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March 20, 2015

Will U.S. Shale Industry Survive Until Demand Recovers?

By Chip Register via Commodities Now

Is the U.S. shale industry at a tipping point? Oil prices fell to a six-week low last Friday after the International Energy Agency warned that the U.S. may soon run out of room to store all the oil being pumped out of shale plays across the country. As oil starts to back up, the worry is that prices could fall like a rock. But despite this grave warning, bullish oil traders are keeping their cool. They believe that the low prices will ultimately decimate the U.S. shale industry, removing a large chunk of supply from the market indefinitely,  similar to what happened during the last major oil price crash 30 years ago.

But is the shale industry really that vulnerable? Growing production levels in the face of lower prices seems to defy the view that the industry is on the edge of collapse. While oil prices fell nearly 50% from their peak last year in June, production across the seven major shale plays increased by 18% to 5.1 million barrels between June 2014 and February 2015. One reason is that the industry is financially more sophisticated than in the past, giving it greater access to the credit markets. This has allowed producers to remain financially solvent through the downturn and continue pumping despite the weak prices. At the same time, advances in drilling technology and engineering know how has allowed producers to respond quicker to price changes, helping to create both a floor and a ceiling to the oil price.
There remains a great deal of controversy surrounding the reasons why oil prices fell off a cliff last summer. Richard Fisher, the head of the Dallas Federal Reserve, said at the Economic Club of New York last month that he believed the Saudis “engineered” the current oil crisis to drive shale producers out of business. Continental Resources Chairman and CEO, Harold Hamm, told Forbes last week he thought the Russians financed the anti-fracking movement in the United States and Europe in an attempt to wipe out shale producers to protect their market share.
But if there were a sinister Saudi or Russian plot to destroy the U.S. shale industry, it doesn’t seem to be working, at least not yet. Only a handful of U.S. shale producers have gone bust since prices fell, like WBH Energy back in January, with the vast majority still operating. They have adapted quickly to the market by almost immediately slashing capital expenditures, negotiating cheaper service contracts and cutting staff.  The name of the game has basically gone from “expand as fast as you can” to “liability management”.
But if some were to get into trouble, the credit analysts at JP Morgan said there exists a “large and varied toolkit of liability management options,” that could help weather the storm. These include second-lien financings, asset sales as well as debt-for-debt and debt-for-equity exchange offers. Given this, the analysts believe the true cumulative default rate, even under a sustained three-year $50 oil price (WTI) scenario, would be less than 30%.
To be sure, a decrease in capital spending doesn’t necessarily lead to a commensurate decline in production. Indeed, the sharp drop in oil prices has also meant a sharp drop in production costs as operators now have the upper hand in contract negotiations with oil service firms. This has led to as much as a 20% to 30% reduction in oil service costs for many firms who continue to drill, according to a note published by Barclays North America oilfield services and equipment lead analyst, J. David Anderson.
Technology is also playing a role in keeping costs to a minimum. Michael Lynch, an analyst at Strategic Energy and Economic Research, believes that technological improvements, along with offsetting increases in production, are reducing fracking costs for shale producers by around 10% to 20% on an annual basis. Combine that with reduction in oil field service costs and you start see how the shale industry can hold on for quite a while with oil prices down in the dumps.
Demand for oil seems to be on the rise, with the IEA seeing what they call “tentative signs of a demand recovery.” As such they now believe that world oil demand will average around 93.5 million barrels a day, which is up around 300,000 barrels a day from their previously bearish forecast. This should help reduce oil inventories, removing the current downward pressure on the oil price due to the storage crunch.
The oil price has always been tricky to forecast. Pretty much no one saw the collapse from its highs last summer and few, if any, will probably call the bottom this year with any certainty.
I continue to see this market stuck range-bound. In one corner you have the shale industry continuing to produce and supported financially by the credit markets. This will define our cap; but, in the other corner, we have slowly increasing global demand and the ever-present potential for political conflict. From there we establish our floor. Certainly in between there will be volatile days and weeks, but those looking for a capitulation or triple digit pricing in the next few years and fighting some pretty obstinate fundamentals.
Ends --
Source: Forbes, Chip Register, Sapient Global Markets via Commodites Now (EconMatters author archive here)  
The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.

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