US Shale Revolution Remains OPEC Threat Despite Low Price Pain

The shale revolution is levelizing the energy marketplace, undermining the pricing power of OPEC, reducing US oil imports, turning natural gas exports as LNG into a big factor in global markets and redefining future market rules. This is a big deal. And OPEC knows it cannot stop it.

US oil production from the shale revolution is way up as oil production rose to 9.077 million barrels a day, the highest level in weekly according to data from the Energy Information Administration going back to 1983. At the current pace the US is expected to set a new all-time high in oil production surpassing 9.637 million barrels of oil per day by 2016.

According to IHS, only about 20% of producers need $90 a barrel to break-even and ‘about 80% of the tight oil estimated to be pumped in 2015 will still be profitable at between $50 and $69 a barrel’.

In a recent presentation Lynn Helms, Director of the North Dakota Department of Mineral Resources, told the House Appropriations Committee: ‘North Dakota needs an oil price of around $55 per barrel at the wellhead and a fleet of about 140 rigs to sustain production at the current level of 1.2 million barrels per day.’ However, the breakeven costs vary significantly, with producers using fracking methods requiring significantly higher prices, ‘breakeven costs reflect a price at which new drilling would cease’ and ‘production from existing wells would be shut-in at $15/bbl.’ Lynn Helms’ view seems to be supported by independent analyst.

Although IHS estimated that a price of $60 a barrel would see oil sourced from fracking drop to as low as 350,000 bbl/d – down from 700,000 bbl/d at $77/bbl – some producers may be able to initially survive lower prices due to the fact that many associated infrastructure costs are already sunk if they have manageable debt loads. But it will become increasingly difficult to get new investment and loans as profit margins are squeezed to break-even prices or below. Small producers will be first and the worst affected.

The shale revolution unlocked the entrepreneurship, ingenuity and resolve of American producers in ways that are difficult for Saudi princes to grasp. Three factors explain why the US shale revolution has a high probability of success against the enormous pressure and market of the Saudi decision to drive down global oil prices:

1. Private Property Rights for Mineral Holders. In most nations mineral rights are owned by the government. That is why we see so many national oil and gas companies and government involvement in the E&P development of resources. The government benefits from the revenue produced from the extraction and sale of the resources. In many case, those governments confiscated private companies and property essential to production. Today some of the biggest national oil and gas companies rival the size of the super majors or are larger. In the US individual land owners retain the mineral rights underlying their property. Landsmen scour attractive plays for opportunities to acquire leases from property owners. Some plays have seen ‘land rush’ enthusiasm for leasehold acquisitions bidding up the price of leasehold bonuses the up-front payments landowners typically receive for granting the right to drill on their property.
2. Disruptive Innovation Drilling Technology and Persistence. The persistence and skill of the pioneers like George Mitchell made the shale revolution possible through their trial and error perfection of new drilling techniques and equipment in horizontal drilling and hydraulic fracturing to make drilling economic in the tight oil and gas. Adding better seismic study of the geology formations has also greatly improved the targeted of drilling operations.
3. Market Structure of Oil & Gas Contracts and Leases. Another key factor in the success of the shale revolution has been the nature of contracts and the balancing of interests and incentives between property owners and producers. Drilling oil and gas contracts typically contain specific clauses such as a ‘Habendum clauses’ that define how long the interest in leasehold will be granted. Most oil and gas leases have a primary and secondary term. In the primary term the lessee can hold the lease without producing, but during the secondary term the producer is required to produce in order to retain the lease rights usually described in language something like ‘so long thereafter as oil and gas is produced in paying quantities.’ The reason for this the owner wants to avoid tying up his property without revenue as landsmen try to assemble acreage and hoard it for later use. Often called ‘hold by production’ these contracts are a big factor in the continued growth of onshore US oil and gas production growth even if the wells are marginal or uneconomic. Leases like these created a ‘forced production’ pressure on the lessee to keep producing in order to retain his lease rights even if he is underwater.

The US shale revolution in being tested by the falling price market conditions but it is unlikely to be derailed by OPEC or other market factors. We are seeing the resilience, agility and entrepreneurship that George Mitchell instilled in the birth of the shale revolution still paying dividends in disruptive innovation improvements by driving down break-even points, enabling continued production even when some wells are underwater as shale producers battle hardened from the experience may become ever more fierce competitors.

Low oil prices hurt America’s shale producers, no question about it, but it is turning them into even more fierce competitors with lower break-even prices and abundant supply.