The new economics of oil

Sheikhs v shale
The economics of oil have changed. Some businesses will go bust, but the market will be healthier
http://www.economist.com/news/leaders/21635472-economics-oil-have-changedsome-businesses-will-go-bust-market-will-be
Dec 6th 2014

THE official charter of OPEC states that the groups goal is the stabilisation of prices in
international oil markets. It has not been doing a very good job. In June the price of a
barrel of oil, then almost $115, began to slide; it now stands close to $70.
This near-40% plunge is thanks partly to the sluggish world economy, which is
consuming less oil than markets had anticipated, and partly to OPEC itself, which has
produced more than markets expected. But the main culprits are the oilmen of North
Dakota and Texas. Over the past four years, as the price hovered around $110 a barrel,
they have set about extracting oil from shale formations previously considered unviable.
Their manic drillingthey have completed perhaps 20,000 new wells since 2010, more
than ten times Saudi Arabias tallyhas boosted Americas oil production by a third, to
nearly 9m barrels a day (b/d). That is just 1m b/d short of Saudi Arabias output. The
contest between the shalemen and the sheikhs has tipped the world from a shortage of
oil to a surplus.
In this section

Sheikhs v shale
Make haste slowly
Abes last chance
A suburban world
Free the drones
Reprints

Fuel injection
Cheaper oil should act like a shot of adrenalin to global growth. A $40 price cut shifts
some $1.3 trillion from producers to consumers. The typical American motorist, who
spent $3,000 in 2013 at the pumps, might be $800 a year better offequivalent to a 2%
pay rise. Big importing countries such as the euro area, India, Japan and Turkey are
enjoying especially big windfalls. Since this money is likely to be spent rather than
stashed in a sovereign-wealth fund, global GDP should rise. The falling oil price will
reduce already-low inflation still further, and so may encourage central bankers towards
looser monetary policy. The Federal Reserve will put off raising interest rates for longer;
the European Central Bank will act more boldly to ward off deflation by buying sovereign
bonds.

There will, of course, be losers (see article). Oil-producing countries whose budgets
depend on high prices are in particular trouble. The rouble tumbled this week as
Russias prospects darkened further. Nigeria has been forced to raise interest rates and
devalue the naira. Venezuela looks ever closer to defaulting on its debt. The spectre of
defaults and the speed and scale of the price plunge have unnerved financial markets.
But the overall economic effect of cheaper oil is clearly positive.
Just how positive will depend on how long the price stays low. That is the subject of a
continuing tussle between OPEC and the shale-drillers. Several members of the cartel
want it to cut its output, in the hope of pushing the price back up again. But Saudi
Arabia, in particular, seems mindful of the experience of the 1970s, when a big leap in
the price prompted huge investments in new fields, leading to a decade-long glut.
Instead, the Saudis seem to be pushing a different tactic: let the price fall and put highcost producers out of business. That should soon crimp supply, causing prices to rise.
There are signs that such a shake-out is already under way. The share prices of firms
that specialise in shale oil have been swooning. Many of them are up to their derricks in
debt. Even before the oil price started falling, most were investing more in new wells
than they were making from their existing ones. With their revenues now dropping fast,
they will find themselves overstretched. A rash of bankruptcies is likely. That, in turn,
would bespatter shale oils reputation among investors. Even survivors may find the
markets closed for some time, forcing them to rein in their expenditure to match the
cash they generate from selling oil. Since shale-oil wells are short-lived (output can fall
by 60-70% in the first year), any slowdown in investment will quickly translate into falling
production.
This shake-out will be painful. But in the long run the shale industrys future seems
assured. Fracking, in which a mixture of water, sand and chemicals is injected into shale
formations to release oil, is a relatively young technology, and it is still making big gains
in efficiency. IHS, a research firm, reckons the cost of a typical project has fallen from
$70 per barrel produced to $57 in the past year, as oilmen have learned how to drill
wells faster and to extract more oil from each one.
The firms that weather the current storm will have masses more shale to exploit. Drilling
is just beginning (and may now be cut back) in the Niobrara formation in Colorado, for
example, and the Mississippian Lime along the border between Oklahoma and Kansas.
Nor need shale oil be a uniquely American phenomenon: there is similar geology all
around the world, from China to the Czech Republic. Although no other country has
quite the same combination of eager investors, experienced oilmen and pliable
bureaucrats, the riches on offer must eventually induce shale-oil exploration elsewhere.
Most important of all, investments in shale oil come in conveniently small increments.
The big conventional oilfields that have not yet been tapped tend to be in inaccessible
spots, deep below the ocean, high in the Arctic, or both. Americas Exxon Mobil and

Russias Rosneft recently spent two months and $700m drilling a single well in the Kara
Sea, north of Siberia. Although they found oil, developing it will take years and cost
billions. By contrast, a shale-oil well can be drilled in as little as a week, at a cost of
$1.5m. The shale firms know where the shale deposits are and it is pretty easy to hire
new rigs; the only question is how many wells to drill. The whole business becomes a
bit more like manufacturing drinks: whenever the world is thirsty, you crank up the
bottling plant.
Sheikh out
So the economics of oil have changed. The market will still be subject to political
shocks: war in the Middle East or the overdue implosion of Vladimir Putins kleptocracy
would send the price soaring. But, absent such an event, the oil price should be less
vulnerable to shocks or manipulation. Even if the 3m extra b/d that the United States
now pumps out is a tiny fraction of the 90m the world consumes, Americas shale is a
genuine rival to Saudi Arabia as the worlds marginal producer. That should reduce the
volatility not just of the oil price but also of the world economy. Oil and finance have
proved themselves the only two industries able to tip the world into recession. At least
one of them should in future be a bit more stable.

Oil firms in Kazakhstan

Cash all gone
One of the worlds biggest oil projects has become a fiasco

http://www.economist.com/news/business/21623693-one-worlds-biggest-oilprojects-has-become-fiasco-cash-all-gone

WHEN it was discovered in 2000, the Kashagan oilfield in Kazakhstans waters in the
northern Caspian Sea was the worlds biggest oil find in three decades. By now it was
supposed to be pumping out 1.2m barrels a day (mbd), enough to meet Spains entire
consumption. But the project, whose name sounds unfortunately like cash all gone,
went spectacularly awry. A year ago, when the first trickle of crude briefly flowed, it was
already eight years behind schedule. Having cost $43 billion, it was $30 billion over
budget. And production lasted only a few weeks before leaks of poisonous gas forced

its suspension. Earlier this month a government minister admitted it would not restart
until at least 2016.
Undeterred by the Kashagan fiasco, this week the government said it would approve a
plan to expand the onshore Tengiz oilfield, another huge budget-buster. Tengiz was first
expected to cost $23 billion but the government said this week that the bill had risen to
$40 billion.
In this section

Banks? No, thanks!

Which MBA?, 2014
Unsustainable energy
Cash all gone
Split today, merge tomorrow
Friends in high places
Polishing up
Beware the angry birds
Reprints

Each of the two oilfields is owned by a different consortium of foreign firms and the state
oil company, KazMunaiGaz. In Kashagans case they include Exxon, Shell, Total and
ENI. In part the projects setbacks are due to unexpected technical problems. Corrosive
and poisonous hydrogen sulphide gas, pumped up from the seabed along with the oil,
has eaten through pipes bringing it onshore. It may cost another $5 billion to fix the
problem. But insiders say privately that with so many companies involved, the project
has lacked clear leadership and suffered from government meddling.
Investors of all kinds worry about the declining predictability of Kazakhstans regulatory
and legal environment, says Mariyam Zhumadil of Halyk Finance, an investment bank
in the commercial capital, Almaty. In 2010 the government filed a $1.2 billion tax claim
against the consortium that operates another field, Karachaganak, while making noises
about breaches of environmental rules, not long after expressing an interest in buying a
stake in the field. Later the consortium gave it 10% in return for it agreeing to expand
the field.
Likewise, at Kashagan, environmental officials have fined the fields operators $737m
for burning off the poisonous gas, which the consortium argues was an emergency
measure. Ms Zhumadil reckons the fine is a tool for future negotiations, perhaps to
strengthen the national oil companys presence in the project. This may not be the best
way to encourage foreign firms to pump in the tens of billions of dollars more that are
still needed to develop Kazakhstans oilfields.

Shale oil
In a bind
Will falling oil prices curb Americas shale boom?

http://www.economist.com/news/finance-and-economics/21635505-will-falling-oilprices-curb-americas-shale-boom-bind

THIS years Christmas parade in Lindsay, in the heart of Oklahomas oil country,
featured the Stars and Stripes every ten yards, 11 horses with riders in Santa hats and
a rifle salute by veterans. But the highlight was a thundering, bright red oil tanker
covered in fairy lights and owned by Hamm & Phillips, an oil-services firm with local
roots that has ridden the shale boom in the state and across America.
That energy revolution is the envy of the business world. Abundant oil and gas have
been extracted from underground rocks by blasting them with a mixture of water,
chemicals and sandfracking, in the jargon. As well as festive spirit, the firms
responsible embody an all-American formula of maverick engineers, bold entrepreneurs
and risk-hungry capital markets that no country can match.
In this section

In a bind
Making the best of a low price
A premium for risk
Take your pick
Power cut
Trading places
Strange bedfellows
The power of self-belief
Last hurrah
Poor behaviour
Reprints

Yet now that oil prices have fallen by almost 40% in six months, these firms mettle is
being tested. Across America shale-shocked executives will spend Christmas
overhauling their strategies to cope with life at $70 per barrel, even as investors dump
their firms shares and bonds. Executives at Lukoil, a big Russian firm, now sniff that
shale is like the dotcom bubblea mania that is being cruelly exposed.
Oil-price slumps usually lead to cuts in energy firms investments. Production eventually
falls, helping prices to stabilise. In 1999, after the Asian crisis, global investment in oil
and gas production dropped by 20%. A decade later, after the financial crisis,
investment fell by 10%, then recovered.

This time some of the pain will be taken by the big integrated energy firms, such as
Exxon Mobil and Shell. After a decade of throwing shareholders cash at prospects in
the Arctic and deep tropical waters to little effect, they began cutting budgets in 2013.
Long-term projects equivalent to about 3% of global output have been deferred or
cancelled, says Oswald Clint of Sanford C. Bernstein, a research firm. Most majors
assume an oil price of $80 when making plans, so deeper cuts are likely.
But much of the burden of adjustment will fall on Americas shale industry. It has been a
big swing factor in supply, with output rising from 0.5% of the global total in 2008 to
3.7% today. That has required hefty spending: shale accounted for at least 20% of
global investment in oil production last year. Saudi Arabia, the leading member of
OPEC, has made clear it will tolerate lower prices in order to do to shale firms finances
what fracking does to rocks.

Even the gods of shale disagree about the industrys resilience. The boss of Continental
Resources, Harold Hamm (whose fortune has dropped by $11 billion since July), has
said he can cope as long as the oil price is above $50. Stephen Chazen, who runs
Occidental Petroleum, has said the industry is not healthy below $70. The uncertainty
reflects the diversity of activity. Wells produce different mixes of oil and gas (which sells
for less). Transport costs vary: it is cheap to pipe oil from the Eagle Ford play, in Texas,
but expensive to shift it by train out of the Bakken formation, in North Dakota. Firms use
different engineering techniques to pare costs.
Two generalisations can still be made. First, in the very near term, the industrys
economics are good at almost any price. Wells that are producing oil or gas are
extraordinarily profitable, because most of the costs are sunk. Taking a sample of eight
big independent firms, average operating costs in 2013 were $10-20 per barrel of oil (or
equivalent unit of gas) producedso no shale firm will curtail current production. But the
output of shale wells declines rapidly, by 60-70% in their first year, so within a couple of
years this oil will stop flowing.
Second, it is far less clear if, at $70 a barrel, the industry can profitably invest in new
wells to maintain or boost production. Wood Mackenzie, a research consultancy,
estimates that the break-even price of American projects is clustered around $65-70,
suggesting many are vulnerable (these calculations exclude some sunk costs, such as
building roads). If the oil price stays at $70, it estimates investment will be cut by 20%
and production growth for America could slow to 10% a year. At $60, investment could
drop by as much as half and production growth grind to a halt.

The industrys weak balance sheet is also a vulnerability, says Michael Cohen of
Barclays, a bank. Most firms invest more cash than they earn, making up the difference
by issuing bonds. Total debt for listed American exploration and production firms has
almost doubled since 2009 to $260 billion (see chart), according to Bloomberg; it now
makes up 17% of all Americas high-yield (junk) bonds. If debt markets dry up and
profits fall owing to cheaper oil, the funding gap could be up to $70 billion a year. Were
firms to plug this by cutting their investment budgets, investment would drop by 50%. In
2013 more than a quarter of all shale investment was done by firms with dodgy balance
sheets (defined as debt of more than three times gross operating profits). Quite a few
may go bust. Bonds in some smaller firms trade at less than 70 cents on the dollar.
All this suggests looming investment cuts that within a year will slow growth in American
shale production to a crawl and perhaps even lead to slight declines. A few firms have
trimmed their budgets already. More are expected to announce cuts in January.

Frontier projectson the fringes of existing basins or in places where little commercial
production has taken placeare vulnerable, including Oklahoma. Most firms will hunker
down in the Bakken, the Eagle Ford and the Permian Basin, where they have scale and
infrastructure. Even in the Bakken, applications for drilling permits fell by almost 40% in
November.
OPECs wishes may seem to be coming true over the next year. But adversity will
eventually make shale stronger. It will prompt a new round of innovation, from cutting
drilling costs through standardisation to new fracking techniques that increase output.
Dan Eberhart, the boss of Canary, a Denver-based oil-services firm, says the industry
has already pressed fast forward on saving costs.
And if and when prices recover, new wells can be brought on stream in weeks, not
years. Americas capital markets will roar back into life, forgiving all previous sins.
There is always a new set of investors, says the boss of a one of the worlds biggest
natural-resources firms. He predicts a shale crashand a rapid rebound.