Shale’s New Reality: Almost All Wells Drilled Now Lose Money
America’s shale producers already had a profitability problem. It just got a lot worse.
At a stroke, Saudi Arabia and Russia and their battle for market share have made almost all U.S. shale drilling unprofitable. Only five companies in two areas of the country have breakeven costs lower than the current oil price, according to data compiled by Rystad Energy, an Oslo-based consultancy.
Wells drilled by Exxon Mobil Corp., Occidental Petroleum Corp. Chevron Corp. and Crownquest Operating LLC in the Permian Basin, which stretches across West Texas and southeastern New Mexico, can turn profits at $31 a barrel, Rystad’s data show. Occidental’s wells in the DJ Basin of Colorado are also in the money at that price, which is where oil settled Monday.
But that’s not the case for the rest of the shale industry — more than 100 operators in a dozen fields. For them, drilling new wells will almost certainly mean going into the red.
Shale projects are heralded for their ability to be quickly ramped up and down. But because output from these wells declines much faster than from their old-school, conventional cousins, companies have to drill more of them just to keep output flat. That has meant sluggish investor returns, one of the main reasons oil and gas represents less than 4% of the S&P 500 Index.
At this point, “companies should not be burning capital to be keeping the production base at an unsustainable level,” said Tom Loughrey, a former hedge fund manager who started his own shale-data firm, Friezo Loughrey Oil Well Partners LLC. “This is swing production — and that means you’re going to have to swing down.”
Already, producers including Diamondback Energy Inc. and Parsley Energy Inc. have said they’re cutting their drilling budgets and dropping rigs. Others, such as Apache Corp. and Occidental, have indicated they’ll rein in activity.
“What they’re not saying is that they’re going to suspend activity,” Loughrey said.
In his view, a typical well in the Midland sub-basin of the Permian requires $68 oil for investors to make an adequate return within 24 months.
BloombergNEF expects producers to move away from using breakeven costs that leave out overhead and other necessary expenses as investors shift their focus to cash flow.
“At a minimum, they will need to add back interest costs to their calculus,” BloombergNEF said in a report. That means the profitability floor for most new wells will rise to $50 a barrel “in the not too distant future,” according to the report, up from $45 in the past.
The shale boom turned the U.S. into the biggest oil producer in the world and, in recent months, a net exporter of petroleum. But if prices remain near $30 a barrel, producers will be forced to ax so much drilling activity that U.S. oil production could fall by 2 million barrels a day from the end of this year to the end of next, according to Rystad.
That would be about a 20% drop.
On Monday, West Texas Intermediate crude fell 25% to settle at $31.13 a barrel, and some forecasters see it falling toward $20. Prices clawed back some of those losses Tuesday, reaching as high as $33.73.
“Even the best operators will have to reduce activity,” said Artem Abramov, head of shale research at Rystad. “It’s not only about commerciality of the wells. It’s a lot about corporate cash flow balances. It’s almost impossible to be fully cash flow neutral this year with this price decline.”
BRUSSELS – The spread of the COVID-19 coronavirus across Europe and the United States has led to a sharp financial-market correction and prompted calls for active monetary and fiscal policy to prevent a recession. But a closer look suggests that such an approach might not help much at all.
The COVID-19 epidemic is marked by uncertainty. Technically, it does not represent a “black swan” event, because there have been other pandemics before. But it was, until a few months ago, unforeseeable, at least in specific terms. And it will have a long-lasting impact even if its precise evolution cannot be predicted today.
For now, it seems that the virus is moving westward. In China, where the virus emerged, infections are declining after the authorities implemented radical measures – including lockdowns that brought the economy to a standstill for over two weeks. Although it is too early to tell whether the virus has really been contained, economic life now seems to be normalizing gradually, implying that the “China shock” may be unwinding.
In the US and Europe, by contrast, the shock seems to be just beginning, with a fast-growing number of new infections raising the specter of severe economic disruption. This risk is particularly pronounced in the eurozone, which may not be able to weather a severe downturn without spiraling into crisis.
To be sure, the epidemic’s direct fiscal consequences seem manageable. Even Italy, which is currently suffering the most, could increase public spending for virus-containment measures without violating EU fiscal rules.
If these costs spiral – as seems likely, now that a quarter of the country, accounting for most industrial and financial activity, is under lockdown – the European Union should be able to offer support to Italy beyond allowing the government to run a larger deficit. Article 122.2 of the Treaty on the Functioning of the EU allows the European Council to grant financial assistance to a member state facing “severe difficulties” caused by “exceptional occurrences beyond its control.” This procedure should be activated now.
In any case, COVID-19’s trajectory suggests that it will likely spread farther, forcing other EU member states to adopt public-health measures at the expense of economic activity, particularly in important sectors such as travel and tourism. Moreover, supply chains will be impaired, not only by the temporary shutdown of the Chinese export machine, but also by disruptions within Europe. Neither interest-rate cuts nor new government expenditures would do much to offset the short-term effects of such shocks.
The more serious problems are likely to emerge from the financial system. While many firms can slash production quickly, running a business in “disaster recovery mode” still costs money, and debt still comes due. In Europe, where labor costs cannot be cut in the short run, the challenges this raises could be particularly serious.
Fortunately, most EU members have some system in place under which the government covers the wages of workers who become temporarily redundant for reasons outside of their employers’ control. These mechanisms, which would sustain personal incomes during the crisis, are the main reason why a long-lasting drop in consumption is unlikely. Once the virus is contained, European consumers will have little reason not to spend as much as before.
Yet two other possible developments could tip the eurozone into recession. The first is a sharp slowdown of global trade, which the EU has little power to counter. The second is a collapse in investment, which the EU can and should work to prevent.
The last eurozone crisis demonstrated that investment collapses when the financial system stops functioning. In market-based systems, like that of the US, this is a question of risk premia and plain access to credit, which policymakers can hardly influence. For Europe, with its bank-centric financial system, the key to weathering the COVID-19 crisis is thus to keep the banking sector healthy.
For that, a calibrated supervisory response is essential. The shift of banking supervision to the European Central Bank has led to more rigorous and selective credit policies by commercial banks. While this has reduced banking risks, applying tough lending standards at a time of severe economic stress caused by public-health measures could punish otherwise creditworthy firms that are facing temporary losses.
Italy’s government is providing direct financial support to companies directly affected by the lockdowns. But if the crisis spreads, the number of sectors that are affected (often indirectly) will increase. Governments cannot provide financial support to all of them. Banks can do much more, but only if they are willing to overlook bad financials. Supervisors should allow – and even encourage – such an approach.
A forbearance-based approach – together with the “automatic” fiscal stabilizers built into Europe’s social-security systems – would do far more to mitigate the risk of crisis than microscopic interest-rate cuts.
Additional fiscal stimulus, meanwhile, would be needed only in the unlikely event that the economic disruption is followed by a period of depressed demand. The eurozone’s fiscal rules pose no obstacle to such a policy mix, because they are flexible enough to permit temporary deficits that result from lower tax revenues, or fiscal support to sectors hit hard by exceptional circumstances. Nonetheless, the COVID-19 epidemic should serve as a reminder of the value of maintaining prudent fiscal policy during normal times. Countries with lower deficits and debts are in a much stronger position to respond to the COVID-19 shock than those, like Italy and France, that have not created fiscal space.
In the face of a severe shock, public authorities must act – and be seen acting. But, in this case, the usual macroeconomic instruments are unlikely to work. Central banks and government authorities should explain this to the public, and then focus their attention on the less glamorous work of safeguarding public health, household incomes, and the financial system.