U.S. oil production has skyrocketed this year, leaving even the most optimistic forecasts in the dust. But, the recent crash in oil prices could do what the much-hyped pipeline bottlenecks could not – slow down shale production.
Between 2015 and 2017, shale drilling activity fluctuated with oil prices (though on a several-month lag), with drillers deploying rigs and adding output when prices rose, and scrapping rigs and dialing back on activity when prices dipped. Drilling and production has always fluctuated with prices, but the much shorter lead times for shale compared to conventional drilling, meant that the oil market was responding much quicker to price changes.
The ebb and flow of drilling activity gave rise to the “shale band” theory, which dictates that oil prices had an upper and lower bound, largely decided by shale output. Whenever prices tested one of those limits, U.S. shale would steer them back into the middle of the range.
More specifically, if prices rose to, say, $60 per barrel, shale activity would ramp up and new supplies would come online, dragging prices back down below that threshold. If prices fell to $40 per barrel or below, drilling dried up and the drop (or slowdown in growth) tightened the market just enough to push prices back up.
Since late 2017, when the OPEC+ production cuts really began to bite, Brent prices reliably rose above $60 per barrel and stayed there. While prices bounced around this year, they did so above the roughly $40-$60 price range that dominated the oil market over the last several years. As such, U.S. shale continued to grow rapidly and consistently. Outages elsewhere in the world, combined with OPEC+ action, kept prices from falling. Until this past month. The crash in oil prices – down more than a third since October – could make the shale band theory relevant again. WTI is down in the low-$50s per barrel, and is starting to flirt with levels that could impact drilling operations. At $50 per barrel, “we generate enough cash to still grow our production single digits within our cash flow,” Whiting Petroleum’s CFO Michael Stevens said at an industry conference this month, according to the Wall Street Journal. “So $50 is an important floor for us.”
Moreover, while many shale drillers have cut their breakeven prices over the past few years, pressure from shareholders on capital discipline is much stronger than it used to be. In years past, shale drillers could pile on the debt, promising to eventually be profitable, and investors went along. That is no longer the case.
That means that the pressure to cut back in order to preserve profitability is potentially higher than it used to be.
On top of that, some shale regions are still suffering from discounts because of pipeline issues. So, while WTI is now in the low-$50s, some shale operators might be fetching even less. Earlier this year, Permian discounts exceeded $10 per barrel. The Bakken is expected to see its discount worsen as pipelines fill up. The flip side is that drilling techniques have advanced considerably over the last few years, boosting production rates and lowering cost. That could allow E&Ps to weather the current downturn – should it stick around – much better than last time.
As the WSJ notes, the shale industry is in the midst of putting together drilling plans for 2019. Up until now, very few industry insiders or analyst forecasts had prices falling below $60 per barrel next year. The recent plunge could force a rethink. If the industry goes in a more conservative direction, shale output might not grow as much as previously thought.
With all of that said, OPEC+ could put an end to the latest slide in prices as early as next week. Rumors of a large production cut began circulating a few weeks ago, and the lower prices go, the more likely it is that the cartel will take action. At this point, with expectations of some sort of action largely priced in, inaction would likely drag prices down much farther. As such, it seems highly unlikely that OPEC+ will do nothing.