The recent decline of oil prices to the low-to-mid $40s is putting the U.S. shale industry to the test. At the current price level, many parts of the U.S. shale patch will likely struggle to compete, and a number of shale companies could be forced to cut back on their drilling plans.
Even though the fortunes of the shale industry have suddenly reversed course, it is not clear that production will abruptly take a hit.
“The growth outlooks proposed by many oily E&Ps appear tenuous at best and not resilient to prolonged weak oil prices,” Mizuho Securities USA analysts wrote in a research note earlier this month.
At the same time, however, even though the fortunes of the shale industry have suddenly reversed course, it is not clear that production will abruptly take a hit.
Can shale turn a profit at $40?
Break-even prices for shale drilling vary widely by company and by specific region, but many analysts see trouble ahead if the market fails to rally. The market stuck at $45 per barrel “slows most U.S. shale plays,” according to analysts at UBS. Shale companies have decamped from some higher-cost shale basins and have increasingly concentrated their activity in the Permian Basin, where stacked shale formations offer better economics. But even the Permian Basin would “hit the brakes” if oil prices traded at $40 per barrel for an extended period of time, UBS says.
While analysts differ over the exact price that will trigger a slowdown, a general consensus has emerged that the market is flirting with that threshold at today’s prices. “With oil at $45, there will be very little movement in capital globally, and fewer projects will get sanctioned,” said David Pursell, an analyst at the investment bank Tudor, Pickering, Holt & Co., according to the Houston Chronicle.
“We’re not going to not drill, because this very well may be the time where the well costs are as low as they’re ever going to be.”
However, some of the stronger drillers are unbowed by the recent drop in oil prices. “We’re not going to not drill, because this very well may be the time where the well costs are as low as they’re ever going to be,” Tim Dove, CEO of Pioneer Natural Resources, said at the JPMorgan Energy Equity Investor Conference this week. “We can pare away and still be profitable even in a $45 environment,” he said. “We may just dial back at the margin in that scenario and not be a significant over-spender.” Pioneer says that it can turn a profit in the Permian even if oil prices drop to $30 per barrel.
Harold Hamm, the CEO of the Bakken and Oklahoma-focused Continental Natural Resources, is not as upbeat as his counterpart at Pioneer. He says that if oil drops below $40 per barrel, it would force cutbacks in spending and drilling, causing supply to “dry up.” He cautioned drillers on being too aggressive. “While this period of adjustment is going on, drillers don’t want to drill themselves into oblivion. Back up, and be prudent and use some discipline,” Hamm said in a CNBC interview on June 28.
Pioneer’s chief executive highlighted another trend that could bedevil shale drillers. Drilling costs could start to rise as activity picks up, allowing oilfield service companies to claw back some of the enormous pricing concessions they have made over the past three years. The result could be that shale companies become squeezed on both ends with rising costs and falling oil prices. “They definitely can’t maintain the trajectory they’re on,” said Ben Shattuck, an analyst at Wood Mackenzie, according to the Houston Chronicle. “For a lot of these pad wells to work, you need those ultralow service prices, and that doesn’t happen when you have more than 300 rigs in the Permian.”
One energy equity investor told The Fuse that current circumstances are actually worse than early last year when prices fell below $30, because of differing expectations. In 2016, production was declining and the industry adjusted, but now forecasts see output rising sharply this year and next, which makes the recent crash even more extraordinary and has caught the sector off-guard. “Even though companies’ stocks are taking a hit, it’s not clear that production strategies will change,” said the investor. “No one is really fazed.”
Most companies have already deployed their rigs and are in the midst of drilling, so they might be reluctant to cancel plans. More importantly, the shale industry routinely hedges a slice of its production, locking in prices for the next year in order to provide certainty. The industry engaged in a wave of hedging after the OPEC deal was announced last November, when crude prices rose above $50 per barrel. Many shale companies already have a large portion of their 2017 production hedged, which will essentially lock in some degree of elevated drilling and output. Bloomberg notes that 31 E&P companies hedged 54 percent of their oil production for 2017 at a price above $50. Even if oil prices drop again in the near term, the effect on production will take time to become visible.
The outlook for next year is an entirely different story. In recent months, hedging activity has slowed significantly because of weaker prices. Without $50 hedges, the growth prospects for shale in 2018 are uncertain. According to Bernstein Research, U.S. E&Ps are slated to spend $20 billion more in 2017 than they take in, a situation that will only worsen as hedges expire.
U.S. E&Ps are slated to spend $20 billion more in 2017 than they take in, a situation that will only worsen as hedges expire.
Companies will have to close that gap somehow. Typically, tapping the debt and equity markets is no problem. But new equity issuance has plunged recently. The industry sold only $3 million worth of new shares in June, down sharply from the $1 billion in equity issuance in May. Yields for energy companies with junk credit are also starting to rise, which could make new credit costly. Waning confidence from Wall Street will add another complication to shale drillers.
A rebound to above $50 could throw the industry another lifeline
If oil rises back to $50 per barrel in the near future, the shale industry will be back on track since it could lock in hedges again. If not, drilling activity will eventually slow as marginal producers fail to keep up in a $40 environment.
Ultimately, in the short run, many are still proceeding with their drilling plans, anticipating a price rebound. Pioneer’s CEO is betting that Saudi Arabia will not be able to stomach prices as low as they are today. He told an industry conference that Saudi Arabia’s budgetary pressure will force it into more action to rebalance the market if prices do not rebound soon. In this game of chicken, the U.S. shale industry hopes it will come out on top.