The debt-fueled game of musical chairs prevalent within the U.S. shale industry has contributed a significant portion of the additional 4.3 million barrels of crude oil produced per day. And in the very near future, crude oil production is set to experience a dramatic climax.
Producers, many of whom have borrowed three to four times their annual revenues to sustain their production streams, are about to come face-to-face with the laws of physics in the form of massive shale reservoir decline rates.
A Rocky Foundation
Prior to 2009, when the shale boom was in its infancy, U.S. oil producers employed a fleet of approximately 418 drilling rigs as they struggled to strengthen a long-declining domestic production trend at 5.5 million barrels of oil per day (BOPD).
The shale revolution, as it is commonly called, exploited technology that was capable of unlocking previously uneconomic oil reserves trapped in low-permeability shale rock. This was accomplished through a combination of horizontal drilling and multistage hydraulic fracturing techniques.
For many producers, the shale revolution contributed to the exploitation of lenders willing to give them cheap access to a great deal of debt. As a result, a cyclonic pace of drilling activity was funded and the U.S. domestic crude production level skyrocketed to 9.8 million BOPD in just five years.
● Consider that a fleet of 418 oil drilling rigs operating in 2009 maintained a production level of 5.5 million BOPD, which implies a sustainable productivity on a per rig basis of 13,277 BOPD.
● At the apex of U.S. shale drilling in October 2014, U.S. producers employed an additional 1,173 oil drilling rigs to realize incremental output that peaked at 4.3 million BOPD, which implies an incremental per rig production of a meager 3,648 BOPD.
● Aggregate U.S. production peaked at 9.8 million BOPD in March 2015, lagging the drilling cycle peak by six months as inventories of previously drilled wells continued to come on stream. This created a veneer that shale production was substantially more resilient than first thought.
A Downward Trend and Misleading Headlines
The onslaught of supply lit the fuse on a Saudi Arabian-led price war in June 2014, driving WTI prices as low as $27 a barrel by January 2016. Shale producers, saddled with debt service requirements equal to 50 percent of operating cash flow when WTI traded at $100, scrambled to reduce costs as prices plummeted.
Drilling and completion contractors capitulated and cut profit margins, but eventually exploration and production companies were forced to slash capital expenditure (capex) and stop drilling. The continued downward trend in crude prices saw producers’ debt service requirements swell to a staggering 83 percent of operating cash flow as oil prices fell through the $40 range according to September 2015 data from the U.S. Energy Information Administration (EIA).
Despite OPEC’s refusal to slow production, global active average rig counts continue to fall:
*Baker Hughes Worldwide Rig Count, March 2016 News headlines frequently cite massive crude inventory levels, but this should be viewed in context. Global consumption levels that are at all-time highs warrant inventory levels at all-time highs. Expressed in days of consumption rather than absolute terms, and considering the incentives for refiners to fill storage at historically low prices, inventory levels might be better described as fat, but not obese.
This figure illustrates U.S. crude oil inventory, expressed in days of domestic consumption:
Waiting Out the Storm
There is little doubt among the well-informed that the oil price crash has found a bottom. There is also little doubt that a recovery will take some time.
Increases in commodity prices will continue to be restrained by high inventory levels, and sluggish global GDP growth will limit consumption growth to 1.2 million BOPD in 2016. Continued aggressive global capex reduction promises to bring a market marginally oversupplied by 1.5 million barrels back to balance.
Conventional wisdom dictates that prices will rise over time, and the U.S. shale industry will recover. Active U.S. oil drilling rigs have fallen to pre-shale boom levels, and U.S. production is off 825,000 BOPD — 8.4 percent — from the peak in March 2015.
U.S. producers have gone into survival mode to wait out the storm, working vigorously to reissue existing debt with longer maturities, issue new debt or equity to raise cash and, most importantly, eliminate capital spending and service their debt requirements by shuttering drilling programs.
It is at this juncture that over-leveraged players prepare to meet the proverbial “three-headed monster”:
1) The Eagle Ford and Bakken Formation, two of the most prolific U.S. shale deposits, have proven decline profiles that suggest 75 percent of recoverable resources are depleted within the first 12 months of production and a further 50 percent in the second 12 months.
Applying this decline profile to the incremental shale production at the peak of U.S. production, it is apparent that the marginal 8.4 percent decline in U.S. domestic production from the peak in March 2015 is but a harbinger of the onslaught of production declines to follow.
Over the first 12 weeks of 2016, U.S. production decline accelerated to 0.2 percent per week and will gain momentum as production offsets diminish from drilled but uncompleted well inventories.
This figure overlays the Baker Hughes rotary oil drilling rig count with the EIA reported daily U.S. domestic production and extrapolates a decline profile derived from the Eagle Ford Shale.
2) Simultaneously, debt-ridden and cash-starved shale producers are forced to liquidate their production at rock-bottom prices in an effort to meet operational and current debt service requirements.
With no new well completions to bolster future supply, highly leveraged firms face a dire future as their source of cash and debt security depletes at an alarming rate.
3) Lengthening maturity dates on increasingly expensive junk-rated bonds exacerbate the shale industry problems. The ability to repay longer, dated debt continues to be eroded by ever-increasing carrying costs and rapidly diminishing supplies of saleable commodities at higher future prices.
By extension, these same companies’ ability to issue the new debt required to restart the hyper-intensive capex merry-go-round and drill new wells will be impaired when prices eventually rise.
The above figure illustrates junk bond yield by industry category.
When the Music Stops and There’s Only One Chair Left
With no additional drilling, the rate of decline could see the U.S. supply reduce by 2 million BOPD in 2016. This would be bullish news for a beleaguered global oil industry in desperate need of sustainable, higher-commodity prices.
The dynamic of an increasingly impaired credit rating for an industry that relies heavily on debt to generate new production undercuts the argument that shale production will come roaring back at the first sign of meaningfully higher prices. The so-called tap will not be easily turned back on, making a case for a higher than anticipated price ceiling for crude oil in 2016 and 2017.
Given the U.S. commitment to energy independence, it is likely that the turmoil within the U.S. shale industry is little more than a disruptive reset, not unlike the dynamics of the dot-com bubble of 2000 in the sense of a new industry finding a sustainable path for the long term.
In the short term, a willingness to allow Peter to borrow more and more money to pay Paul will soon have everyone scrambling for the last chair when the music stops, creating new opportunities for firms with strong balance sheets and operating discipline.
About the author: Neil Schmeichel is a leader in coil tubing services for Western Canada’s oil and gas industry. He is also President and General Manager of Balanced Energy Oilfield Services.
Photos courtesy of Neil Schmeichel