GAVIN WENDT: The current stoush between ‘Sheikh and Shale’ (as The Economist has brilliantly described it) presents the ideal opportunity for an examination of the economics (or otherwise) of shale oil production.
I’ve been a long-time skeptic of the hype surrounding shale oil, as it is high prices over the past few years that have made shale oil viable.
If you listen only to the hype emanating from the USA spouted by brokers, deal-makers, drilling-rig operators and company executives, the economics of shale oil are beyond question.
But this is far from the truth. Sure, there has been a tidal wave of new oil produced from various US shale formations over recent years, but the commerciality of this oil has been underwritten by the high oil price environment (+US$100 per barrel) over recent years.
Without high oil prices, this shale oil is in most instances uneconomic – a fact we’ve been at pains to point out. Effectively, it’s high prices that have made shale oil viable.
The danger has always been that if production surges (as it’s done over recent years due to the plethora of US drill-rig owners cashing in on the fracking boom), the resulting production glut would drive down prices and render many shale producers uneconomic.
Shale oil has significant cost disadvantages
There’s nothing earth-shattering about shale oil – it’s been known to exist for decades.
The big change however has been the advance in modern extraction technology, which has made it commercially viable to extract oil from great depths from ‘tight’ reservoirs that typically won’t flow without significant assistance.
But as always there’s always a catch – shale oil requires a high oil price environment in order to survive.
The reason is that ongoing operating costs associated with maintaining production from shale oil fields are very high.
This is primarily due to the fact that shale oil wells have a very rapid rate of depletion, unlike typical conventional oil wells, where depletion rates are much steadier.
Another significant disadvantage of shale oil production is that hydrocarbons are heavier and thus flow more slowly.
The fracking process required to enable the oil to flow ultimately drives up the cost of production (particularly by comparison with conventional oil reservoirs).
What this all means is that shale oil production requires aggressive drilling of new wells in order to keep the oil flowing – which is a very costly business.
A business that US drilling rig companies have profited massively from over recent years.
The statistics are stark. Locations within North Dakota’s Bakken Shale are losing 85 per cent of their capacity within a few years.
Industry experts Global Sustainability estimate that the US will need to drill 6,000 new wells per year at a cost of US$35 billion just to maintain current production rates.
Accordingly, it estimates that by 2017 the US will hit its maximum production levels and ultimately return to 2012 production levels.
Given the necessary time, difficulty and cost, shale production break-evens within the USA can range any-where between US$60 and US$80 per barrel.
At current oil price levels this is clearly unsustainable – a situation being borne out in the drastically falling drilling-rig rates.
You won’t have heard of him, but US geologist Art Berman is one of the most out-spoken critics of the shale gas revolution.
Based on the US Energy Information Agency’s (EIA’s) own data on US shale gas resources, he concludes that there is only about eight years’ worth of supply left in the ground – far less than forecast by EIA, which projects dramatic increases in production at least through 2040.
According to an article on Berman’s contrarian claims, he “recently studied one area that has been actively drilled for several years and found that between 25 per cent and 30 per cent of the wells drilled that are five to seven years old are already sub-commercial.”
On the other hand, industry typically claims up to a 40-year lifespan for new wells, highlighting a very large potential discrepancy. Many of today’s wells don’t, according to Berman, even cover lease and operating expenses because their production has already fallen too low.
Berman estimates that the average annual decline in the first five years for shale gas is between 30 per cent and 40 per cent, compared to about 20 per cent per year for conventional wells. This means that every three years, the entire shale gas production resource needs to be replaced.
Berman also concludes that the commercially viable area of most natural gas fields is around 10 per cent to 20 per cent of the geographic area.
If Berman is even close to being right, the very crude model that the EIA uses to project natural gas production will be well wide of the mark.
This is because the EIA projects future production based on geographic area and well density in that area.
But if historical production data comes from the 10 per cent to 20 per cent of the area that is the best producing area, the ‘sweet spots’ as it were, it will not lead to accurate extrapolations for the entire area.
Berman adds that shale gas plays are often unprofitable, even when they’re producing at high levels, be-cause it costs a lot more to produce shale gas than it does to do so in conventional plays.
He has good company in this assessment. Exxon CEO Rex Tillerson has said that, “we are all losing our shirts” on shale gas, though he made this statement when natural gas prices were far lower than today.
Berman sums up his view thusly: “We are spending more and more to get less and less.”
Berman is certainly the loudest critic and also the source of many other critics’ information about EIA forecasts.
Time will tell if shale energy turns out to potentially be the biggest ‘ponzi’ scheme ever created.
OPEC producers are also under margin pressure, but have a greater capacity to ride out the storm, particularly heavyweight producer Saudi Arabia.
It simply doesn’t make sense for OPEC to cut production as it has in the past in order to try and restrict supply, if at the same time US shale producers also don’t implement cuts.
Any OPEC cuts would simply provide price support prices and relief for US shale producers, who are obviously hurting more. OPEC wants to protect its market share.
Impact on Australian oil companies
In terms of the earnings and share market impacts on the key domestic oil players like Woodside Petroleum (ASX: WPL), BHP Billiton (ASX: BHP), Santos (ASX: STO) and Oil Search (ASX: OSH).
For example, Australia’s biggest independent oil play Woodside Petroleum has seen its share price fall by around 15 per cent along with Oil Search, whilst BHP Billiton is down by around 30 per cent and Santos is down by more than 45 per cent.
What this tells us is that all companies are impacted differently and it’s therefore hard to generalize about the impact on oil price falls on the sector.
For example Woodside has only been modestly impacted because it generates a sizeable chunk of its earnings from LNG.
Furthermore, its share price had taken a battering over the previous 12 months for various corporate reasons, so the stock was coming off a rather low base.
PNG-based Oil Search has also not been as dramatically affected, mainly due to the fact that it’s quite a low-cost oil producer and is also diversifying its income stream into LNG.
BHP Billiton has a significant shale oil exposure and the cost of producing oil from shale is typically higher than from conventional oil fields. BHP’s share price has also been impacted by falling oil prices.
Santos is by far the worst affected because it has quite a high debt burden as a result of its heavy exposure to Queensland coal seam gas and export LNG.
Put simply, strong underlying oil prices have encouraged the advent of shale energy and are continuing to facilitate its sustainability.
Whilst shale can produce vast new volumes of oil, this comes at a cost – and a robust underlying oil price is necessary for its commerciality.
Rather than driving down oil prices, shale’s commerciality is as a direct result of strong existing oil prices.
I believe that the current low oil price environment cannot last and that after a period of price consolidation, we will begin to see oil prices climb during H2 2015.
Gavin Wendt is the founder of MineLife, publisher of the MineLife Weekly Resource Report
This article first appeared in 
