Some tout shale as a game changer, with the production growth of 1 mb/d seen over the last three years set to continue forever and spread to the rest of the world. While others consider shale to be a great Ponzi scheme, with steep decline rates likely to make the so-called revolution a rather short-lived one. More often than not in such situations, the reality is somewhere in the middle, but in the case of shale, the market is highly skewed towards the former, heavily influencing both long-term oil prices and sentiment. Thus, in this focus piece, we dive deep into the shale industry, considering some of the key metrics that have been overlooked by the market so far and how these might shape the future of oil supplies. Is the US really the new Saudi Arabia or is shale a flash in the pan, which would once again place global supply growth in an extremely challenging trajectory?
Widely discussed and acknowledged features of this industry include high decline rates, high costs, extremely high Capex levels that are required to fund the drilling programmes, and, to a certain extent, the extremely light quality of crude oil that cannot substitute one-for-one with declining conventional crude production. But rarely talked about is how these features are impacting the profitability of the companies that are at the heart of the shale boom.
The very nature of shale wells, which exhibit high decline rates, results in the need to constantly allocate capital towards exploration drilling in order to maintain and grow production volumes. As a result, the average Capex spending of the 35 companies analysed to serve as a guide to the industry has amounted to a staggering $50 per barrel of oil equivalent (boe) over the last five years, at a time when their revenue per boe has averaged $51.5. For these same companies, free cash flow has been negative in almost every quarter since Q2 07. Negative FCF is not necessarily an issue, as it could just be a sign that companies are making large investments, however such investments would be expected to make high returns, which the shale industry cannot necessarily boast at least today.
Worse still, to meet their Capex requirements, the companies have had to take on increasing levels of debt, and this is where we highlight the key risk to this business. The companies involved in shale production are highly geared, and this makes them susceptible in an environment of falling liquids prices, faltering production growth or rising interest rates. In this regard, it is worth bearing in mind that these companies produce large volumes of super-light condensates and NGLs. Prices for these liquids have started to fall sharply and disconnect from crude oil, in much the same way as natural gas did, and lower realised prices across the liquids and gas stream can significantly impact baseline revenues.
Of course the shale industry is in its infancy and as efficiencies like pad drilling increase, costs should come down. Further, increasing amounts of forward hedging do protect cash flows to a certain extent. Moreover, as infrastructure bottlenecks get ironed out, producers are likely to realise higher oil prices, a positive for their revenue stream. Clearly, there are upsides for these companies, but the shale revolution is not a panacea that offers endless extension of the growth paradigm and it is important to appreciate this to prevent the potential for a sharp disappointment in future global supplies, not necessarily by volume but relative to sentiment.