‘The revolution devours its children.’ That observation, made by French journalist Jacques Mallet du Pan in 1793, has become a commonplace of political upheavals, but it is often true of revolutions in business, too. Companies that create a new market or disrupt an existing one do not always benefit in the long run.
Many of the pioneers of the US shale revolution are still thriving, although they have experienced some hard times along the way. With the fall in oil prices since the summer, they face their most serious challenge, largely as a consequence of their own success.
Eric Otto, an analyst at CLSA, says the industry appears to be in “a multi-quarter period of lower oil prices”, and that the US shale industry will have to adjust to that new reality.
The first crisis in shale came with the collapse of natural gas prices in the summer of 2008. For the first five years of the industry’s life, beginning with the successful combination of horizontal drilling with hydraulic fracturing to extract gas from the Barnett Shale of Texas in 2003, gas prices rose steadily. In 2008, Henry Hub, the US natural gas pricing benchmark, peaked above $13 per million British thermal units.
As the financial crisis deepened and the US plunged into recession, natural gas prices fell and hit a 10-year low below $2 in April 2012. Peak to trough, it was a fall of more than 85 per cent.
Industry analysts kept wondering when low prices would make so much production uneconomic that supplies would fall and prices recover. That point was lower than many expected. It is possible for the best operators in the best areas of the Marcellus Shale of Pennsylvania to produce gas more cheaply than almost anyone realised.
Cabot Oil & Gas, for example, reports a cash cost in the Marcellus of just 75 cents per mBTU. That is somewhat misleading, because it excludes expenses needed for long-run production, but even including other costs, the estimate that its wells can earn an 80 per cent internal rate of return while selling gas at $2.80 per mBTU is still remarkable.
From 2010, many shale companies that found it impossible to compete in gas production at the prevailing prices began to shift their rigs to oil production, taking advantage of the discovery that techniques that worked for gas could be applied to liquids.
The economics were irresistible. With US benchmark crude at about $100 a barrel, and gas at about $4 per mBTU, oil was worth four times as much as gas for an equivalent energy content. US oil production boomed: crude output rose from 5m barrels a day in 2008 to about 9m barrels per day currently.
Even though the US has strict controls on its crude oil exports, its production affects world markets, as it imports less. Yet as the US added millions of barrels a day to the market, its impact was offset by disruptions elsewhere: sanctions against Iran and the turmoil in Libya. With demand in emerging economies growing, global oil prices stayed above $100 a barrel, making most US shale oil production commercially viable.
This year, however, the balance in the market has changed. Gary Ross, head of the consultancy Pira Energy Group, says oil producers’ “luck ran out”. Demand growth slowed sharply, particularly in China, and some supply disruptions eased, with a rise in exports from Libya. US prices have fallen by about 30 per cent since June. Other high-cost sources of oil, including offshore production and the Canadian oil sands, will be hit. Transocean, the offshore contractor, has warned of a “cyclical downturn”. But US shale producers are in the line of fire as well. Estimates of the costs of shale production vary widely. Half of North American shale developments would still be profitable with US crude at $57 a barrel, according to IHS, the research group, while Abdalla El-Badri, secretary-general of Opec, has suggested half of US shale production would be knocked out by oil at $85. The decisive factor is likely to be whether US shale companies can keep raising the cash to finance their drilling programmes.
Matt Portillo, an analyst at Tudor Pickering Holt, says he expects the US shale industry to slow down, rather than go into reverse, but says the effect depends on how long the oil price remains at these levels, especially for financially weaker companies.
“Most are believers in the commodity long-term, so they don’t want to cut [their drilling budgets]. But the longer we stay in this commodity price environment, the more pressure they are under,” he says. “If they are outspending their cash flows, eventually, the numbers won’t work out.”
The shale oil boom proved an escape route for gas producers that were under financial strain. It does not look as if there is anything that can provide a refuge for oil producers in the same way. The coming year is set to test how durable the US shale revolution really is.