousand gallons of oil, or even nothing at all. On the other hand, shale chugs out oil to bring an assured return to the investor.

And this is the key economic differentiator that makes Shale a clear winner over conventional oil exploration: having been hurt by Saudi Arabia's "pump-and-dump" strategy, the majors have cut down on multi-billion dollar offshore exploration projects seeking conventional reservoirs and have instead diverted funding into short-term "stop-and-go" shale drilling, which consistently extract oil in short order. In other words by attempting to kill shale, OPEC caused more investments to go to Shale which now has a lower barrier of entry and well understood - and controlled - risk vs. profit dynamics. Whereas state-owned Saudi Aramco is obligated to fund the lavish lifestyle and social welfare of an entire society - which is only possible with high markup -, US Shale companies are thankfully free of that burden and manage to grow while remaining barely profitable. This is a tremendous competitive advantage that US shale enjoy over Gulf producers, a "vaccine" against future OPEC price wars.

No doubt then that Shale changed the energy landscape of the US, ushering in the much needed energy security in the process. The shale revolution, made possible by advancement in technology and production, is a fascinating story. Can the story go awry again under President Trump? Let's find out.

Phase 1 From 2008-2014

High oil and gas prices were the root cause of shale revolution, it has to be stated. With high prices shale production picked up with gusto. The growth was due to two factors: debt and new technology.

In fact, the shale boom in the US happened because of debt. Banks were more than willing to issue debt to oil companies (and even independent drillers) to finance shale wells. The main reason was that the 'reserves' of oil companies were promising. Low oil prices would have meant unviable reserves and reduced lending.

Money was on offer and shale producers went into debt to finance "a rolling mill" of fracked wells in North Dakota. It was the 'free' lending from banks that helped the drillers acquire more acreage. Because of accessible debt, many oil companies didn't have to sell useful assets to finance new wells.

Further, new technology made fracked wells economical and reliable. Advances in horizontal drilling and hydraulic fracturing techniques meant that it was possible to tap into previously unviable oil in shale rock. Soon, commercial oil and gas available in the US outgrew even the most promising outlook. If in 2009 the oil production averaged 5.4 million barrels a day, by 2014 the crude oil production went up to 8.7 million barrels per day, which was the largest one year volume increase in over a century.

Of course, it took guts but shale wells had an almost guaranteed chance to extract oil. With a breakeven cost of $70/barrel and WTI at more than $100/barrel, banks were lining up to finance drillers while packaging these obligations as "high-yield corporate bonds". With a near-zero fed rates, these high-yield bonds were happily picked by investors creating a gold-rush fracking. In a matter of months, North Dakota became one of the richest states in the nation. To put this in perspective the US, at this point of time, surpassed Saudi Arabia as the world's number one crude producer.

Best of it all, employment in the oil and gas industry showed definite rise with the shale boom. In the period between 2010 and 2012, the oil and gas industry added 169,000 jobs, showing an exponential growth rate ten times that of overall nationwide employment.

Till the end of 2014, the surplus oil from the US didn't alter global oil prices because of the geopolitical situations in Libya and Iran. So much so, the shale industry continued to enjoy oil price in the range of $105-110 a barrel.

The second phase started in 2014

With better techniques, oil production in the US continued to rise. With it, the dynamics in the market shifted too.

As we stated in the introduction, Saudi Arabia felt threatened. The kingdom was anxious to maintain its market share and did something it never did before: instead of cutting production to lift up prices, it increased production to crash prices and force shale producers out of the market. And the orchestrated coercion worked, kind of: Since shale production involves higher costs than conventional wells, Saudi gamble paid off. With oil prices collapsing to below $40 and breakeven costs at $70, the US oil industry was brought to a grinding halt. It was a double edged sharp sword as the oil companies had to keep drilling in spite of low oil prices as shale wells are known to decline easily. But for how long? With prices crashing, the oil companies couldn't keep up. Rig counts fell and the Petroleum companies were forced to lay-off.

Saudis rejoiced with their brutal 'kill'

As it turned out, this was a short-sighted move on the part of Saudis as US shale producers went back to the drawing board and found innovative ways to improve the (still fairly new) process of fracking. Within a year the following improvements were made.

Local suppliers were strengthened to reduce money lost in transportation. Efficiency increased with the recovery of more oil from each well instead of going for a new one. In other words, refracking older wells became cheaper. It turned to be a better option to extract more from wells already paid for. Average speed of well completion increased from 35 days to 21 days, resulting reductions in costs approaching 50%.

Better drills and sensors, along with new fracking fluids came along. Another innovative technology was the multi-pad drilling which paid off rich. Multi-pad drilling is a technology allowing drilling rigs to drill a series of consecutive horizontal wells at a rapid pace. The drilling rig only needs to move less than 30 feet to start a new well which results in huge savings in time and completion costs.

And, US oil production peaked in April 2015 with 9.63 million barrels a day. Yet the story was far from rosy. Over the next few months, production dropped by about a million barrels.

Third phase: 2016-now

The Saudi factor's greatest victory came in the February of 2016 when oil prices crashed to $27 a barrel, the lowest since 2003. Consequently, 2016 also saw record number of bankruptcies for North American energy companies. Yet, didn't the oil companies reduce costs to turn profitable? Adding to the woes, Iran's production increased to about three millions a barrel in early 2016. Along with increase in Iraqi output, exports from Saudi Arabia spiked too.

So, how did the shale industry respond? They boosted production. By the second half of 2016 things began to look up. The crude oil production in the US averaged 8.9 million barrels per day in 2016, according to EIA. What about the rigs? From a peak rig count in 2014 and the subsequent decline, it was only after June 2016 that the rig count in the US showed slight improvement. By December 2016, the average US rig count was 634 about five hundred more than the previous month.

Well, the efficiency increased so much that oil companies could make profit at $45 a barrel where as previously the marker was at $90 a barrel. Shale oil recovered faster than anyone could have anticipated. Yes, Saudi Arabia had underestimated the US.

So, OPEC went under serious dilemma with regards to further production cuts as any further production cut will be market share lost by Saudis to the US. OPEC extended the production cuts but it was already too late. Shale had scored a decisive victory.

In marked contrast, at present, shale producers can dynamically ramp up production if there is shortage in the market. Could anyone, leave aside Saudi Arabia, have expected such a turn around? Such positivity in the US energy field is also thanks to Saudi Arabia's schemes.

Further, this situation where US producers are able to increase oil production makes the supply 'elastic'. Basically, it means that oil producers are on track to produce more on the face of immediate volatile demand. Remember, it was 'inelastic' supply that caused oil to shoot up to $140 a barrel in 2009 when rise in demand caused shortage? Of course, the present 'elastic' supply is a big cause of worry for OPEC.

Even if, in the future, OPEC increases output, oil prices will fall below $30, which will impact the fiscal management of OPEC countries especially Saudi Arabia more. A move none of the OPEC countries can afford.

Shale dominates

Oil production in the US is all set to record a historic high of 10 million barrels per day before December 31, according to latest reports. As a matter of interest, it's shale drilling that has compensated for the declines from conventional oil fields. Thus it would be shale that will help the US match the record of 10 million barrels a day seen previously in 1970. At present, production is at about 95,000 barrels per day.

On the export side, the oil industry exported about 1.3 million barrels of crude per day last month. On the back of it, the decision of OPEC and Russia to cut output by 1.8 million barrels a day for another nine months hasn't had an expected impact on the market.

The refineries in the US too processed a record 17.51 million barrels in May beating 17.29 million barrels set in April. In the first quarter, US exported about 900,000 barrels of crude per day, which is a significant number. Exports are now reaching markets in Europe and Asia too.

The big question is: will the strides continue with Trump at the helm?

Looking forward

The analysis of Trump and Saudi Arabia in recent times throws up quite a few implicit pointers. 'Tremendous investments in the United States' said Trump after meeting the Saudi king. Which begs the question - While on the state visit, what concessions did Trump have to make with Saudis behind closed doors for that $100B weapons deal? Reading between the lines, looks as though the oil industry in the US has many reasons to watch their toes. Indeed, they'll have to keep an eye out for a downfall of this "Saudi deal" disguised as new legislation that would penalize frackers.

Time and again, we've seen that close-door deals with Saudis hidden from public scrutiny usually come with heavy consequences. Take France for example. France is the world's second biggest aerospace exporter next only to the US with $77B vs $131B of USA. In June 2015, France inked some historic deals with the Saudis for $12B worth of defense equipment including H145 airbus helicopters. Months later, France signed another deal with the same kingdom for $11.4 billion. France is also helping Saudi Arabia in its communication and observation satellite's programme.

Strip away the fa&‌ccedil;ade and you'll find that the architect of these deals was none other than Olivier Dassault, heir to the Dassault Group, maker of the Mirage and Rafale multirole fighter aircrafts. Olivier Dassault is also chairman of the Saudi-French Friendship Group of the French Parliament, an extremely controversial government entity which for many years has centralized and promoted Saudi culture in France - importing radical Imams and fast-tracking their residency permits - in exchange for military contracts. Coincidently, Olivier's father Serge Dassault - currently CEO of Dassault Group - routinely sells massive quantities of military and civilian aircrafts to Saudi Arabia. Clear?

Over the years, this cozy friendship has proven too expensive for France. Indeed, it has turned France into the number one western exporter of ISIS fighters. Saudi-funded and controlled mosques are strategically being planted in all of France's major metropolitan areas in spite of Saudis propagating a very hardcore Wahhabist branch of Islam. Suicide attacks and terrorist plots have become a common occurrence.

Yet coincidently with Trumps' deal, the Saudis also inked another $100B deal with Blackstone Group LP, a sizeable investment in US infrastructure projects. That is, a direct access to the nerve centres of the US. It also comes at a time where Trump is planning to privatize power transmission lines in 20 western states currently operated by the Federal government.

So, we are giving the Saudi Kingdom control over one of the most important strategic assets and chore engine of American innovation: electrical power in the western states, the same - currently inexpensive - power that make Google, Facebook, Data Centers and the Silicon Valley competitive. Was this "condition" attached to the $100B defense deal? No one could tell as it's the nature of closed-door deals.

Since 2014 low oil prices have depleted the Saudis wealth fund which stands at $400B by our estimates, and $100B is no chump change to the Saudis. Now that Saudi attempt to derail the US energy market has failed, this is a last-ditch attempt to diversify away from crude oil, whose price OPEC no longer control.

A productive workforce - which the Saudi's sorely lack - is the most important asset of any modern economy. Owning the western grid will let the Saudis once again levy a tax on today's American productivity as they did in the 70s when productivity was more tied to fossil fuels. Which is a mighty shame, to say the least.

Expect your power and internet bills to go up in the next few months.