By Nick Cunningham
U.S. oil production continues to grow, with the EIA reporting a shocking jump in output last week.
Total U.S. production rose to 9.5 million barrels per day (mb/d) for the week ending on August 11, up 79,000 bpd from a week earlier. That puts U.S. output at the highest level in nearly two and a half years. The U.S. shale industry has been adding new supply pretty much uninterrupted since late last year, despite volatile swings in oil prices over the course of 2017.
In fact, the gains continued even through the price downturn in June, which saw WTI flirt with the $40 per barrel threshold, which, at first glance, suggests that the shale industry is doing just fine.
To be sure, some shale drillers have breakeven prices well below the prevailing market price, allowing them to make money even during those tough times.
But in the aggregate, the industry needs something around $50 per barrel to be sustainable, or perhaps even $55 per barrel. If that is the case, how is it that the U.S. oil industry continues to add new supply, even when some companies are not even making money?
The short answer is that they have been given a long leash by Wall Street. Generous financing, high levels of debt, and repeated equity issuance has given shale drillers a lot to work with. Many of them have seen their debt levels climb, but major investors have been patient, hoping that the growth-before-profits model will eventually pay off.
That approach was more sensible when it was assumed that oil prices would rebound, the idea being that the massive cost reductions have allowed these companies to breakeven at today’s price, which would lead to huge profits when oil prices eventually rebounded to, say, $70 or higher.
But there are several problems with that. First, the conundrum for shale E&Ps is that they have not successfully lowered the breakeven price on a structural basis. A lot of the “efficiency gains” were the result of cyclical – and temporary – declines in the cost of labor and services. The market downturn led to price deflation for oilfield services – equipment and rig rates, completion services, frac sand, etc. Those costs are rising again as activity picks up. Oilfield services companies will demand higher prices, labor shortages will inflate wages, and so on. As the price of oil ticks up, so will breakeven prices.
In other words, “it appears the breakeven points for shale are actually a function of the past price of oil itself,” Ellen R. Wald, a historian and scholar of the energy industry, wrote in Forbes earlier this month.
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The second problem is that most analysts do not see oil prices really staging a rally, at least anytime soon. Just to take one example, Citigroup estimates that WTI will not average $52 per barrel…until 2020.
The third, and perhaps most glaring, problem with the growth-first shale model is that shale companies were burning through cash when oil prices were $100 per barrel, and they are still burning through cash even after the much-heralded efficiency gains achieved over the last three years. According to Bloomberg and Bloomberg Gadfly, the free cash flow after capex for a collection of 33 shale E&Ps has been profoundly negative over the past 12 months. More worrying for investors is that the cash burn in the Permian has been particularly large, and worse, it has accelerated over the past year.
As Ellen R. Wald puts it in Forbes, “when the financiers lose interest, the Shale Revolution will be over.”
And there are some early signs that investors’ patience is starting to wear thin. A long list of shale companies saw their share prices savaged after the latest earnings reports, even as oil prices have regained ground. In a warning sign for the industry, Goldman Sachs reported that it has fielded calls from major investors looking to “reallocate capital across the energy industry” after souring on shale E&Ps.
Meanwhile, equity issuance for E&Ps has fallen substantially this year after spiking in 2016. According to Liam Denning of Bloomberg Gadfly, the industry is on track to issue just $10 billion in new equity this year, the lowest since 2010. There could be perfectly sensible reasons for this – Liam Denning suggests that the rally in oil prices at the end of last year led shale drillers to hedge their production, allowing them to grow without the need of new sources of finance. But, the plunge in new equity issuance could also be the result of shale drillers tapping the Wall Street well too many times.
Ultimately, investors will catch on and the game will be up. If shale drillers cannot turn a profit at today’s prices, they will need to cut back on production and spending, and some will be forced out of business. That means that overall U.S. production will have to cap out, and perhaps even decline, which should eventually force up oil prices.
By Nick Cunningham of Oilprice.com