A Supply-Constrained View of the Shale Production Surge

Oil prices certainly have been weak.  How should we think about the matter?

Shale oil has been and continues to be the star of the global oil supply.  Crude oil production growth from the Lower 48 states, including shale oil, has averaged about 1 mbpd (million barrels per day) / year since late 2012.  Importantly, however, supply growth has not broken through this ceiling, despite astounding performances from both the Bakken and Eagle Ford plays.  Whether shale production can accelerate depends heavily on the Permian, where horizontal drilling activity has surged in the last year.   In addition, a large number of horizontal rigs are now active in other mid-Continent plays, although with unclear upside potential.

North American Production Growth (Sept. 2014).png

 North American Oil Production Growth – Annual (3 month moving average)

Source: EIA STEO

US production growth has also been sustained by the Gulf of Mexico, with a number of projects coming online in the coming year or so.  Finally, Canadian production has done well, principally on the back of oil sands growth, but with Canadian shale production providing a notable supporting role.  To this, I would add impressive growth in natural gas liquids, which are typically considered part of the oil supply, even if they are not entirely fungible with crude oil.

Taking all these together, the pace of North American unconventional supply growth exceeded 2 mbpd / year during the summer of 2014.  This is a simply phenomenal performance unprecedented since the 1960s.  It may also be unsustainable.  The EIA sees production growth decelerating materially from Q2 2015.  Indeed, peak production growth should be occurring just now.  On the other hand, shales have tended to outperform expectations, and may do so again.   If so, the peak may last longer or go higher than expected.

I would note that the EIA’s forecast is not all that different from that of the major forecasting companies, and is more conservative than that of Astenbeck Capital Management, Andy Hall’s firm.

Whether shales over-produce will ultimately depend on the underlying economics.  In a supply-constrained approach to analysis—the one which we at Princeton Energy Advisors use—there is no price restraint.  That is, producers will increase their production at an increasing pace until the oil price falls or until they become limited by geological or technological costs.  The general presumption has been that costs, rather than oil prices, would prove the binding constraint. 

EOG FCF and Production.png

EOG – Oil Production and Free Cash Flow

Source: Bloomberg

The performance of EOG, the very best shale oil producer, casts some doubt on this view.  From being massively free cash flow negative from 2005 to 2012, EOG has turned the situation around, posting positive free cash flow in 2013 and looking to increase that number to $0.9 billion in 2015.   If EOG is unique in this regard, then other producers will fail to achieve material accounting profits over the investment cycle.  On the other hand, if a large number of other producers successfully follow EOG’s path, then their production growth might also resemble EOG’s: continued growth at a compounding rate until the oil price is brought to marginal cost, which Goldman Sachs suggests might be around $80 / bbl on a WTI basis.  

This would be devastating for conventional producers.  In fact, the squeeze is already on, and was at Brent prices of $110 / barrel.  The oil majors, as the graph below shows, have been experiencing deteriorating free cash flow since 2011 and are now firmly in negative territory.  As a result, they are rapidly divesting and cutting capex.  On current trends, we might expect oil production from the majors (as listed below) to fall by about 1 mbpd in 2014, similar to declines since 2011.  Were Brent oil prices to even sniff a number below $90 / barrel, the majors will pull in their horns in a hurry, and capex compression will accelerate at an appreciable pace. 

Oil Majors FCF (Sept. 2014).png

Major Oil Companies’ Free Cash Flow

Source: Astenbeck Capital Management

Any shale-induced oil price drop will thus be accompanied by substantial weakness on the conventional side, at least from non-OPEC producers like Shell and Statoil.  In global oil production, not all the arrows are pointing in the same direction.  Some are decidedly pointing down.

If anything could help the majors, it is enhanced oil recovery.  Much has been written at various times about its potential.  Of course, such methods are routinely used around the world.  The question is rather whether some technological innovation would lead to higher recovery rates in a short period of time for a large number of wells.   It is hard to say, beyond noting that pressures in the industry will favor innovation, rather than capital intensity, from here on out.  From 2003 to 2011, the oil companies could count on continually increasing oil prices to support incremental exploration and production activities.  That strategy ran its course in 2011 when oil prices reached the global carrying capacity.   From here on out, incremental oil will have to be recovered relying on brains, rather than money. 

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Of course, oil prices depend on more than supply.  Demand may matter even more. 

Almost all the world’s economies, leaving aside the stable Gulf oil producers, have underperformed GDP projections made by the IMF in 2010.  The causes are hotly debated.  Until about a year ago, the theories of Harvard economists Carmen Reinhart and Kenneth Rogoff prevailed, suggesting that slow growth was related to deleveraging following financial crises.  This theory has recently lost favor. The US has stopped deleveraging in the private sector and household debt service is near historical lows (since 1980) as a share of disposable income.  Even the US federal budget deficit is expected to come in under 3% through 2017.  Nevertheless, the US has not returned to trend growth, and the economics community is progressively trimming their expectations for potential GDP to meet observed data.  Economists like Larry Summers, former US Treasury Secretary, worry about ‘secular stagnation’, in which the US sees chronically low growth of the sort experienced in recent years, with no return to traditional levels.

Potential and Actual GDP (CBO Sept. 2014).png

US GDP – Actual and Forecasts from 2007 and 2014

Source: US Congressional Budget Office

Our view has been—just as a supply-constrained model would suggest—that weak advanced country growth has resulted principally from high oil prices, and if and when prices drop, growth would accelerate, bringing oil prices back up.   We will see if this occurs on a sustained basis, but 4.6% GDP growth for the second quarter in the US is heartening.  By contrast, Europe is currently experiencing recessionary pressures, apparently the result of tensions with Russia.  China is also facing a weakening economy, in large part a function of a real estate bubble which may or may not burst.  Thus, drivers of demand may be missing for reasons other than oil prices.  Notwithstanding, as these ease, our model suggests that demand should pick up, and it could pick up quite a bit.  Our estimates put global pent-up demand on the order of 3.4 mbpd, that is, the volume which could be absorbed in a short time were it available at reasonable prices.

Finally, there is a risk to oil prices from exchange rates.  As oil is priced and traded in dollars, a strengthening of the dollar will tend to depress the price of oil. The exchange rate is a function of a number of factors, including interest rates, political and economic uncertainty, and trade fundamentals.  One of these is the US current account balance. As the graph below shows, the current account deficit is entirely sustainable by historical standards.   Further, for every 1 mbpd of incremental US oil production, the current account should improve by about 0.33% of GDP, as US oil production directly displaces imports.

US Current Account Deficit.png

US Current Account Balance – Percent of GDP

Source: FRED

Should US oil production continue to increase at the recent pace for the next few years, and should the economy hold together sufficiently for the Federal Reserve to end quantitative easing, then interest rates might rise and the US dollar could appreciate. 

US Trade Weighted Dollar Index.png

US Trade-Weighted Exchange Rate

Source: US Federal Reserve Bank

And indeed, the dollar has appreciated by nearly 9% against the Euro since early summer, a change consistent with a drop in the oil price for $108 to $98 / barrel.  Curiously, the threat to oil prices might arise not so much from increased supply, but rather from a strong dollar and a recovery of US economic dynamism.

Can oil prices stay low?  If North American unconventional production can continue to grow at 2 mbpd / year and China and Europe remain weak, then that’s a possibility.  However, if EIA expectations for shale growth prove right, tensions with Russia ease, and China regains its mojo, expect oil prices to return to levels typical of the last three years.