The world has become accustomed to ever-increasing production from U.S. shale reservoirs. As you can see in the chart in the next section production from these tight reservoirs has increased six-fold over the last ten years. It surprised everyone as it grew. Now it’s about to surprise everyone with the rate of its decline.
In this article we will discuss some of the fundamental flaws and misconception the market has about the ability of shale to continue to grow. We will compare and contrast shale reservoirs with the conventional reservoirs that have traditionally supplied most of our energy needs, as well as the reasons why they have been under-funded for the last half-decade. Finally, I will offer a look a little bit down the road for the energy markets as these realities set in.
Here is a little bit of shale-history. In the early 2000’s fracking technology began to be broadly applied to reservoirs that had been viewed as being uneconomic for previous 100 years or so. It was a success, and as the horizontal intervals began to get longer and longer (typically reaching almost 2-miles now, more in some cases), and the amount of sand packed away grew into the 1000’s of pounds per foot of interval…the world changed.
Proclaimed as a miracle, oil imports from traditional sources dropped, and oil exports to foreign markets grew. Along with this shifting of export and import polarity, came the sentiment that the U.S. was now the swing producer of crude oil and would quickly fill any gaps left by other producers. It was a comforting thought if you drive a giant SUV (as I do) and like cheap and plentiful gasoline. In arriving at this determination, some fundamental half-truths and misconceptions were missed by the market.
Half-truth #1. Technology could overcome a fundamental flaw of shale; that being the lack of horizontal connectivity of the reservoir rock. This is known as permeability. In fact through fracking, technology was able to overcome this flaw, but only at a price in the millions of dollars, and only for a limited time, thanks to the high decline rate of shale reservoirs.
Half-truth #2. Cheap money would always flow and fund new drilling. In some part the shale miracle has been kept alive by historically cheap money looking for a return. The problem here is that eventually loans must be repaid or pushed out to infinity. Bankers are getting tired of pushing loans out, hence the increasing rate of bankruptcy in shale drillers.
Misconception #1. All shale reservoirs are created equal. In fact, as we are learning they are not. The Marcellus in the North Eastern part of the U.S. is being abandoned in droves as it is too gassy and thin. By and large the Permian is the receiving play as operators look for ways to grow production. The best example I can cite for this point is Chevron’s, (NYSE: CVX) write down of its Marcellus assets in Q-4 of 2019. I wrote an article about this shift recently that was published in OilPrice
Misconception#2. This is the biggie. The runaway apparent success of shale drilling led the world to anoint the U.S. as the new King of Energy, or the swing producer as I’ve noted previously.
It was obvious, in just a few years from being the largest energy importers in the world we had changed into a net exporter. This was the new reality. One of the fundamental mistakes in investing is thinking the past is a predictor of the future.
The flaw in this thinking as pertains to shale ignores a shale fundamental truth (review Half-truth#1 before reading on) as compared to most oil reservoirs in the Middle East and particularly the Kingdom of Saudi Arabia, (KSA). The flaw being that shale is a tightly compacted clastic with porosity in the 6-7% range most places and permeability in the 10-20 MD range (an MD is 1000th of a Darcy, a standard unit of measure for rock’s flow capacity), and a decline rate of 60-70% per year. By comparison, Ghawar (the biggest oilfield ever discovered) is a conventional reservoir with up to 35% porosity and is comprised of a highly turbidite mudstone and carbonate mix that has a natural permeability above half a Darcy, 500 MD+, and a decline rate of about 2-3% per year. I have worked on Middle East wells with perms of several Darcys. They often flow tens of thousands of barrels of oil per day, mostly without expensive stimulation. I will wrap this up because I am about to get too techno-geek and bore you.
KSA will always have a natural advantage over shale and retain the title of Swing Producer when the world discovers the shale miracle was an illusion. The chart below is a little dated, but the point it makes retains its validity today.
Summary for shale. It has maintained production growth over the last year for two reasons. First, the rate of drilling has continued to bring new production on faster than the decline rate of older wells. Second, Drilled but UnCompleted wells, (DUCs) have been brought out of storage to replace production previously supplied by new drilling. Neither of these scenarios are sustainable, and absent higher prices to spur a resumption of drilling, will result in a decline in overall shale production. Not the growth rate, actual production. This will happen soon.
What attributes do companies need to bring to the shale conundrum going forward?
Low cost of production
Economy of scale
As I have said, this is the future of shale production in America. A future that is just around the corner. What will this mean? For many independent shale operators it will mean they can no longer compete for resources with better organized companies. The era of rapid expansion is over and there will be a consolidation among shale players, led primarily by the Super Major oil companies. This was discussed in a recent article in OilPrice.
This type of development sometimes goes under the moniker “Long Cycle,” and has been shunned in recent years as oil producers fell under the Siren spell of shale’s promise of quick cash flow.
Source It is worth noting that currently we are using about 36.5 bn bboepy against proven reserves of 1.73 Trillion bbl. That equates to 46 yrs of supply, so we are not in any danger of sucking the tank dry anytime soon. But, the larger point is every year we are drawing down known capacity by a factor of 5-6.
Long cycle means it can be several years before any oil is produced. In some cases where complex infrastructure has to be installed, it can run 5-years or longer. During this time money is going out and none is coming in, which is part of the reason shale is so seductive. A couple of weeks to D&C and “Bob’s Your Uncle,” you’ve got an oil well. Not so much with conventionals, as increasingly they are found in deepwater environments and take existing infrastructure and or huge cash outlays to develop.
The good news is that more and more capex is returning to the conventional arena. You can see the trend here. Once contract demand hits about 80 rig years, you should see rates that will provide an adequate return on investment. The question is of course will the legacy companies survive to see it?
General Drivers in the market for oil
One of the things I’ve been discussing in recent articles is a need for a change in the market’s perception from one of abundance to one of shortage, or at the very least interruptible supply. We came close to realizing the latter point a couple of months ago when the U.S. and Iran appeared be ready to go to war. Wiser heads prevailed and the status quo resumed. As a result, oil began to back off rapidly toward the mid-$50’s. The Covid-19 concerns have destroyed the flow of global trade presently and have taken down forecasts for oil consumption another 1-mm bboed.
What isn’t being discussed is the rebound in demand as fears ease. Store shelves are being emptied as people across the world begin horde things that make their existences comfortable. Take a look, at your favorite item, chances are it was grown, built, or created in a foreign country. In a month or two demand will pick up as exhausted supplies of everything will have to be replenished. This means the 3-6-month bull case for oil is pretty strong.
Over the short run, the next few weeks to a month or so, I am more pessimistic. Nothing is going right for WTI or Brent currently. The crash below $50 last week felt very spongy to me and I am nowhere near calling a bottom.
Nor do I expect much from OPEC as they are linked to the Russians now, and Russia seems happy with current prices. There is a case to be made that the Saudis may go the other way and make a run for lost market share. As I said in an earlier article, Putin is ready to give his buddy, MbS some tough love. Will they come around eventually; I think so but MbS is going to have to give something in return other than a bear hug.
When will see a bottom for oil?
You should be able to guess here if you’ve paid attention. The bottom will be firmly set in when production from shale plays actually turns south. That will put the final nail in the coffin for the notion of ever-increasing light oil from U.S. shale. When the market takes this into account WTI and Brent should head higher.
As I’ve said that day is coming, and I don’t think it’s that far off.