Oil prices have bounced off of recent lows of just below $40 per barrel in early August and are hovering just under $50. Even though they are still languishing at a fraction of what they were years ago during the shale drilling frenzy, prices are high enough to support a small rebound in drilling in the U.S. Several companies, in fact, have announced their intention to restart some activity, while many more have signaled their willingness to do so if prices rise a bit more.
Even though prices are still languishing at a fraction of what they were years ago during the shale drilling frenzy, they are high enough to support a small rebound in drilling in the U.S.
A recent analysis from Rystad Energy finds that the average North American shale well can break even at $25 to $30 per barrel, which amounts to a 22 percent year-on-year decline between 2013 and 2016, reflecting ongoing cost savings in the industry. The irony of lower costs, however, is that a resurgence in shale drilling threatens to put a ceiling on oil prices. There is a great deal of uncertainty surrounding the extent to which drilling will rebound since now is the first time the U.S. shale industry has been tested in the wake of an oil bust. Still, the short-cycle flexible nature of shale drilling could result in oil prices trading within a relatively narrow band for quite some time.
All eyes on the Permian
The U.S. rig count climbed to 406 for the week ending on August 19, according to Baker Hughes, an increase of 90 rigs from the low point hit in late May. Shale drillers are slowly coming back, confident enough that they can turn a profit when oil is $50 per barrel or lower.
But the rebound among shale drillers is not happening everywhere. The top shale basins are weathering the collapse of oil prices in different ways. The once prolific Bakken and Eagle Ford are giving way to the much more attractive Permian Basin in West Texas and the SCOOP/STACK play in Oklahoma. The Permian Basin has added 59 rigs since May, while the Eagle Ford—one of the earliest regions to see shale drilling take off—has seen a return of just 7 rigs over that timeframe.
The Permian has become the default option for shale companies looking to drill new wells.
The divergence in the data among the different plays is showing up in the production figures. The Eagle Ford in South Texas has been one of the largest victims of the oil price downturn, losing 700,000 barrels per day since hitting a peak at 1.7 million barrels per day (mbd) in February 2015. The Permian, on the other hand, saw production increase throughout 2015, and output is down by only a negligible 40,000 barrels per day from a peak earlier this year at just over 2 mbd. This trend is expected to continue: The EIA expects the Eagle Ford to lose another 53,000 barrels per day from August to September while the Permian is expected to see a slight uptick of 3,000 barrels per day.
The Permian has become the default option for shale companies looking to drill new wells. Not only are production figures holding steady and the rig count rebounding, but the Permian is also home to the majority of asset sales this year, as oil companies, banks and private equity hunt for bargains in one of the few areas of the country that can still turn a profit at today’s prices.
Bloomberg reported that the Permian Basin accounts for nearly half of the overall asset sales this year—of the $16.7 billion in asset sales, about $7.46 billion took place in the Permian. The Eagle Ford, by comparison, saw only about $1.88 billion in sales. In the latest example of this trend, PDC Energy paid $1.5 billion to purchase two companies with assets in the Permian. A few weeks ago, Parsley Energy agreed to pay $400 million for drilling rights in the Permian, and Concho Resources said that it would buy more than 40,000 acres in the Permian from Reliance Energy for $1.6 billion. Concho’s CEO Tim Leach told analysts in a conference call in early August that the Permian has “the hottest zip codes in the industry.”
Enough to move the needle?
The impressive performance of the Permian Basin does not necessarily mean that overall U.S. oil production figures will bounce back. While companies drilling profitable wells when oil trades below $50 per barrel is noteworthy, the industry could merely be focusing its increasingly scarce resources on the best plays. This strategy of “high-grading” makes sense for individual companies that can gain access to profitable areas in the Permian, but it does not reflect an industry that is healthy at sub-$50 oil.
While companies drilling profitable wells when oil trades below $50 per barrel is noteworthy, the industry could merely be focusing its increasingly scarce resources on the best plays.
Production is holding steady in the Permian as companies reroute billions of dollars from the Bakken and the Eagle Ford, but the result is a sharp fall in output at just about every major shale play in the country outside of West Texas. U.S. oil production is still down more than 1 mbd and the losses are expected to continue into next year. The EIA projects U.S. oil production to fall from 9.4 mbd in 2015 to 8.7 mbd in 2016, with output falling to just 8.3 mbd in 2017. Those figures assume that WTI rises from an average of $41.16 to $51.58 per barrel from 2016 to 2017.
The Eagle Ford, the Bakken, and other shale basins will require higher prices before drilling restarts in earnest. If the other shale basins in the U.S. can rebound as well, the effects could be profound for oil prices. If U.S. shale bounces back when oil prices rise to $55 to $60 per barrel, the new supply will send prices careening right back down. Similarly, with a substantial volume of shale unprofitable below $40, any price dip under that threshold knocks output offline, forcing prices back up. The end result could be oil prices trading within a “shale band,” as Olivier Jakob of Petromatrix coined it last year—a price range where oil trades because of the quick stop and start reactions of shale drillers.
If U.S. shale bounces back when oil prices rise to $55 to $60 per barrel, the new supply will send prices careening right back down. Similarly, with a substantial volume of shale unprofitable below $40, any price dip under that threshold knocks output offline, forcing prices back up.
The shale band theory has not been thoroughly tested yet, and the sharp cutback in exploration and development could be sowing the seeds of a supply shortage somewhere down the line. The industry has cut about $1 trillion in planned capex between 2015 and 2020, which means prices could suffer a spike toward the end of the decade when demand growth increasingly exceeds increases in supply.
But if shale production can fully spring back to life once oil prices rise to $55 or $60 per barrel, WTI and Brent might not be able to sustain price levels much higher than that upper part of the price band for long. In other words, the oil market could see several years of oil trading at $60 or lower if shale drilling picks up pace.