Since the start of July, oil prices have fallen from nearly $110 per barrel (WTI) to $45. While drops of this magnitude have happened before (60% in this case; more than 100% in the global financial crisis of 2008-09), the pace of this decline has taken many by surprise. There are lots of articles out there as to why it’s happened – Saudi’s flexing their muscles in a bid to maintain market share; slowing demand in Europe and Asia; collusion between the USA and the Saudis to ‘pressure up’ the Russians and the Iranians – among others.
For me and many others in the Baby Boomer oil patch cohort, this is Bust #4. The first occurred when many of us were in college or just about to graduate (1985-86) – prices dropped into the single digits; job offers were withdrawn; and massive layoffs hit the industry (Exxon, my employer out of college, laid off 30% of its technical staff in Exxon USA the Friday before I started my first day with the company).
Prices imploded again during the Asian financial crisis of 1997-98. The impacts were similar, with bankruptcies soon to hit the geophysical industry (recall PGS). Then we had Bust #3 during the global financial crisis. And now we’re onto Bust #4.
Without wanting to be so bold as to put forth an argument that “it’s different this time” (though I think it is), let’s simply take a look at what the impact of this price decline is likely to be on USA production in 2015.
First, a few bits of numerical context. The world produces and consumes around 80 million barrels of oil every day. The top three producers – each of which produces around 10 million barrels per day – are Russia, Saudi Arabia and the United States (this was the order in 1Q2014). During 2014, the U.S. vaulted to the #1 spot, with production exceeding 11 million barrels per day. Various financial analysts projected the U.S. would be producing 13 million barrels per day by the end of the decade.
This surge in U.S. production – driven by the shale boom – upset the Saudis and other OPEC producers as it displaced the need for their products in the U.S. and other importing nations around the world. So, as they have before, the Saudis opened up the taps to keep the market oversupplied and force out the high-cost producers. The best guess estimates of the level of this oversupply range from 1-3 million barrels per day.
So the question is, how fast does this supply overhang come off the market? To get a sense of this, let’s look at Continental Resources and the Bakken for a little back-of-the-envelope estimate. As many know, the Bakken (along with the Eagle Ford) has become the epicenter of the USA shale boom. The Bakken produces about 1 million barrels per day (from a diminimus level a decade ago). Continental and Whiting are the Bakken’s largest producers, each pumping roughly 100,000 barrels per day. Others in the Top Five in the Bakken are HESS, EOG and Statoil who all produce in excess of 50,000 BOPD.
With prices falling, capital budgets are soon to follow. In December, Continental cut its CapEx targeting the Bakken by $1 billion. Given the economics Continental has in it’s investor presentation, it’s easy to see why. With $45 oil, Continental’s Bakken wells generate ‘only’ a 10% return.
The average Bakken well costs roughly $8 million to drill, complete and frac. So if Continental cuts $1 billion from its Bakken budget (almost all of which would be targeted at drilling wells), then that’s 125 fewer Bakken wells that Continental will drill in 2015. Let’s say Whiting makes similar cuts, as do all other Bakken players. That implies to me that somewhere around 1,000 Bakken wells that would have otherwise been drilled in 2015 no longer will be. What does the average Bakken well produce? The type curves in Continental’s and Whiting’s investor presentations state that IP’s are somewhere around 850 barrels per day. So calculating it out, that implies 850,000 barrels of oil that would have come into the market in 2015 from the Bakken no longer will.
While the D&C economics of all shale plays are different, they are also fairly similar in many regards. Thus, it wouldn’t be too hard to assume that the Eagle Ford, Permian, Niobrara and other oil-rich shale plays will suffer similar declines. So with budget cuts alone, it’s pretty easy to see how the amount of supply entering the market in 2015 from USA shale plays will be dramatically reduced compared to what everyone thought just 3 months ago.
But those are new wells you say…what about wells already in production? Well, this is where the current shale bust is somewhat unique (at least compared to other oil busts of the past). When the market was heavily supplied by conventional fields, the base decline rates of the ‘swing production base’ were in the 4% per year range. But shales are different. Look at the curve below.
You’re seeing the type curve for a typical Bakken well drilled by Whiting. You’ll note the 850 BOPD initial production rate. But after just one year, that same well is only producing 275 BOPD; and after two years, production has dropped to around 150 BOPD. So if the industry dramatically cuts back on the drilling of Bakken wells, not only will we remove upwards of 1 million BOPD that would have come into the market, we’ll also be facing a situation where – depending on the age of the well – we’re probably removing 20% of the legacy production base every year. That’s going to amount to several hundred thousand barrels per day in each major shale basin.
As this process repeats in other shale basins across the U.S. (not to mention other development projects in conventional fields around the world), we’ll remove a significant amount of supply from the market and, I would assert, the market should come back into balance pretty quickly. With USA shales now serving as the world’s ‘swing producer,’ I would argue that this time, it really is different. Unfortunately, like all these rides down have been in the past, it’s probably going to be a pretty bumpy ride with some white-knuckle moments along the way.