The Fuse

Can Shale Undercut the OPEC-Fueled Price Rally? 

by Nick Cunningham | December 16, 2016

The OPEC deal last month immediately pushed oil prices up more than 10 percent, gains that have been sustained in the ensuing weeks despite choppy trading. Together, the OPEC cuts of 1.2 million barrels per day (mbd) and the 558,000 b/d of non-OPEC reductions will take almost 1.8 mbd off the market, possibly tipping the global supply balance into deficit as early as the first half of 2017.

The OPEC cuts, if implemented, will substantially tighten global supplies and thereby provide price support for crude. However, higher oil prices may merely spark a revival in U.S. shale production, which in turn could kill off the price rally.

With demand expected to exceed supply, the record buildup in oil inventories over the past two years will likely start to come down, although estimates over how quickly that will occur vary widely. Bloomberg estimates that oil inventories will draw down by 760,000 b/d per day, while the IEA pegs the figure at a slightly smaller 600,000 b/d drawdown. The EIA is less bullish, expecting inventories to actually increase by 400,000 b/d over the course of 2017.

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The OPEC and non-OPEC cuts, if implemented, will substantially tighten global supplies and thereby provide price support for crude. However, higher oil prices may merely spark a revival in U.S. shale production, which in turn could kill off the rally.

U.S. shale picking up

Securing hedges for future production offers price certainty for shale companies, which allows them to spend and drill with confidence. That alone could lead to an uptick in drilling.

The OPEC deal has already been a boon to U.S. drillers. Shale companies rushed to hedge their production for 2017 and 2018 following the cartel’s announcement to remove supply from the market, locking in prices above $50 per barrel for future production. Prices are volatile, so drillers are not taking any chances. The result has been a flattening of the futures curve, with contracts for delivery in the next few years hovering in the mid-to-low $50s.

Securing hedges for future production offers price certainty for shale companies, which allows them to spend and drill with confidence. That alone could lead to an uptick in drilling.

There is a great deal of uncertainty surrounding the implementation of OPEC and non-OPEC production cuts, given the history of mutual distrust and a long track record of cheating on quotas. Former Saudi oil minister Ali al-Naimi recently admitted as much, saying “we tend to cheat.” However, the agreement called for monitoring committee to oversee compliance, and while it is completely plausible that there will be some cheating, it is not unreasonable to expect a relatively high level of adherence to the production targets. Goldman Sachs offers a scenario that assumes a 73 percent compliance rate, which would take OPEC’s collective output down to 33.0 mbd instead of the 32.5 mbd announced on November 30. Even if the cartel delivered on only three-quarters of its promised reductions, Goldman believes that U.S. shale production will surge back by 800,000 b/d in 2017, with WTI averaging $55 per barrel.

Although estimates vary, most oil watchers agree with that general sentiment—U.S. shale is coming back.

Breakeven prices lower

According to S&P Global Platts, an average well in the Permian Delaware has a 37 percent internal rate of return (IRR) at $55 per barrel. But at $65 per barrel, that IRR rises to a 51 percent. Other basins, even outside of the highly prized Permian Basin, will also see profitability rise substantially if WTI moves into the $60s. In fact, as recently as two years ago, the major shale plays in the U.S.—the Eagle Ford, the Bakken, the Permian and the Niobrara—all had breakeven prices at or above $60 per barrel. By 2016, however, breakeven prices have fallen by half, as technology has improved, operations become leaner, and equipment and services become cheaper. Reuters reports that the average Bakken well can now breakeven at $29.44 per barrel.

The U.S. oil and gas rig count has already climbed by more than 50 percent since May, adding 220 rigs in six months. The industry could begin adding rigs at an accelerated pace—for the week ending December 9, the U.S. saw 21 oil rigs and 6 gas rigs added back to the field, the largest single-week increase in more than two years. Clearly the industry has been revitalized as a result of the price rally.

The larger oil majors are expected to remain cautious through next year, but U.S. independent shale companies are starting to step up their spending plans, eyeing a swift return to the shale patch as oil prices rise.

The larger oil majors are expected to remain cautious through next year, with billion-dollar investments tied up in offshore drilling or LNG export terminals. Many of the majors repeatedly lowered their 2016 spending guidance over the course of the year in order to slim down. Chevron alone is expected to slash 28 percent from its spending levels in 2017.

But an array of U.S. independent shale companies are starting to step up their spending plans, eyeing a swift return to the shale patch as oil prices rise. In its December Oil Market Report, the IEA noted that independents such as Anadarko, Apache, Chesapeake, Continental Resources and EOG Resources revised their 2016 capex levels upward by 13 to 20 percent compared to their original plans earlier this year. On top of that, Chesapeake, Devon Energy, Murphy Oil, and Noble Energy are boosting their 2017 guidance by even larger percentages.

“In the upcoming year, we plan to continue to accelerate drilling in our world-class Delaware Basin and STACK assets. We expect this increased activity to deliver strong growth in high-margin production and further expand our recoverable resource in the U.S.,” Devon Energy’s COO Tony Vaughn, said in a December 6 statement after reporting positive results from a New Mexico drilling prospect.

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Another reason that drilling is likely to increase at a faster rate is due to the sharp improvement in the financial health of the shale industry. To be sure, there have been a high number of bankruptcies in the U.S. shale industry over the past two years, and debt levels are still extraordinarily high. But cost reductions and operational improvements have led the consolidated industry to hit a milestone—the IEA says that in the third quarter of 2016, for the first time in its history, the U.S. shale industry achieved cash flow neutrality. After years of surviving on debt, shale companies are now largely able to finance their capex budgets from cash flows. As the IEA put it, “After more two years of very difficult times, the US shale business model seems on a much more sustainable path.”

Shale benefits from short-cycles and low upfront costs, which makes it a much more favorable investment in today’s uncertain price environment compared to larger conventional projects. For example, while Chevron is making large cuts to capex in 2017, it is increasing spending specifically on shale by $1 billion.

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Shale to kill price rally?

The consensus is that shale is already rebounding and will raise production in 2017. The debate is only over how strong and how quickly the resurgence will unfold.

Weekly EIA data, which is not quite as accurate as the retrospective monthly figures that are published on a lag, shows that U.S. oil production is already back up by more than 300,000 b/d since hitting a low point at 8.43 mbd in July. The Permian is the hottest shale basin in the country, but other regions are also showing some signs of life. The Bakken is back up over 1 mbd in total output after spending a few months below that threshold. The consensus is that shale is already rebounding and will raise production in 2017. The debate is only over how strong and how quickly the resurgence will unfold.

The OPEC deal could create a supply deficit in the early part of 2017, pushing oil prices up to $55 or $60 per barrel. But further price gains are unsustainable, Goldman Sachs says. As the new U.S. shale supply comes online, prices may fall back again. Goldman expects WTI to drop to average just $50 in the second half of 2017 as the rebound in U.S. shale undercuts the price rally.

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