U.S. Shale Oil: Maybe Down, But Not Out FEBRUARY 19, 2015











The rise of shale producers has transformed the U.S. oil industry and altered global oil market dynamics; although several years of high oil prices masked underlying weaknesses.

Hussein Anooshah

Slumping prices will reinforce an underlying slowing trend among U.S. shale producers causing overall U.S. crude oil output to plateau at just over 9 mbd.

ASSOCIATE ECONOMIST 1-202-857-3621 [email protected]

We project U.S. crude oil production growth to decelerate from about 1 mbd annually over the past three years to 0.3 mbd in 2015 and 0.1 mbd in 2016, assuming WTI averages $55 and $65, respectively.

George T. Abed

Nevertheless, constantly improving technology, a dynamic capital market environment, and a gradual improvement in oil market fundamentals will keep the U.S. a key player in the global oil market.

SENIOR COUNSELOR & DIRECTOR 1-202-857-3644 [email protected]

The shale boom has altered the balance of power in the U.S. oil industry. The global integrated oil firms that had dominated U.S. crude production for decades have seen their market share overtaken by independent exploration and production firms (E&Ps). These E&Ps were among the first to exploit advanced drilling technologies to unlock large volumes of oil (and gas) trapped within shale rock and, riding the wave of elevated prices in excess of $100/bbl, were able to ramp up shale production from 1.2 mbd in 2007 to 5.5 mbd at present, equivalent to 60% of U.S. total output of crude. However, the sudden collapse of oil prices since mid-2014 is blunting momentum in the near term as the vulnerabilities of some shale-producing E&Ps begin to manifest themselves in financing difficulties, cutbacks in spending and ultimately a slowdown in output growth. This note assesses the ability of leading independent E&Ps to maintain growth in an extended low-price environment. We conclude that without a significant recovery in prices, U.S. oil production growth is likely to decelerate to 0.3 mbd in 2015 and 0.1 mbd in 2016, compared to the 1.1 mbd yoy increase in 2014. Overleveraged, lower-margin operators will face rising difficulties in financing new activity, forcing some to exit the market. Over the medium term, the business agility of operators, combined with declining costs and technology improvements, will maintain the relevance of shale producers to the oil market, but U.S. crude production is likely to plateau at just over 9 mbd. Chart 1 U.S. Crude Oil Production Forecast at $55 2015 and $65 2016 WTI Prices mbd IIF Projection 10 Other Global Integrated E&P Sample 9 8

Current EIA Total U.S. Crude Forecast

7 6 5 4 3 2 1 0 2010

2011

2012

2013

2014

Source: EIA, IIF. iif.com © Copyright 2015. The Institute of International Finance, Inc. All rights reserved.

2015

2016

The oil price collapse will blunt U.S. crude production momentum

U.S. SHALE OIL : MAYBE DOWN, BUT NOT OUT | FEBRUARY 19, 2015

page 2

THE EMERGENCE OF THE U.S. INDEPENDENT E&PS Prior to the shale revolution, U.S. crude production had been on a steady decline, decreasing from 9 mbd in 1983 to 5 mbd by 2008, and only a handful of oil firms dominated the market. These global integrated oil companies, with involvement in upstream, midstream, and downstream sectors, had largely accepted the U.S. production decline as a foregone conclusion. After nearly a century and a half of production, most U.S. conventional wells had already been exploited and the only source of new oil and gas deposits came from offshore deep sea wells. The promise of shale, therefore, went largely unnoticed by the big players, leaving the door open for independents. Independents represented a new breed of drillers, solely involved in upstream operations their peers. They established a niche market in shale early on and laid the groundwork to

Table 1 World Oil Supply* 2008 2014

rebuild domestic production capacity. At the time, a number of factors were aligning to

Total

(or exploration and production), and therefore less risk-averse and less diversified than

86.7

93.0

bring independents into shale: a favorable business environment with secure ownership of

OPEC

36.1

36.8

mineral rights; easy access to finance; rapidly developing technological know-how; readily

Non-OPEC o/w Russia

50.6 10.0

56.1 10.9

available equipment; and suitable topography for hydraulic fracturing. Perhaps the greatest incentive of all came from persistently high oil prices, which made the high cost

o/w Canada

3.2

4.2

of shale extraction feasible. Independents pounced on the opportunity afforded by shale

o/w U.S.

7.0

11.4

% of total

8.0

12.2

and engineered a complete turnaround in U.S. oil production growth, raising U.S. crude

Source: IEA. *Includes condensates and NGLs.

output from 5 mbd in 2008 to 9.2 mbd at present (Chart 2). In the process, they remade the U.S. into the world’s top oil producer (when including NGLs and condensates), increasing its share of global supply from 8% to 12% between 2008 and 2014 (Table 1). High oil prices and increasing volumes year after year brought in large revenues and cash flows for independents. As cash flows from operations grew, so too did capital expenditures, albeit at a higher rate due to the technical characteristics of shale production. Unconventional wells gush out large volumes initially, yet suffer steep decline rates of up to 70% after the first year (compared to 4-5% for a typical conventional well). New wells have to be continuously developed and drilled to make up for lost legacy production (Chart 3), which requires additional cash outlays. E&P activity in the earlier Chart 2 U.S. Crude Oil Production mbd

Chart 3 Changes in Legacy Production thousand barrels per day 0

10 9

Other

Bakken

8

Eagle Ford

Niobrara

-50

Permian

-100

7

-150

6

-200

5

Eagle Ford Niobrara

-250

4

-300

3 2 2008

Bakken

2009

2010

2011

2012

2013

2014

2015

Source: EIA. 1

Includes crude, condensates and NGLS

iif.com © Copyright 2015. The Institute of International Finance, Inc. All rights reserved.

-350 2008 Source: EIA.

Permian

2009

2010

2011

2012

2013

2014

U.S. SHALE OIL : MAYBE DOWN, BUT NOT OUT | FEBRUARY 19, 2015

Chart 4 E&P Trends in CapEx, Aggregated $ per BOE

percent

CAPEX/Reserve Replacements

25

15

CFO/CapEx + Dividends

Chart 5 E&P Trends in Debt, Averages $ per BOE

100

5.5

90

5.0

80

4.5

CFO/CapEx

20

page 3

70

Net Debt Per Unit of Reserves

percent 45 43 41

Debt to Capital

39 37

4.0

35 3.5

33

3.0

31

60 10

50

5

40 2009

2010

2011

2012

2013

Source: Bloomberg. IIF sample.

29

2.5

27

2.0

25 2009

2010

2011

2012

2013

Source: Bloomberg. IIF sample.

years focused on the more productive acreage within the Bakken, Permian, and Eagle Ford shale plays, helping support a rise in production even when prices were not so high. However, as the industry expanded in these and in less productive plays, costs rose; Reserve replacement costs, for instance, increased from $12 to $24 per BOE in the span of five years, contributing to a deteriorating capital expenditure financing gap (Chart 4). Many E&Ps turned to borrowing from banks and in the capital markets to make up the difference, raising debt-to-capital ratios in the process (Chart 5). This highrisk strategy proved to be quite profitable at prices above $100/bbl. As a result, banks responded with larger credit lines, investors scooped up debt issuances, and shares of these companies rallied (Chart 6) on the back of hefty dividends from cash flows, even when these fell short of investment outflows. After a sharp recovery in 2010 (from a 2009 low of $41), prices remained at or above

As the shale industry expanded, increasing reserve replacement costs led to higher capital expenditure financing gaps

$100/bbl through mid-2014, and this “new normal” seemed to be taken as a given for the foreseeable future. U.S. (and more generally non-OPEC) production responded with steady increases in supply, largely offsetting shortfalls from a number of OPEC member countries (notably Libya, Iraq, and Iran). The growing thirst for oil from energy-intensive emerging markets provided an added impetus from the demand side. However, many of the factors that kept a high floor under prices reversed in 2014 (After After the Fall), Fall the most important of which has been the change in the global demand and supply balance. From 2008 through 2012, the 4.2 mbd growth in world supply more or less balanced the 4.1 mbd growth in demand, keeping the supply/demand gap exceptionally tight and prices at high levels. However, from 2013 onwards, with the surge in U.S. oil production gaining momentum coupled with lack-luster global economic growth, supply began to grow faster than demand (Chart 7). Markets, however, remained bullish, fearing supply disruptions on account of rising geopolitical risks in the Ukraine

iif.com © Copyright 2015. The Institute of International Finance, Inc. All rights reserved.

From 2008 through 2012, growth in world supply balanced growth in demand

U.S. SHALE OIL : MAYBE DOWN, BUT NOT OUT | FEBRUARY 19, 2015

Chart 6 Equities: NA E&Ps and S&P Before Oil Price Decline index, Jun 2012=100 200

115

Chart 7 Changes in Global Oil Demand & Supply mbd U.S. 6 Other Demand U.S. 5

110

4

105

3

100

2

95

1

$/bbl 120

180 160 140

page 4

120

BI NA 50 (lhs)

100

S&P (lhs)

90

0

Brent (rhs)

85

-1

80 60 Jun 12

80 Dec 12

Jun 13

Dec 13

Jun 14

Source: Bloomberg North American E&P Index.

-2

China OPEC Other Supply

Total

2008-2012 Demand Supply

2013-2015 Demand

Supply

Source: IEA, EIA, IIF.

and the Middle East. However, the music could not go on forever, and it stopped abruptly the moment Saudi Arabia upended the prevailing price-setting norm in August 2014 by discounting prices to Asian consumers to protect market share. Until then, Saudi Arabia had served as a market stabilizer by supplying or withdrawing the incremental supply needed to keep the market in balance. Suddenly, however, Saudi Arabia, facing rising competition from high-cost producers, especially in the U.S., decided to abandon its traditional role and do whatever was necessary to protect its market share. The change in strategy was formalized at the OPEC meeting in late November. Discipline in OPEC collapsed and prices along with it, contributing to a cumulative 50% drop in as little as six months (Chart 8). High-cost producers (notably shale oil in the US and tar sands in Canada) were caught unprepared and their difficulties began to mount.

AT THE MERCY OF A WEAK MARKET Low prices negatively affect E&P financials in a number of ways. First, low prices reduce revenue and squeeze margins, reducing cash flows that help finance capital expenditures. For E&P operators, financing capital expenditure is critical to long-term growth because those funds go towards finding and developing new wells. At the same time, low prices reduce the attractiveness of developing new wells and the available acreage. Second, low prices impact E&P funding through the valuation of oil and gas reserves. Reserves play a key part in a bank’s decision to lend and in valuation metrics used by investors. The growth in reserves since the onset of the shale revolution has been buoyed by high energy prices, which not only raised the value of existing reserves but also made feasible the inclusion of higher-cost reserves in the valuations. A positive

iif.com © Copyright 2015. The Institute of International Finance, Inc. All rights reserved.

Saudi Arabia upended the priceprice - setting norm in August 2014 by discounting prices to Asian consumers to protect market share

U.S. SHALE OIL : MAYBE DOWN, BUT NOT OUT | FEBRUARY 19, 2015

Chart 8 Saudi Arabia Discounts to Asia and Brent Prices $/bbl versus benchmark* 5

4 3 2

$/bbl 120 110 100 90 80

1 0

70

page 5

Chart 9 Past Reserve Revisions & Energy Prices percent change, YoY 80 WTI

60

$ billion 8 6

Henry Hub

40

4

Revisions

20

2

0

0

60

-20

-2

50

-40

-4

40 -2 Jan 13Apr 13 Jul 13 Oct 13Jan 14Apr 14 Jul 14 Oct 14Jan 15

-60

-1

Source: Bloomberg. *Oman/Dubai Light

-6 2006 2007 2008 2009 2010 2011 2012 2013

Source: Bloomberg. IIF sample.

correlation observed between energy prices and revisions to reserves since 2008 supports this view (Chart 9). Some firms are likely to have overvalued their reserves in the scramble for acreage, acquiring less than optimal areas where costs are higher and recovery rates lower than in established shale plays. A sustained period of low prices will thus reduce the carrying value of those reserves, lead to impairment expenses, and reduce equity book values. As a result, leverage ratios rise; loan covenants are breached; and credit availability dries up. In short, low prices have unraveled the financial position of a large number of the highly leveraged independent E&P firms, leading to a vicious cycle in which the lack of financing impedes their ability to continue to finance investments for future production and remain a viable entity. The severity of production cuts will depend on how low prices drop and for how long, but it will be a particularly painful experience for overleveraged high-cost shale producers. In the aftermath, only the lower-cost, wellfinanced operators in relatively rich plays will be able to weather this storm.

The lowerlower - cost, well-- financed well operators in relatively rich plays will be able to weather this storm

THE HAVES AND THE HAVE NOTS Shale producers are far from a homogenous group. Some are public and others private. Most extract both oil and gas but production mixes can vary substantially. All producers, however, have unique financial profiles. To get a handle on the aggregate impact of lower oil prices, we have identified a sample of 55 publicly traded, independent E&Ps involved in shale production. In the third quarter of 2014, these firms accounted for 3.3 mbd of the total 8.6 mbd U.S. crude output (or 38% of U.S. production). About 1.6 mbd (18%) was contributed by the four global integrated oil majors. As previously noted, supplies from the global integrated oil firms have been fairly stable since 2008. This leaves about 44% that is unaccounted for in our sample, presumably supplied by private and much smaller, publicly-traded players (Table 2). iif.com © Copyright 2015. The Institute of International Finance, Inc. All rights reserved.

Table 2 U.S. Oil Industry 2008 2014 U.S. Crude

8.7

5.0

Global Integrated

1.6

1.6

E&P Sample

3.3

1.4

Other

3.8

2.0

Source: Bloomberg, EIA, IIF sample.

U.S. SHALE OIL : MAYBE DOWN, BUT NOT OUT | FEBRUARY 19, 2015

Table 3 North American Independent E&P Financial & Operating Data* units vary according to metric Global Integrated Q3 Production, mbd, total 1.6 % of Total US production 18.0 2015 Production¹, mbd, total 1.6 Lease Operating Expense, $/BOE, average -Interest Expense, $/BOE, average 0.5 Debt to Capital, percent, average

All 3.3 38.0 3.5 11.8 4.2

page 6

Large Medium 2.1 0.9 23.8 10.7 2.2 1.0 13.9 12.4 2.0 3.8

Small 0.3 3.5 0.3 10.6 5.3

17.5

56.1

0.0

50.1

0.0

CapEx, $ billion, total CFO, $ billion, total

136.9 140.3

140.0 117.9

82.1 79.6

38.2 26.3

19.7 12.0

% of CapEx Dividends, $ billion, total Reserve replacements, billion BOE, total

102.5 31.0 11.8

84.2 9.9 9.5

96.9 7.2 4.7

68.9 1.9 2.1

60.8 0.8 2.7

3.4

17.7

12.9

3.3

1.5

Shale acreage², million net acre, total

Source: Bloomberg Intelligence. Company 10-Qs, 10-Ks, and Investor Presentations. *IIF sample. ¹Sell-side consensus on total oil & gas production adjusted for U.S. oil mix ²Includes Permian, Eagle Ford, and Bakken Memo: Categories based on 2014 Q3 U.S. oil volumes. Large includes companies that produced >100 tbd U.S. oil; Medium includes companies that produced between 100 and 20 tbd U.S. oil; Small includes