As low oil prices force the US shale sector to reduce output, Melodie Michel looks at where the industry can position itself in the global oil market.

When OPEC members decided not to cut production to support oil prices at the end of 2014, they (wilfully or not) pushed shale out of the staple mix of oil sources, and into a peripheral role. That decision made economic sense: shale’s breakeven price is around US$65 per barrel, compared to US$27 for most OPEC members. The strategy paid off in the middle of 2015, when demand picked up and lifted prices with it – to a respectable average of US$60 per barrel.
“Since prices broke, it was an opportune time to remind the world that oil is one of the most attractive energy resources and to entrench its usage by offering it at an attractive price for a while. The likely outcome is that we will have lower prices for longer periods unless the global demand equation changes significantly,” says Ben Lett, a Texas-based managing director in Bank of America Merrill Lynch’s (BofAML) energy investment banking group. As this issue went to press, it emerged that in May, OPEC members had pumped the most oil since October 2012 at 31 million barrels per day (bpd), while US shale production went down (for
the first time in four years) by around 45,000 bpd to 4.98 million. And although the sector announced plans to increase supply if prices remained above US$60 a barrel, it will need to remain flexible for some time to come.
“I would see the industry as almost being the marginal supply, at least in the short to medium term. Once prices rise above US$70 for a couple of months, some shale oil will come back online, which will push prices back down, so shale oil will turn off again – it’s almost a stabilising mechanism, while OPEC will be kind of a base load type of production,” Thomas Pugh, a commodities economist at Capital Economics, tells GTR.
So after years of hype, it seems that shale has found its place on the global oil scene, as a swing producer. For the moment, this realisation hasn’t deterred investors: Lett still sees capital flowing to producers, both through the debt and equity markets, probably on the expectation that prices will move upwards later this year. He does admit, however, that “things could get more challenging” if this pick-up doesn’t happen.

Overleveraged companies

The challenge comes from the fact that the shale oil model is based on large-scale acreage acquisition at any cost, followed by massive over-production. The expensive nature of the drilling has led companies to raise more and more debt, and most of them are now very highly leveraged, operating on almost 50/50 debt-to-equity ratios. Encouraged by low interest rates, this behaviour did not alarm investors as long as oil prices were averaging US$100 a barrel, but will undeniably become an issue as financial markets pick up and oil prices stay down – Reuters announced a rise in the US oil and gas industry’s default risk as early as February 2015, on the back of a wave of oil firm credit downgrades from Standard & Poor’s.
And while some investors see the tightened market as an opportunity to get more shares in overleveraged oil companies – John Browne, executive chairman of equity fund L1 Energy and former CEO of BP, made it clear this was going to be his company’s strategy in a May interview with Bloomberg – others are bound to be less bullish.
Besides, not all producers are well positioned for a tighter market, but those who are will likely focus on areas maintained by output and sell off less developed acreage that would still require large cash injections to become profitable. For Pugh, that focus on increasing efficiency in the sector will have the unavoidable consequence of reducing investment. “The primary focus has been getting as much oil out as quickly as possible, regardless of how much it costs, and that’s really inflated costs in the industry and attracted a lot of investment. You’re not going to have that anymore, there’s not going to be as much investment, but the investment you do have will be much more carefully targeted, and cost structure will be much more important going forward,” he says.

Efficiency issues

More concerning than the overleveraging and huge capital expenditure is that, even in times of high oil prices, shale companies were running on negative cashflows. In a May 2015 presentation, David Einhorn, the founder of hedge fund Greenlight Capital, slated shale companies – naming Pioneer Natural Resources and EOG Resources in particular – for having a largely unsuccessful cost model.
“The large oil frackers have spent US$80bn more than they have received from selling oil. Wall Street greased those skids by underwriting debt and equity securities that allowed them to garner billions in fees. The banks are clearly incentivised to enable the frack addicts. What’s less obvious is whether investors are furnished a clear analysis of the returns these companies actually generate,” he pointed out, decisively adding: “We object to oil fracking because the investment can contaminate portfolio returns.”
Following the presentation, shares in the two companies dropped, and media reports started questioning the shale model’s resilience and sustainability, particularly as the imminent return of Iran’s mammoth resources onto global markets threatens to push prices back down.
But according to Lett, shale oil production remains “an important part of the supply equation in any reasonable scenario”. “The long-term outlook for the sector is generally good. Middle East producers are dealing with resource maturity issues despite a coming surge from Iraq and Iran as they recover from war and sanctions. Brazil pre-salt production is exciting, but moving slower than originally anticipated,” he says.

Export ban debate

Another factor likely to affect the future of the sector is whether or not Washington will lift its ban on crude exports. While shale oil’s price efficiency makes it largely uncompetitive on international markets, it could be sent to specific destinations in exchange for heavier crude oil, as US refineries are not accustomed to the light shale produced domestically. This streamlining of the refining process would help reduce the gap between international (Brent) and domestic (West Texas Intermediate, or WTI) oil prices to just US$3 a barrel (compared to the current forecast of US$7.40) in 2017, according to a BofAML report from May.
The report found “a surprising amount of support” to remove the 40-year-old ban across members of the House of Representatives and Senate and estimated the chance of that happening in the next two years at more than 50%.
“US oil exports should be allowed for efficient use of global refining infrastructure yielding the lowest-cost finished product,” says Lett on the topic.
But for Pugh, the likelihood of the US government lifting the ban remains low. “The Obama administration has made it clear that they’re quite happy with the exports for now and want to see how it goes. I don’t think there’s going to be a forward move on export restrictions anytime soon. The spread is only about US$5 at the moment anyway, so that’s not a massive difference.
“It would definitely improve the efficiency of US oil production and refining, so it would still certainly be a good thing, but from my reading of the politics of it, I doubt that’s going to happen in the next few years,” he explains.
Despite its rather worrying cost structure issues, US shale oil definitely has a role to play on the international supply scene, particularly as new and more expensive sources like deep-water or Arctic extraction come online, making this decade-old method appear more established and “mainstream”. In that sense, perhaps the dramatic drop in oil prices observed last year should be seem as more of a blessing than a curse, as it is forcing the sector to take a long, hard look at its flaws, and change for the better.