Energy Economist: Shale oil’s response to prices may call for industry re-evaluation

OREANDA-NEWS. Global crude oil production has only fallen in six years since 1984 and then generally as a result of geopolitical disruptions to supply or restraint by OPEC, rather than as a reaction to price. This is because the conventional oil industry has a strong lagged cyclical dimension, as evidenced by the 300,000 b/d of new oil slated to come on-stream in the US Gulf of Mexico this year. This output is the result, in some cases, of exploration more than a decade back and investment decisions five to six years ago.

Current production is governed not by the initial capital cost but by operational costs. WoodMackenzie has estimated that, based on 2,222 oil fields, representing total liquids output of 75 million b/d, only 190,000 b/d of oil production is cash negative at \$50/b. The figure rises to 400,000 b/d at \$45/b and to 1.5 million b/d at \$40/b.

A low oil price therefore has little impact on production from an existing field and little impact on developments under construction for which capital has already been committed. It will have significant impact on new phases of field development, but will have most impact on new field development. The effects of this will not hit production levels for three to five years or longer for major new offshore field developments in harsh and remote environments.

Moreover, both development and operational costs have some elasticity. Just as oil companies ceded value to the services sector as oil prices rose, they will look to reclaim some of that value as oil prices fall. Producers can expect to rebuild lost margins to some extent through lower input costs. As a result, the currently estimated breakeven cost of new developments should fall. The oil sector will experience internal deflation, which reinforces the cyclical aspect of oil investment. Companies will not invest in new projects today, if they believe the cost of doing so will be cheaper tomorrow.

However, US shale oil adds a new dynamic. The Baker Hughes US rotary rig count saw a peak of 1,609 oil-directed rigs in the week ending September 19, but this had dropped to 1,575 by the beginning of December and to 1,317 by January 23. Shale oil production is reacting quicker to price than conventional drilling.

Shale wells are quick to drill and have a different decline profile to conventional wells. While conventional wells typically display a hyperbolic decline curve, the decline rate from a shale well is much steeper from the start. A typical Bakken well might lose 65% of initial output in the first year followed by a further 35% of the remaining output in the second. There is then a long tail of output at very low levels extending for over two decades.

As shale drillers can drill and complete wells more quickly than a conventional development, and will receive the bulk of a well’s output almost immediately, they have a different price horizon, one much more focused on current price levels and the short-term outlook. They are not, like conventional drillers, so interested in the oil price ten years hence.

The January report from the North Dakota Department of Mineral Resources noted that the state’s rig count dropped 3 in November, 7 in December and a further 25 up to January 14. The number of well completions fell from 145 in October to a preliminary estimate of 39 in November. Drilling continued to outpace well completions by some margin: the backlog of uncompleted wells jumped from 610 in September to 650 in October and to 775 in November.

A conventional driller will complete a well to recoup development costs even in a low price environment. Shale drillers appear to be weighing the drill cost of the well against the completion costs, given the high proportion of initial output from the well. They can expect well completion costs to fall and can hope that oil prices will rebound. From this perspective, they may choose to delay well completions, in which case US shale output will fall more quickly. The data from North Dakota suggests this is what drillers are choosing to do.

Then there are shale’s legacy declines. The problem for US production is that not just growth in output but the maintenance of existing levels of production are dependent on continuous drilling. Moreover, following a period of strong growth, legacy declines will continue to rise as new drilling and completions stall. The inflexion point at which legacy declines overwhelm new production should occur much earlier than for conventional activity.

The relationship between new production and legacy gains might crudely be illustrated by two sine curves one ahead of the other, with the net gain represented as the difference between the two.

If US shale output slows quickly, it also follows that it can expand again rapidly should prices rebound. It will be an industry with surplus productive capacity in the form of drilled but uncompleted wells, ready to go. It also follows that after a period of contraction, legacy declines will also start to slow, providing the potential for a spurt in net output growth once drilling activity returns to former levels.

This suggests that shale is best placed to benefit from any upturn in the oil price. The different response rate of the shale sector to price swings may now cause a re-evaluation throughout the industry of how oil companies address the investment cycle.

Share this: