US shale patch faces worsening headwinds
Mounting constraints on US light-tight oil only compound the hazardous task of predicting growth
Major oil forecasting organisations, such as the IEA, EIA and Opec, have severely underestimated growth in US light-tight oil (LTO)—and shale-related natural gas liquids (NGLs)—production for much of the last decade.
But over recent years, the Big 3 oil forecasters, especially the IEA, have significantly reversed this trend, ramping up their medium-term projections for US LTO growth. Are they about to finally get it right, or have they jumped on the bandwagon just in time for it to lose a wheel?
Growth in US LTO production has dropped like a stone since peaking in August 2018. Increasingly production out of the prolific Permian has been pivotal to US output, in sharp contrast to the Eagle Ford which is showing clear signs of age.
Capital markets are largely shunning shale producers because of years of disappointing returns for investors and negative free cash flow
Now the industry is facing increasing headwinds, both below and above ground. These include less access to investment capital, the so-called parent-child well issue negatively impacting well productivity, and two out of the three frontrunners for the Democratic Party’s 2020 presidential candidacy being anti-oil and anti-fracking.
The US LTO industry could, though, continue to benefit from two key factors that have made it the dominant driver of the world oil market in recent years: technological advancements helping to improve well productivity, control costs and expand the country’s crude resource base; and relatively high oil prices, at least for a few more years, given the massive amounts of oil removed from the global market for geopolitical reasons—although this could prove to be a double edged sword.
Forecasting errors for US LTO production over the past decade have often been extremely wayward. Even when the major oil forecasting organisations predicted relatively strong growth for US LTO over the next year or two, which they did last decade, they always had growth rapidly tapering off over the medium term.
The relatively optimistic IEA, for example, underestimated US LTO growth by an average of 3.2mn bl/d annually when comparing final year forecasts to actuals for their medium-term outlooks released between 2011-14 (see Figure 1). The average error is even higher for their 2015-17 reports, at 3.4mn bl/d, when comparing to a 2019 actual estimate of 8.6mn bl/d.
In contrast, the IEA nearly doubled forecasted growth for US LTO in its last two medium-term outlooks, compared to their previous seven reports, to an average of 3.3mn bl/d,. As a result, the agency’s forecast of 9.6mn bl/d for US LTO in 2024 from its 2019 report is actually 1mn bl/d above the 2019 actual estimate, whereas its forecast for 2023 from its 2018 report remains about 800,000bl/d below.
The recent rapid slowdown in growth has ramped up concerns about the sustainability of future US LTO growth. After increasing a record 1.9mn bl/d year-on-year in August 2018, growth has declined by half to 954,000bl/d in November (see Figure 2). Among the major LTO regions, growth remains strong in the Permian, moderate in Bakken, Anadarko, and Niobrara, but flat in Eagle Ford.
The major cause of this slowdown is the US rig count dropping by nearly a quarter to 729 over this period, due to declining capex, the result of the US LTO—and shale gas—industry falling out of favour with the investment community, and a decline in the price of US benchmark grade WTI last year.
Adam Waterous, former head of investment banking at the Bank of Nova Scotia who currently runs his own energy fund, believes that capital markets are largely shunning shale producers because of years of disappointing returns for investors and negative free cash flow. This could explain the surge in bankruptcies among US oil and gas producers last year.
The average spot price for WTI at Cushing, Oklahoma declined to $57/bl last year, compared to $65/bl in 2018. As can be seen in Figure 3, the US rig count has moved in near lockstep with WTI prices since January 2008.
According to information firm IHS Markit, capital spending for US onshore drilling and completions fell by 10pc to $102bn last year, and is expected to decline by another 12pc to $90bn this year and a further 8pc to $83bn in 2021.
In addition, the parent-child wellbore production interference issue could reduce the amount of LTO that can ultimately be recovered by 15-20pc, based on analysis of the Permian Basin by Houston-based investment bank Tudor, Pickering, Holt & Company. The bank found the amount of oil recovered from child wells is on average 20-30pc lower than parent wells—wells drilled initially to assess the resource—when child wells are spaced too close to the parent. On the other hand, producers risk leaving oil in the ground if the spacing is too extreme.
3.4mn bl/d – average forecasting miscalculation 2015-17
One solution is to drill both parent and child wells at the same time, which Tudor, Pickering, Holt finds improves recovery rates to levels largely in line with company projections. This is a costly endeavour, though, at $100mn or more per drilling program, which only the larger companies, such as deep-pocketed majors Chevron and ExxonMobil, are likely able to afford.
In a research note to clients in September, Sanford C. Bernstein analyst Bob Brackett argued that parent-child well issues could end up retarding US LTO production by 1mn bl/d. But it is likely to become a medium to longer-term issue for the country’s LTO industry—prime targets remain available for fresh drilling, but their supply is not inexhaustible. In 2018, 60pc of the wells drilled in the Permian’s Delaware sub-basin were child or co-developed wells, according to Tudor, Pickering, Holt, whereas the bulk of them were parent wells in 2017.
Bernie Sanders and Elizabeth Warren, currently running second and third behind Joe Biden in national polls for the presidential nomination of the Democratic Party, have both made it crystal clear they will do all in their power to shutdown the US shale industry if they become president.
“We have got to ask ourselves a simple question: what do you do with an industry that knowingly, for billions of dollars in short-term profits, is destroying this planet?” Sanders said during one of the many Democratic candidate debates. “I say that is criminal activity that cannot be allowed to continue.”
“What do you do with an industry that knowingly, for billions of dollars in short-term profits, is destroying this planet?” Sanders
Sanders’ climate program explicitly states that any effort to prevent worsening climate crises depends on a full fracking ban on public and private lands. In September, Elizabeth Warren tweeted that, on her first day as president, she would “sign an executive order that puts a total moratorium on all new fossil fuel leases for drilling offshore and on public lands” and would “ban fracking—everywhere”.
According to Edinburgh-based consultancy Wood Mackenzie, if a hydraulic fracturing ban was to come into effect, it would cause US oil and gas production to plummet. About 75pc of oil and gas wells that came into production in the US last year were horizontal, based on Wood Mackenzie data, and these are typically involved in fracking.
Productivity, costs and resource
The production of LTO—and shale gas—in the US has often been compared to an industrial process, with companies constantly attempting to push the technological and innovation envelope to squeeze out greater quantities from lesser quality resource and at lower costs.
But the combination of horizontal drilling and hydrofracking was just the beginning for the shale industry. Digital technological advances and increasingly cheap computing power have helped to supercharge well productivity improvements, to keep costs under control, and to expand the LTO resource base—as well as to identify the so-called ‘sweet spots’ that make ideal drilling locations.
Improvements in LTO rig productivity have been truly impressive. Initial oil production per rig in US LTO basins has grown by an average of 2.1pc per month since January 2007. This is despite productivity growth slipping into reverse from September 2016 to August 2017—as the rig count more than doubled to 810—and the parent-child well issue more recently. The revival in crude prices following the 2014-16 crash also led to acreage of more variable quality being targeted.
This incredible rate of productivity improvement has led average monthly LTO production for a rig to skyrocket from 35bl/d in January 2007 to a record 819bl/d in November 2019 (see Figure 4).
These productivity improvements have helped keep US LTO breakeven prices basically flat since 2016, despite record growth, after basically cutting them in half over the previous six years. According to Oslo-based consultancy Rystad Energy, LTO breakeven prices range between $45/bl and $63/bl, with the Delaware region of the Permian at the bottom of this range and Eagle Ford at the top.
At the same time, US drilling rig numbers suggest there is substantial slack in the industry, also holding down costs. The US rig count was 729 in November, less than half the US shale revolution high of 1,549 in October 2014.
And as more digitised drilling information has become available we have seen an expansion of both technically recoverable resource and sweet spots in major LTO basins. The EIA ramped up its assessment of technically recoverable US crude oil resource (TRR) each year of the last decade on the back of rapidly rising LTO resource (see Figure 5), a trend that is likely to continue for the foreseeable future. Between the beginning of 2008 and 2017—with the January 2017 estimate from the Annual Energy Outlook 2019—the EIA has increased its TRR estimate for US crude oil by 105bn bl to 303bn bl, despite the US producing 26bn bl in the interim.
The EIA did not release a formal TRR estimate for LTO early in this period, but it appears to have contributed most, if not all, of the increase in total crude oil resource. LTO resource accounted for 113bn bl of the 2017 estimate, more than a third of the total, with 48bn bl of that located in the Permian Basin.
Oil price cushion
WTI has entered the New Year and decade on a relatively solid note, near $60/bl, which should give drilling activity and US LTO production growth a boost in the coming months. And the price of WTI should remain moderate—if not spike higher—for at least a few more years on the back of continuing Opec+ cohesion and the massive amounts of oil removed from the market for geopolitical reasons.
819bl/d – average rig production November 2019
However, with such a long list of geopolitically-inspired disruptions to oil supply – the major ones alone being Iran, Libya and Venezuela—it may only a matter of time before substantial volumes from one or more of these countries return to the market. This will test Opec+ unity, especially given Russia’s reluctance to agree to substantial cuts in the past and adhere to them when it does. WTI at $40/bl or less would cause US LTO production to contract, as it did over the April 2015 to September 2016 period.
Taking all of these factors into account, US LTO production is likely to grow at a solid pace for at least a few more years—even an anti-fracking president will not kill the shale industry overnight—supporting the predictions of forecasters such as the IEA. But continued growth over the medium term is hardly guaranteed.