In the last few years, US crude oil production has soared above 6.5 mb/d, the highest since 1996, thanks largely to hydraulic fracturing (‘fracking') combined with horizontal drilling that have allowed shale hydrocarbons to be produced more economically. The rapid pace of development has fuelled ideas of energy independence in the US and a widespread belief that shale production will revolutionise an otherwise ailing non-OPEC supply. In turn, this has led to suggestions of a paradigm shift lower in future oil prices, also reflected in the back end of the oil futures curve, which has been significantly depressed relative to the front.
In our view, shale oil is not going to return us to an era of cheap oil. While the short lead times to bring production online from when the first well is drilled works in favour of shale, the capital intensive nature of the industry has driven overall costs substantially upwards.
Our compilation of various cost data shows that to maintain current growth rates, the US shale industry is likely to have to spend close to $100 billion per annum, translating into a hefty oil price required to manage cash flows. While production itself can breakeven at around an average of $65 per barrel (WTI), adding in the various upfront capital costs makes the total variable cost far more expensive, taking breakevens well into the $80s (WTI) for some shale plays. The changing regulatory environment is also adding to costs for some producers.
Not surprisingly, various surveys of oil and gas company CAPEX reveal that North America is leading the global increase in E&P spending this year. We believe that a drop in oil prices to $70 per barrel (Brent) would take some $60 billion out from the system, worth a full year's worth of CAPEX in unconventional oil across the US. Instead of growing, overall US production would then flatline at best, if not start to taper downwards. By our calculations, a Brent price of $88-$93 per barrel is required to generate enough cash flow for current US CAPEX spend.
The rapid response of shale oil producers to the sharp fall in oil prices seen earlier in the year, with some rapidly abandoning rigs, was a case in point for the high breakeven price. Our findings are also supported by the price levels at which US independents have tended to carry out their hedging programmes. Across 2012, over 50% of the main 40 US independents have hedges in place between $86-$97 per barrel. For 2013, the recent wave of producer selling in the market was carried out only once WTI prices climbed near and above $95 per barrel.
The other sources of new supply, Canada and Brazil, also face rising costs. Neither of these production methods are simple or cheap and so scaling up capacity according to schedule has been a significant challenge with cost overruns a recurring feature. On average, current non-OPEC production trends reflect a twofold dynamic, whereby geological and investment conditions have both become more challenging.
Thus, it is high prices that has led to the development of shale oil just as it has facilitated the growth of oil sands and sub-salt deposits in Brazil. If we move away from $90+ Brent prices, non-OPEC supply will be struggling again. However, the growth in these marginal barrels are likely to put a cap on long term oil prices, making any runaway increase in average prices much above $110-$115 per barrel, beyond geopolitical or economic reasons, increasingly difficult.