When will the US fracking spree finally slow down?
The oil market is becoming obsessed with a single question: when will shale crack?
Not in the sense of pumping rock full of fluid until it fractures to release petroleum. But as in, when will the US shale oil industry’s fracking spree finally slow down? The discussion has become more urgent since West Texas Intermediate crude tumbled below $50 a barrel.
Independent companies exploring shale in aggregate act like a precision valve in the oil supply machine, increasing output as prices rise and decreasing it when they fall.
Yet Wall Street seems to have miscalculated the point at which lower oil prices force producers to constrict this valve. This week Andy Hall of Astenbeck Capital Management, famed as a resolute oil bull, warned in a letter that the “long-term price anchor for oil has moved lower” because the cost for extracting shale oil has become surprisingly cheap.
The shale industry’s recovery from the market plunge of 2014-16 is one of the two main influences on today’s oil market. The other is Opec, whose decision with allies including Russia to cut output, inadvertently helped rescue shale producers last year.
After declining in 2016, US crude oil production returned to growth this year. The government’s latest forecast projected volumes would reach a record above 10m barrels per day (b/d) in 2018, led by drilling in places such as the Permian Basin of west Texas and the Scoop and Stack areas of Oklahoma.
The expansion followed a doubling of oil prices from the sub-$30 depths of early 2016 to $55 in January. But on Friday WTI was just above $44, with prices dropping over the past month. At that price, operators in less attractive basins struggle to make money, analysts say.
Any fall in shale output would not happen until 2018, if then. Six months typically pass between sinking a drill bit and getting oil from a new well, and the number of drilling rigs climbed in the first half of this year.
Analysts have been slashing their oil price forecasts and examining the sensitivity of shale production to lower prices. Every dollar-per-barrel move adds or subtracts 100,000 b/d from next year’s US crude supply, argues Bank of America Merrill Lynch. “Within a $20 band, you get an almost 2m b/d swing,” says Francisco Blanch, the bank’s global head of commodities research.
Citigroup sees price swings having a modest effect on production this year. But next year US oil output could range from 9.6m b/d if it was $40 a barrel to 12.1m b/d at $70 barrel. “It’s all about 2018,” the bank says.
The industry’s resilience in the face of lower prices reflects efficiency and productivity improvements, such as drilling multiple wells from the same spot above ground and making each one longer. Occidental Petroleum, the largest Permian operator, says it can increase production by 5-8 per cent with oil prices at $50 a barrel and keep it steady at $40. “We believe that we need to be prepared for a $40 environment,” Vicki Hollub, chief executive, told a conference last month.
Many producers also took advantage of an oil price rally last December, after Opec’s agreement on output cuts, to lock in sales for 2017 and so insulate themselves from lower prices. As of early May, leading US companies had hedged 57 per cent of their oil output for 2017, according to figures compiled by Energy Aspects, a consultancy.
Next year may be a different story.
When Energy Aspects took its snapshot, producers had hedged only 21 per cent of output planned for 2018. While that percentage is likely to rise, the hedges will be unpalatable at current levels. Futures contracts for oil in 2018 traded below $50 a barrel this week.
“Eventually the forward price is the brake on shale production,” Mr Blanch says.
Hess, an independent producer, was recently running four drilling rigs in the Bakken shale of North Dakota, more than needed to increase its production. Plans to add two more “will be a function of oil prices”, John Hess, chief executive, told investors late last month. “And at current prices, we would likely defer the increase.”
What happens next will depend in part on Opec, led by Saudi Arabia. The cartel and its allies recently extended their production cuts until early 2018, and could tighten the taps further if the situation becomes too dire.
Timothy Dove, chief executive of Texas producer Pioneer Natural Resources, reassured investors last month the industry was “not going to drill ourselves into oblivion”. Current prices are “not sustainable”, he said. Why? “Two words: Saudi Arabia.”
But if the Saudis and other Opec members try to boost prices by further curtailing supplies, they risk throwing shale companies a lifeline. As Mr Hall said in his letter to investors, it would be “futile” to try to push oil prices to $60 when shale’s marginal cost is sinking into the $40s.
“It is unlikely that Opec will find the cohesion necessary to keep prices at an artificially elevated level,” he wrote, “if all it does is accommodate rampant growth in shale oil production.”