Decline In U.S. Shale Production Is Closer Than You Think

Summary

• Shale production is transitioning from growth to consolidation, albeit at an uneven pace.
• In this article we will discuss what we think the market is missing.
• We think the turn will come (may have come already) by year's end at the latest.
• The market perception will then swing from surplus to scarcity.
• This idea was discussed in more depth with members of my private investing community, The Daily Drilling Report. Get started today »

Introduction

I wrote an article a couple of years ago about the "end of days" for little fracking companies, focusing one in particular, Liberty Oilfield Services (LBRT), that was the then-darling of fund managers looking for growth. It came out in early 2018 and I caught a lot of grief in comments, much of which curiously took me to task for putting a "k" in frackers. (It just doesn't look right to me without it, although I will freely admit the verb form frac, is just fine.)

"Beware The Little Frackers...."

After 40 years in the oilpatch, I am fairly thick-skinned and have been cussed out by experts in the art of pointed invective. Commenters on Seeking Alpha have nothing on the rig tool pushers that have upbraided me from time to time in my career.

Let's look at the fortunes of a few companies I highlighted the article linked above.

The slide in the market this year, post not going to war with Iran and the compounding effect of the coronavirus, has left me in a reflective mood, and I thought I would start this article revisiting the status of a few of these "little frackers."

Seeking Alpha, Chart by Author

In my article I proposed that if you wanted to participate in the frac revolution you would be better off in Schlumberger (SLB) and Halliburton (HAL) than the little guys. If you're long either of the big colors you've lost about half your money in the past 10 months. Not a record to brag about whatever the circumstances.

However, the little frackers have been ruder with your capital by comparison, shedding between 70% and 98% of their value, respectively.

I consider that point made, we'll move on.

Let's reestablish the case for oil

This point doesn't get made often enough. That fact is evident in the market's pricing of anything related to oil and gas to historic lows currently. It's a matter of perception. Right now the perception is that we are drowning in oil, so why invest in companies that search for it? Also, we are on the cusp of just not needing it anymore. Neither of these perceptions are grounded in reality. In fact as I will point out later in this article we are just a few months away (potentially) from a change in the market's perception on the first point, from one of endless surplus to scarcity.

So let's look at the prospects of demand a few decades out. I often turn to the EIA for data to buttress my contentions about oil. Not that they are right necessarily, but rather they churn out so much information on a plethora of topics, it's easy to find a salient graphic. In the case below the EIA is telling us that 30 years down the road about 80% of the cars being sold will run on gasoline.

Source

Let's say this graphic turns out to be right, or nearly so. In that scenario someone better drill enough wells to make a bunch of gasoline. In 2018 we used 147 bn gals of the stuff. That about 3.4 bn barrels of crude oil! Being generous and still using the graphic above, it looks like BEVs take a couple of million cars a year from gas powered cars, leaving us with still about 12 mm cars a year thirsty for gasoline. The demand remains at around 139 bn gals a year in 2050.

The oil industry isn't going anywhere but into the future.

On to our main topics.

• Shale reservoirs
• General drivers for oil over the next few months.

Shale

A quick review of the history of shale fracking. Starting in the early 2000s the technology known as "fracking" began to be broadly applied to unconventional reservoirs. It was so unlikely that these reservoirs would produce for any length of time, that had been viewed as being uneconomic for previous 100 years or so.

To no one's great surprise this proved a success. As operators became more familiar with their reservoirs and the technology, the horizontal intervals began to get longer and longer (often reaching almost two miles now, more in some cases). Additionally, the amount of sand packed away grew into the 1000s of pounds per foot of interval. The world changed as these wells gushed new oil production.

EIA, Chart by author

Never at a loss for superlatives, the word miracle was applied liberally, sometimes even by folks who down deep knew better. While imports from traditional sources dropped, and exports to foreign markets grew, investment in shale became a kind of mania. Even bad shale. I will discuss what I mean by "bad shale" a little later in this article.

It was widely proclaimed that the U.S. was now the swing producer of crude oil able to produce to infinity and beyond, regulated only by the number of drilling rigs you were able to deploy. It was a comforting thought if you drive a giant SUV (as I do) and like cheap and plentiful gasoline. It is one, however, that was built on some fundamental half truths and misconceptions.

• Half truth #1. Technology could overcome a fundamental flaw of shale, that being the lack of horizontal connectivity of the reservoir rock. In fact technology was able to overcome this flaw, but only at a price and for a limited time.
• Half truth #2. Cheap money would always flow to shale producers. In some part the shale miracle has been kept alive by historically cheap money looking for a return. The problem here is that eventually loans must be repaid or pushed out to infinity. Bankers are getting tired of pushing loans out, hence the increasing rate of bankruptcy in shale drillers.FTSource: Haynes and Boone
• Misconception #1 All shale reservoirs were created equal. In fact as we are learning they are not. The Marcellus is being abandoned in droves as it's too gassy and thin. By and large the Permian is the receiving play as operators look for ways to grow production. The best example I can cite for this point is Chevron's, (CVX) write down of its Marcellus assets in Q4 of 2019. I wrote an article about this recently if you are new to the DDR.
• Misconception #2 and this is the biggie. The runaway apparent success of shale drilling led the world to anoint the U.S. as the new King of Energy. It was obvious, in just a few years from being the largest energy importers in the world, we had changed into a net exporter. This was the new reality. One of the fundamental mistakes in investing is thinking the past is a predictor of the future. The flaw in this thinking as pertains to shale ignores a shale fundamental truth (review Half Truth #1 before reading on) as compared to most oil reservoirs in the Middle East and particularly the Kingdom of Saudi Arabia, (KSA). The flaw being discussed is that shale is tightly compacted clastic with porosity in the 6%-7% range, most places and permeability in the 10-20 MD range (an MD is 1000th of a Darcy, a standard unit of measure for rock's flow capacity), and a decline rate of 60-70% per year. By comparison Ghawar (the biggest oilfield ever discovered) is a conventional reservoir with up to 35% porosity and is comprised of a highly turbidite mudstone and carbonate mix that has a natural permeability above half a Darcy, 500 MD+, and a decline rate of about 2-3% per year. I have worked on Middle East wells with perms of several Darcys. They flow tens of thousands of barrels of oil per day, mostly without expensive stimulation. I will wrap this section up because I'm about to get too techno-geek and bore you and this getting way too long for a bullet.

Bottom line. KSA always will have a natural advantage over shale and retain the title of Swing Producer when the world discovers the shale miracle was an illusion. The chart below is a little dated, but the point it makes retains its validity today.Source

Summary for shale. It has maintained production growth over the last year for two reasons. First, the rate of drilling has brought new production on faster than the decline rate of older wells. Second, DUCs have been brought out of storage to replace production previously supplied by new drilling. Neither of these scenarios are sustainable, and absent higher prices to spur a resumption of drilling, will result in a decline in overall shale production. Not growth, production. Soon.

Is shale production going to disappear? Certainly not, it will continue to be productive for decades. What will change is the factoryization of shale drilling, meaning that successful companies will bring the following attributes to the task. If you read my articles regularly, you've seen these before.

• Great rock
• Superior technology
• Logistical advantages
• Low cost of production
• Economy of scale

As I have said, this is the future of shale production in America. A future that is just around the corner.

General Drivers in the market for oil

So this is the part you've been waiting for. Where I prognosticate the direction I see oil taking over the next few months. Thanks for your patience.

One of the things I've been discussing in recent articles is a need for a change in the market's perception from one of abundance to one of shortage, or at the very least interruptible supply. We came close to realizing the latter point a couple on months ago when the U.S. and Iran appeared be ready to duke it out. Wiser heads prevailed and the status quo resumed, oil began to back off rapidly toward the mid-$50s. The COVID-19 concerns have destroyed the flow of global trade presently and have taken down forecasts for oil consumption another 1-mm bboed. It will have an impact for a couple of quarters, this is known.

What isn't being discussed is the rebound in demand as fears ease. So that's the bull case for crude later this year. Exhausted supplies of everything will have to be replenished. Oil will be in demand.

Over the short run I'm more pessimistic. Nothing is going right for WTI or Brent. The crash below $50 felt very spongy to me and I'm nowhere near calling a bottom for the next couple of months anyway.

I don't expect much help from OPEC as they are linked to the Russians now, and Russia seems happy with current prices. I haven't had a chance to do any further investigation on this topic, but if it turns out to be actually the case that the Saudis are left to twist in the breeze, something we haven't seen since 2014 could happen. In that scenario, I think they may go the other way and make a run for lost market share as they did in 2014. As I said in an earlier article, Putin is ready to give his buddy MbS (Mohammad Bin Salman Al Saud) some tough love. Will they come around eventually, I think so, but MbS is going to have to give something in return other than a bear hug.

When will I call a bottom?

You should be able to guess here. The bottom will be firmly set in when production from shale plays actually turns south. That will put the final nail in the coffin for the notion of ever increasing light oil from U.S. shale. When the market takes this into account WTI and Brent should head higher.

That day is coming, and I don't think its that far off.

Analyst’s 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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

I am not an accountant or CPA or CFA. This article is intended to provide information to interested parties, and is in no way a recommendation to buy or sell the securities mentioned. As I have no knowledge of individual investor circumstances, goals, and/or portfolio concentration or diversification, readers are expected to do their own due diligence before investing their hard earned cash

Comments

[Brian C. Nelson]

Fluidsdoc - what do you think oil prices would have averaged the last ten years if US shale would have never happened?

[Fluidsdoc]

@Brian C. Nelson an interesting question Brian. I would have to give this some thought to provide a halfway intelligent answer. An easy answer is higher, particularly for the last 5. Perhaps you have some ideas as well. Any interest in a collaborative article? Cheers

[Brian C. Nelson]

The answer is roughly $100/bbl because Saudi recognized pre-shale it was the only large producer with excess capacity that it could use to dial up or down depending on global demand. I suppose this is the definition of swing producer.

Saudi/OPEC further refused to meet the marginal barrel of demand at any price with its excess capacity. They made the rational economic any quasi-monopoly would in that it supplied the marginal barrel of demand at whatever price they deemed fair (i.e., $100 Brant). Effectively, by producing 20% below capacity, they increased oil prices 200% to 300% above what would have been more likely in a free market environment.

This strategy made them very wealthy, especially in the last 20 years. Their spending habits increased to reflect this wealth with entitlements and social programs that are now taken for granted. It's extremely challenging to take a socio-economic step backwards - Economist call it "sticky downwardness".

I mention the above because the cash on cash profit/loss equation is essentially Rev - AF&D - OPEX - Overhead - cost of capital - tax = Firm Profit.

As you correctly pointed out, Saudi's asset level costs are the envy of the world. Overhead related to running an entire country is the exact opposite and is the main reason it needs ~70+ oil to balance its budget.

The unwelcome arrival of US shale and its unprecedented growth has made sustained $70+ oil challenging which threatens forced austerity or long-term and unsustainable debt financing. As such, Saudi's quasi-monopoly is under siege thanks to US shale, which has so far been a windfall to consumers worldwide.

[Fluidsdoc]

@Brian C. Nelson thanks Brian. As shale production begins to decline we may see the oil price rise as the global economy begins to rebound. With the destruction of the fracking infrastructure taking place, it will take time for shale to ramp up...if it's even possible to do. Game, set, and match to OPEC+. Cheers

[DCO1982]

@Fluidsdoc what are your thoughts on midstream these days? Is PAA going to make it out of this?

[Fluidsdoc]

@DCO1982 I've been a little bearish on midstream. I think they've over-invested for the future demand. With shale production set to fall MLPs could have some concerns. Cheers

[SuperPac]

For me the 2 graphs say it all.

Declining investments in fracking as a decade long trend and rising bankruptcies among frackers. Why am I not surprised...what flummoxes me is the nexus that developed b/w frackers and bankers. There is more to it then meets the eyes. Bankers look at projections out years. They are not dumb, esp the ones who finance commodities. They have cyclical data, geological reports etc etc. Something else was going on here. Something the American oligarchical class or a faction of it wanted done. It is ending in tears - for some. Good.

Thanks @Fluidsdoc

[Algorithmic]

@Fluidsdoc great article. I am long BP, XOM, RDSB with far to many shares. I read a stat from "The Quest" that said it took 100 years for the world to consume 1 Trillion barrels of oil. Then 30 years, to consume the next Trillion. Now 27 years to consume this Trillion.

Where are all these Trillions coming from? I find it staggering that the premordial pits that created this oil were that productive.

[Contango82]

They are to a decreasing extent coming from US shale following the last 3 days of development. Good riddance. Only 9 million barrels of unprofitable oil gone...

[Fluidsdoc]

@Algorithmic thanks for the kind words. I think the simple answer to your question is two-fold. First what do you classify as oil, and then what can be produced economically at present prices. Example Canada has huge reserves-hundreds of billions of barrels of 10 gravity oil bitumenous oil that has to be strip mined/steam flooded out of the rock. Under $40-50 a bbl it doesn't pay out. Do we count those or not? Cheers

[BrutalHonesty]

I'm a bit confused. The costs to produce oil in the diagram for US shale is under $25 per barrel. So if the oil price is over $30, why wouldn't they just continue to produce?
At what price do they start to become squeezed due to required ROI's, etc.?

[Sir V-i-val]

Tight oil producers claim that they need between 48 to 54 dollars to break even for a barrel od oil...yet they say.. The problem has been the discount to WTI for our barrels sold. For the Permian area, it’s been a $7 to $12 per barrel discount, so a WTI barrel priced at $58 nets us between $46 and $51 per barrel....If this is true then the average tight oil producers is losing 20 dollar per unhedged barrel produced .... BTW the Rystad figures are worthless...The average prices necessary to cover operating expenses across regions range from $27 to $37 per barrel. as per answers from 160 tight oil producers to questions from the Dallas Fed....www.dallasfed.org/...

[Sir V-i-val]

You forgot the most important fact....The average unhedged price for WTI was 74 dollars a barrel....it looks like the average unhedged price for a barrel of WTI will 47 dollars a barrel....that is a difference of 27 dollars a barrel.....no shale play is making money at this level not even OXY,FANG,CVX or OXM................in fact in 2019 OXM were already their shirts in the Permian...

[Ed.N]

Hi Doc. Its been a long time for me with a reply back to you.
And once again you put together another very good 'Write-Up'. One that I agree 100% with. The only thing missing now is a bottom and turn around.
And oh ! - May I add another 'point of view' > To the many comments ? Its from Marty A., you remember ? Well he is saying that during '22 Inflation will start up again because of "lack of supply". He did not give any details as to the type of things we were to be short of, but Commodities I am sure will 'reflect' in price movement with inflation . . . .
And yes ! I to am down a lot myself.
Take Care, ED.

[bonzo barzini]

I recall when Charlie Maxwell was dean of the oil analysts and he told Louis Ruykeyser that oil was going to $200 and that Suncor was his favorite stock. Will he be proven right?

[Fractalman]

CDC put out their weekly flu update, you know, the one for the regular ol' Flu A and Flu B. This is for the USA only. This season only. Through the end of February.
Total flu illnesses: 34 million
Hospitalizations: 350,000
Total deaths: 20,000 (up 2,000 from the previous WEEK!)
Children deaths: 136

This is a fairly typical flu season for the USA. Now, are we living in the Age of Propaganda or what?

[twfry]

Trump will be taken down, even if millions lose their jobs and the economy is tanked to do so.

[U99109437]

Fracman, and your point is?? You’re comparing a long established disease with one that has just appeared. If nothing is done, it will infect several billion worldwide and 100M in the US before there’s enough natural immunity to end it in a couple years. At a 1% death rate, 1M could die in the US alone. So, yeah, just put your head in the sand. The intelligent response is to contain it if possible, and slow it if containment isn’t possible, which is looking to be the case in the US. This requires testing which hopefully will expand rapidly.

Tw, trump is irrelevant, except to the extent he scares people by sounding clueless, and convinces the gullible that there’s nothing to worry about. That’s a serious problem.

[16384692]

I follow the offshore drillers closely. Their thesis is that shale production will decline in 2020 and bankrupt companies will not be refinanced. The number of shale companies operating will significantly decrease and the fewer remaining will be stronger -- but overall shale oil production will be much less. The world will then realize that US shale is not the answer to the world's oil production (and it has been the ONLY source of oil growth since 2014). Then offshore drilling will begin a new, long upcycle after the longest bear market in it's history. In short, the shale miracle is ending and production will return to normal with some shale but mostly other sources of oil production.

Agree?

[PapaWhisky]

@16384692

Agreed.

But that thesis is about 4 years old now and it's getting a bit long in the tooth.

[Fluidsdoc]

@16384692 I agree but as @ PapaWhisky notes the thesis has some cobwebs on it.

[Fluidsdoc]

@PapaWhisky Amen Papa. I've replaced the candle in the window for the return of conventional D&E a number of times now. Reworking this thesis actually. Putin bit*h-slapped MbS today. Be interesting to see if my thesis about them going for share holds up. Wish I was playing with Monopoly money. It's painful right now. Cheers

[ejboczar]

Great article and question the credibility of DUC data. I understand how it is calculated and the rationale for meeting lease requirement but have not found operators who admit to having DUCs. Hence, how true are DUC numbers?

[User 21793061]

You still holding a torch for Torchlight?

That Orogrande prospect is taking longer than an offshore basin to prove out. It's been 5+ years now. They still don't even have enough results to entice investment or a JV partner. But I guess shell companies take a long time to die.

[fundydoc]

good article, but ignores the efficiencies which will drive breakevens lower over time and the fact that major exporting countries will pump at any price, even at significant losses to keep the needed funds to run their economies - I can see a case for Brent sub 40 and WTI sub 33 in the near term.

I am selectively long currently, but wish I was not - will sell into any rallies for the next 3 months, even at a loss.
I fully expect that some of my holdings will go to zero, others will shock you as to how low they will go. For example HSE / TSX now with a 5 handle. PEY / TSX (gas) about to break 2.00
Charts are monumentally and uniformly awful for all.
Expect to see more WLL's in the near future.

Avoiding all US plays for now, Cdn names providing much better FCF, but still very vulnerable to much lower prices.

Deep discount guys like Sam Zell are just starting to dip their toes in - too early IMHO.
We are all about to get spanked further, I am afraid.

Wish it wasn't so, but it is the reality of the situation currently.

[Fracguy]

Great article, Doc. Particularly like the graphic from EIA showing predicted motor fuel use 30 years out. That alone is enough to keep me long in the O&G sector in these turbulent times. Any thoughts on if the declining interest rates will be a lifeline to those E&P's that are hanging on by their fingernails?
BTW shale operators wish they had 10-20 mD. More like 10-20 micro Darcies.

[PT Larry]

My best guess is that bankers will want to bail, citing lower oil prices, the CO-19, and by understanding the situation can only change for the better, if the majors take over, in my view.

[Jamjack]

The Majors that greenies call dinosaurs will survive and thrive. Likely to pick up bankrupt small gems bankers that will consider to risky imo. CoronaVirus may hasten demise of some due to impacts on price of fossil fuels due to slow downs.

[Ray Merola]

@Fluidsdoc

Excellent article.

Got a question for you:

"The bottom will be firmly set in when production from shale plays actually turns south."

How do you interpret your view with that expressed by Schlumberger CEO Le Peuch:

seekingalpha.com/...

He indicates the growth rate of shale oil production will slow greatly, but overall production will continue to increase out into at least 2021. How's that reconcile with depletion?

I agree with your initial comment, but wrestle with how to forecast when we'll get there.

[PT Larry]

The signs of a bottom will include news of multiple acquisitions, in my view. The majors want the Permian and Eagle Ford.

[Fluidsdoc]

Good morning @Ray Merola. There is no way really to reconcile my views with his. It is interesting don't you think though, that the same guy who's telling us that North American activity will be down again this year is telling us that shale production will increase at a moderated level???? A head scratcher, that one.

Schlumberger is a historically horrible forecaster of activity, relying on IHS Markit reports and the like for deep analysis. You might also remember these are the guys who spent $440 million to buy WFTs Frac equipment the month the frac market turned in 2018. So much for Big Blue's forecasting. (Chuckles)

I am a simple guy with a vintage Rockwell 8R calculator. I can't afford IHS Markit reports. You write for SA as well so you know this is a labor of love and not a source of revenue that can pay for $10K reports.

There is one inescapable truth about production. When the rate of new production from drilling activity falls below the decline rate of existing production, total production will fall.

With what we are being told about scarcity of Tier I rock, lack of success of child vs parent wells, when frac sand companies are closing mines, when water management companies report a fall in volumes, when the rig count falls 25% in a year, when frac spread counts fall from 480 to 300 over the same period, when new well Permian completions fall from 1310 to 635 YoY (www.rrc.state.tx.us/...).... it suggests to me that a tipping point may be near.

We will see how long the DUCs can suspend production. Remember, newer DUCs are unlikely to be as productive as older DUCs!

I think the candle is burning at both ends. Cheers big guy!

[Ray Merola]

I like your style @Fluidsdoc

We agree on many points. SLB has been horrible forecasting the future. I've been willing to give a new CEO some leeway, but he's got to show me, not tell me.

Oil in for another rough day as Russia nixed a deal with OPEC. Perhaps KSA will open the floodgates and jam it down everyone else's throats.

Guess we will see.

[kongfuzi]

Another good article urging perspective. To me the problem is how does the multiple change for oil stocks leading to lower stock prices even if oil price rises. When do they become a wasting asset merely paying a dividend on a declining asset base? Why be in oil when there’s ZM and BYND etc? Seems like the whole O&G E&P sector is being bad mouthed. Ugh.

[frankmorris]

Better question is WHICH companies are positioned well for the changing dynamics of shale. Some companies have better or worse acreage, so what people are NOT talking about is that a good portion of the energy space (I don't mean a majority, such a dedicated portion) will massively benefit when weaker players fade away and production drops off a cliff.

So, the question is no long IF shale will fall, but which shale players will stay around long enough to capitalize?

[Captainthinker74]

I don't follow all the ends n outs of oil, but I can say I've hauled more then one train load of crude from Canada heading to Texas already this year.

[mjanisch]

Good article with data back up. Thanks