Shareholders in shale oil producing companies have been meeting with company executives to press for more profitability. While shale oil production has defied earlier estimates about the effects of low oil prices, strong production has not translated into good investment returns. Since 2007 the S&P 500 is up 80 percent, while an index of oil and gas producers has fallen 31 percent.
Over the past decade, companies have spent $280 billion more on shale investments than they have received in returns. Consumers and local economies have benefitted from investments and higher domestic energy production, but some investors are signaling they find the current state of play untenable.
That the current situation seems to come as a surprise to private equity investors shows how little they know about the oil industry or its boom and bust cycles over the past century. Most price swings that characterize the boom and bust cycles are caused by supply and demand imbalances that are perhaps impossible to avoid despite the best intentions. The problem of predicting when the boom or bust will end is complicated because crude oil is a global commodity and its demand is influenced by unpredictable economic conditions, except in cases of externally caused disruptions.
As prices fall because supply exceeds demand, companies begin reducing their capital budgets, projects, and staff, but not at the same pace. As demand begins to exceed near-term supply and inventory estimates, prices and profitability begin to rise. This leads to new investments, which can be for projects that span long time horizons. As profitability increases so does risk taking, especially by independents and smaller companies who are hungry for a piece of the action. Financial markets are more than willing to provide debt financing to support the rising tide of price.
Higher prices, however, are self-correcting because they lead to declines in demand which then lead to the inevitable imbalances. When prices then fall, independent oil companies, large and small, are stuck with a dangerous imbalance between debt and equity. That seems to be the current situation with shale oil producers who paid premiums for leases and production costs that result in unprofitable production which continues as a way of covering marginal costs.
For shale oil the financial problem is exacerbated by shale oil’s decline rate, or the rate at which the amount is produced at a well falls over time. The decline rate for shale oil production can be close to 10 times greater or more than for conventional oil production—greater than 40 percent versus about 5 percent. As a result, after the initial surge in production from a shale well, rapid production drops force producers to drill more wells to maintain just to maintain their overall production levels. With much of this activity financed by debt, some companies and independents are financially vulnerable. In low price situations, this becomes self-defeating.
The consulting firm Wood Mackenzie estimates that if crude prices remain around $50 a barrel, shale firms won’t generate positive cash flows until 2020. If history is any indicator and crude prices do not become stronger, a continuation of today’s prices will lead to serious upheaval among shale producers. It will cause a consolidation in the industry from sales of leases to companies that have been more prudent. EIA's most recent Short Term Energy Outlook is not encouraging, although if global economic growth continues on its current pace oil prices could prove EIA too conservative.
Some companies are heeding investors and are planning to shift money from drilling to dividends and share buy-backs. That will only work if crude oil prices start climbing and if producers do not once again increase drilling prematurely. That type of discipline has not been evident in the past. Perhaps at some future point investors will be able to forecast the boom and bust cycles, but that time is not near.
William O'Keefe is a contributor to Economics21.
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