US Shale Revolution: Smaller, Leaner, Stronger
The shale oil industry will likely emerge from the current turmoil somewhat smaller and slower, but leaner and more competitive
2014 economic metrics for shale oil are a “rear view mirror”: the industry’s cost structure and average well productivity will look very different a year from now.
An oil price of $60 per barrel may prove sufficient for the aggregate U.S. shale oil production to be sustained at current levels or even grow.
The shale oil industry will likely emerge from the current turmoil somewhat smaller and slower, but leaner and more competitive.
Due to its flexibility, shale oil has greater resiliency to oil price swings in terms of returns than conventional oil mega-projects.
Lack of sufficient correction in the “Super-Majors” stock prices, particularly for Exxon, raises a concern regarding ultimate under-performance.
Shale Oil: Adaptability
In its January investor presentation, Continental Resources provided return estimates for its revised 2015 drilling program (as a reminder, Continental recently reduced its capital spending plan to $2.7 billion from the initial plan of $5.2 billion).
The slide below summarizes estimated returns by play for a wide range of oil prices, from $40 to $90 per barrel, and $3.50 per MMBtu natural gas
(Source: Continental Resources, January 2015)
The slide illustrates the main challenge U.S. shale oil operators are facing:using the current strip pricing and existing cost structure, the vast majority of existing drilling programs cannot justify investment.
The slide also captures the essence of the industry’s response to the change in the macro environment that will become increasingly apparent as more operators roll out their plans for 2015:
- * Drilling programs narrowed down to “core of the core” areas;
- * Deep, across-the-board cost cuts;
- * More disciplined matching of cash flows and spending;
- * Continued search for return-enhancing technical solutions;
- * Reduced growth rate and effectively shrunk asset bases.
Many of these remedies are what investors probably desired but could only dream of just six months ago. Arguably, such adjustment is objectively needed in the industry that has been booming for several years in a row. The most important change is the greater focus on efficient use of capital, as the flood of external funding on highly favorable terms has effectively been interrupted.
The obvious (and high) cost of these measures: shale oil will be a somewhat smaller industry in the next couple of years, as the run rate of drilling activity will likely decline by approximately one-quarter to one-third by the middle of 2015 from the third quarter of 2014 (based on my estimate) and may decline even further if low oil prices persist. Capital spending cuts are likely to be even deeper, in part compensated by higher well productivity, lower cost per well and other efficiencies.
With the industry cutting capex and reducing focus mostly to select sweet spots, the exploration and delineation of many promising assets will be put on a back burner. Those assets are not going away, however, and the industry’s technical progress will continue uninterrupted. In fact, those less established or less prolific assets will also indirectly benefit from the adjustments the industry is going through. Due to the industry substantially reducing its cost structure, marginal assets are effectively becoming less marginal (let’s not forget that U.S. shale oil is just a small component of the global oil supply). Still, marginal assets’ valuations will be impacted strongly due to the uncertain timing and pace of their development.