Shale Oil Boom Uncertain In Wake Of Falling Oil Prices

|
Includes: BNO, DBO, DNO, DTO, DWTI, OIL, OLEM, OLO, SCO, SZO, UCO, USL, USO, UWTI
by: Global Risk Insights

No state in the U.S. has benefited more from the shale oil boom than North Dakota. Just as quickly as the transformation came, it could disappear with low oil prices. Since 2005, North Dakota's oil production has expanded ninefold to make it the second largest oil-producing state in the U.S. This is all due to technological advances in hydraulic fracturing, or fracking. The fields and pastures that covered western North Dakota suddenly became known as the Bakken Oil Field. The way shale oil has changed North Dakota's political economy is the most extreme case study of the changes it is having throughout the U.S.

The impact of fracking on North Dakota's economy has been well documented. The state's population has grown more than 7% since 2010 and unemployment is 2.8% - both the best figures of any U.S. state. North Dakota's economy has grown 168% since 2003, compared to 46% for the U.S. as a whole. The contribution from oil and gas skyrocketed more than twenty-seven times in the same period.

Underneath the seemingly miraculous arrival of oil wealth, growing pains for the state's political economy are increasingly apparent. While the state's economy is growing at a breakneck speed, government spending is unable to keep up. From 2003 to 2013, spending was up 51%, just one-third of speed of private industry. The breadth of the regulatory apparatus and infrastructure remain largely what they were before the boom, and the problems caused by the outdated systems are mounting.

This fall, the New York Times published an investigative report detailing the state's relaxed approach to regulating the new industry. The report characterizes the state as having turned a blind eye to major environmental blunders, including accelerating trends in oil spills and injury-causing drill blowouts.

North Dakota produced one-fourth of the oil that Texas has since 2006, but the North Dakota Industrial Commission, whose members have received over $60,000 in campaign contributions from the state's two largest oil producers, imposed one-thirtieth the fines.

For the agricultural industry, which has long been the backbone of the area now called the Bakken Oil Field, transporting crops to market has become much more expensive - if they can get it to market at all. North Dakota is the largest U.S. producer of wheat, barley, and many types of beans.

Backlogs are reaching all-time highs in the area, with more than 120,000 freight cars' worth of product waiting to be shipped. Each load of wheat not delivered is a blow to the incomes of farmers, making it even more difficult for other industries to compete with oil.

North Dakota's infrastructure, especially in the western part of the state, was built to accommodate the third smallest population in the U.S. and not an oil boom. Roads are crumbling under the weight of trucks hauling in loads of fracking sand and water. Housing has been unable to keep up as well, as shown by the $2,000 per month rent for one-bedroom apartments in the city at the center of the boom, Williston.

The question the state faces now, when the price of oil has fallen 50% in just a few months, is what will happen to the industry in the future. Has the tremendous growth in production lowered prices too far for it to be profitable?

To answer those questions, producers need to know whether they will be profitable and whether they will be able to secure the financing to drill new wells. Both carry a high level of uncertainty.

Analysts have put together a wide range of estimates of "breakeven" points, the price below which producing oil is no longer profitable. For the Bakken range, the consensus is between $60 and $65, although one headline number cannot capture the complexity of assessing project viability.

With oil prices sitting near those prices now, companies are becoming wary about drilling new wells. This poses two problems.

First, consistent production in the Bakken Field requires consistently drilling new wells. Continental Resources, the largest producer in North Dakota, recently lowered its forecast of new Bakken wells in 2015 by 14%. All wells decrease in production over time, but fracking wells decrease much faster. The wealth from the region could quickly dry up without reinvestment.

Second, it is almost useless to predict both oil prices and drilling costs. Who predicted that oil would fall so quickly? Fracking technology has been equally unpredictable in that it has progressed much faster than expected. Breakeven points were once thought to be between $80 and $100 for the Bakken Field, but multi-pad well technology has quickly lowered those estimates.

Complicating the situation is OPEC, which in late November decided not to cut production. OPEC is no longer the well-oiled machine that brought the U.S. economy to its knees in the 1970s. Nonetheless, it has chosen to play a game that looks just like the basic game theory structure of the War of Attrition, which takes immense wherewithal to win from OPEC's position, but can cause collateral damage to its members and US shale producers in the meantime.

If oil prices remain near or below the breakeven point, the impact on the North Dakota economy could be catastrophic. It has put aside all other industries to fuel the surge of jobs and money flowing from the Bakken Oil Field, but it may not last. Tax revenues would dry up and new residents who came for oil jobs would be left looking. Approximately 10% of North Dakota jobs are in the oil industry.

Worse yet would be the impact emanating from the oil companies operating in North Dakota. These companies are heavily indebted, and ending operations would begin a wave of defaults and losses in corporate bonds.

Continental Resources, the largest producer in North Dakota, carries $5.8 billion in debt at a leverage ratio of 5.4x trailing twelve month adjusted net income (based on GRI's calculations). If forced into default - which is purely speculation at this point since there is no indication that Continental Resources nor its peers are near default - bond markets would be rattled and shareholders would sustain even greater losses.

Already the corporate bond market has seen a major retreat based on worry over this scenario. Interest rates on high-yield energy bonds rose over 500 basis points in the last six months and credit spreads, a good indicator of the risk of default, rose 33 basis points in early December. That magnitude of spread volatility has usually been reserved for Greek government debt.

For what it is worth, North Dakota politicians are using the slowdown as an opportunity to regroup and spend its share of oil revenues to improve infrastructure and housing. If oil prices remain high enough to support the Bakken Oil Field, the state will be in a better position to handle it. But there is considerable uncertainty if it will. That is the risk in following too-good-to-be-true commodity booms.