Brilliant analysis: If US Shale passes endurance test, lower oil prices here to stay

As we have been reporting on Biznews, the oil producers’ cartel OPEC has declared war on the North American shale industry. Led by Saudi Arabia, OPEC’s play is to let the oil price drop to a level where its new competitors go out of business. As the Saudi crude oil production cost is considerably lower than that incurred by America’s frackers, the Arab bet is to let the low oil price become the solution to the low oil price. This morning the Iranian Oil Minister explained that if OPEC disintegrated the oil price could drop to as low as $40. How the two sides stack up is explained in this brilliant analysis by Ed Crooks of the Financial Times of London. We’re witnessing a wrestle between oil and shale – in whose outcome the entire world has an interest. Especially oil importers (and potential frackers) like South Africa. – AH  

By Ed Crooks of the Financial Times 

When Saudi Arabia and other Gulf countries last month rejected calls for a production cut by Opec, the oil cartel, they put the responsibility for stabilising plummeting crude prices on to the US shale industry. Suhail al-Mazroui, energy minister for the United Arab Emirates, said US shale companies and other producers who had created an oil glut should “respect the needs of the market”. Less diplomatically, Scott Sheffield, chief executive of Pioneer Natural Resources, one of the leading shale oil producers, said Opec had “declared war” on the US industry.

Two weeks on from that Opec decision – and against a backdrop of a 40 per cent fall in the oil price since June – evidence of its negative impact on US producers is starting to emerge.

Rather than a war, the US shale industry is braced for a test of endurance. As the pressure on oil producers mounts, weak companies face the threat of dwindling investment, faltering production, forced asset sales and possible bankruptcy. The successful companies will be the ones that both entered the downturn in the strongest position and are most effective at improving their efficiency. They can hope to make it through to better days when the oil price recovers and are also likely to be able to pick up some undervalued assets.

On Monday, ConocoPhillips, the US’s largest exploration and production company, unveiled plans to cut its capital spending by about 20 per cent next year to $13.5bn – a steeper reduction than analysts had expected – and said it would defer drilling programmes in several North American shale areas.

Last Friday, Baker Hughes, the energy services group due to be bought by rival Halliburton, published data which showed the number of rigs drilling for oil in the Eagle Ford shale of south Texas had fallen by 16 since October to 190. The number of rigs in the Bakken shale and related North Dakota formations had meanwhile dropped by 10 to 188.

Also last week, Drillinginfo, a consultancy, published figures showing applications for permits to drill new wells had fallen by about 30 per cent in both the Bakken and the Eagle Ford areas last month compared with October. That may overstate the likely drop in activity, because companies will have a backlog of permits they can use, but it is clear the industry is responding to a steep drop in the oil price.

Allen Gilmer, Drillinginfo chief executive, said: “Because production from shale wells comes on fast and drops off fast, their economics are more exposed to short-term prices.” This applies more than for other types of production, where wells can take years to come on stream. Activity and output from shale can be stepped up and down quickly.

While all shale companies are under pressure, their responses to the declining oil price will often be different. The companies vary widely in terms of debt levels, financing, hedging against price falls, product mix, location and quality of their assets and operational efficiency, and those differences have been reflected in share price movements over the past six months.

One important issue for companies is their gas production. From 2010 until this summer, many US shale companies were shifting away from natural gas and towards more lucrative oil production.

But now gas is back in favour. It has fallen less than oil and is likely to rebound if there is a cold winter in the US. As a result, the shares of gas-focused companies such as Cabot Oil and Gas have often been less affected than their more oil-focused peers.

Another critical factor is debt. The shale surge has been built by borrowing: companies have typically spent more on drilling and completing wells than they have generated in cash flows and in the past decade about $163bn worth of high-yield debt has been issued by US oil and gas producers. Some have relied more heavily on debt than others, however.

If US crude were to average about $70 per barrel next year, EOG Resources and Anadarko Petroleum would have debts roughly equal to a year’s earnings before interest, tax, depreciation and amortisation – a very comfortable level, according to analysts at Tudor Pickering Holt, the investment bank. Other larger companies including Marathon Oil, Apache, Devon Energy and Chesapeake Energy also have debt burdens that seem manageable.

At the other end of the scale, companies such as Laredo Petroleum, SandRidge Energy and Range Resources would have debts about four times their ebitda, according to Tudor Pickering, while for Ultra Petroleum, Exco Resources, Goodrich Petroleum and Halcon Resources the multiple would be even higher.

Beyond the financial metrics, the quality of a company’s assets is also important. Some of the companies that are focused on the Bakken shale, including Continental Resources and Whiting Petroleum, have been out of favour with investors, but the early evidence from rig activity and drilling permits is that there is no one “play” – as the different geological formations are known – that has been worse affected than any other.

More than the broad region where a company operates, it can be the quality of its specific lease areas within the region that matters, according to Cody Rice of Wood Mackenzie, another consultancy. In an area such as the Eagle Ford, companies in the core where the rocks are most productive, can continue to thrive, he says, “but if you’re underperforming your peers, and you’re not in the core of the play, it’s not going to be so good for you”.

The other crucial variable is operational performance. Reid Morrison, the advisory leader for US energy at PwC, the accounting firm, says that until this summer there was very little focus on efficiency in the shale industry. When he tried to advise on cost savings, “the reaction we were getting was: ‘We agree with that, but it’s not important right now’,” he says. “There was a lot of confidence that the new floor for the oil price was around $90 per barrel.” Now that view has changed completely: interest in ideas for cost savings is soaring.

Newcomer is here to stay

When Opec members talk about the US contribution to world “oversupply”, they are referring to the growth in US crude production of about 4m barrels per day, about 80 per cent, since 2008. US shale has caused an upheaval in oil markets, and many rival producers, in Russia as well as Opec, hope it will go away.

The existence of a group of financially strong shale companies such as EOG Resources and Devon Energy, however, suggests that the US industry is not about to crumble. They have been covering their capital spending from cash flow generation, unlike many of their rivals, and have little debt. They may cut capex next year, but do not face pressure to make deep reductions.

Any good US shale assets owned by companies that cannot afford to develop them are likely to be picked up by financially stronger groups. If these can drive down costs, helped by increased spare capacity in the energy services industry, the oil prices needed for development to be commercially attractive could be lower than previous estimates have suggested.

Many investors will suffer losses on exposure to oil and gas if prices stay at current levels. But some analysts expect the overall impact on US oil production to be relatively modest.

“The rate of increase in production is going to slow down,” says Philip Verleger, an energy economist. “Even at $50 oil, though, US production probably plateaus, but it doesn’t start going down.”

The groups vary widely in terms of debt, financing, hedging against price falls, product mix and efficiency.

(c) 2014 The Financial Times Limited