Evidence That Shale Oil Will Boom

by: Andrew Butter


Shale oil new production per rig more than doubled from 2011 to 2015.

Producers with lifting costs more than $60 will be depleted and die.

Then shale oil will boom.

The 3.6 million barrels/day surge in U.S. shale oil production over four years, from March 2011 to March 2015, took everyone by surprise. Particularly the planners in the Kingdom of Saudi Arabia, who in 2011 were saying that $100 oil was a bubble that would lead to overcapacity and therefore -- as night follows day -- to a bust. They were a distinct minority, but they were not alone. Pity for them that they did not pump the nascent shale oil industry out of business in 2011 when the shale-oil breakeven price averaged $80, because now the cat is out of the bag and the breakeven has gone down to $60 or less. Pity also for the countries that need more than $60 to break even, because they won't be seeing more than that for a long time to come.

Of course, the E&P companies -- many with crippling debt around their necks and their investors quietly panicking -- are talking up their prospects, but there is evidence that's not just so much hot air:

The above chart is for the three main shale oil producing areas that account for 95% of the output. New production every month is calculated from EIA data; the production per rig is simply that number divided by the number of working rigs, also as reported by EIA.

In March 2011, new production brought online per rig averaged about 100 barrels per day in the Permian; by the time the bubble finally popped, it had doubled to 200. In the Bakken and Eagle Ford it went from 150 up to 600 -- a 4x increase. Since the start of the bust, unit production doubled again, although that was mainly because new drilling was drastically cut back (today, only one in three rigs is working). But the "fracklog" continued to be brought online. Rule of thumb, one-third the cost of development is in the drilling. The rest is the cost of the frack and the acreage, but the message is clear: Advances in technology and improved infrastructure over the past five years have had a dramatic impact on cost.

So why is $60 the new magic number?

A bubble is when the price of something -- housing, commercial real estate, dot.com shares, whatever -- for some reason departs from what some people call the "fundamental," what Warren Buffett calls "intrinsic value," and what the International Valuation Standards Council calls "other than market value." In the case of oil, it's what the Saudi's used to call the "fair price" (defined as the price the customers could afford without suffering, or more likely going into debt to pay for it), but at the same time provided sufficient incentive for the E&P industry to bring in enough oil to replace what was being used up. Of course, at the time everyone says it's not a bubble because the "fundamental" changed, and the evidence is simply in front of everyone's faces. The only way to know for sure that there was a bubble is that there is a bust.

Here's the thing: Bubble and bust creates no net economic value. The amount of money paid out by buyers, more than what was "fair" in the bubble, is exactly equal to how much the sellers get, less than what is "fair," in the bust. To put it another way, money does not grow on trees and central bankers cannot create wealth by manipulating prices, even if they say they can. That's my theory, anyway, and I call it the "General Theory of the Pebble in the Pond," which says that if someone throws a pebble in a pond there will be waves, but eventually the pond will get back to its equilibrium level.

Do the arithmetic on that logic: If the price just before the bubble popped was the "fundamental" x (1+x), then the price at the bottom of the bust has to be the "fundamental" divided by (1+x). Rearranging that logic, the "fundamental" is logically the square root of the price just before the bust ($115 (Brent)) multiplied by the price at the bottom of the bust ($30) = $60. Intriguing that $60 is the price most shale oil E&P companies say they can make money; perhaps markets are not so inefficient after all?

When that price will be reached will depend on how quickly the rest of the world starts running out of oil that costs less than $60 to lift; that will likely be within a year or two. After that, now that the technology has improved, it's unlikely the price of oil will go much higher than $60 until opportunities for shale oil, not just in the U.S., start to run out. That could easily take 10 years.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.