The Threat to Shale

We begin with a brief recap of our expectations of US shale before the price collapse. One of shale’s attributes is that it is a highly elastic source of supply, where drilling and completion activity can ramp up or slow down relatively quickly in response to changes in price. Production growth was already slowing down due to a generally lower oil price and the need for fiscal discipline to meet investor demands for higher returns.

The nature of shale production is also characterized by high initial rates of production followed by steep decline. The high rate of decline (most shale wells are over 90% depleted after just a few years of production) means drilling and completions must continually keep up to offset this legacy decline. Productivity can help offset some decline but gains in productivity have been plateauing at best over the past year.

The large number of wells that were brought in to production in the past two years means there is more legacy decline to contend with. The chart below illustrates the offsetting nature of high decline rates on new well production from the Permian, Eagle Ford, Bakken, and Niobrara. From the chart, one can see that new well production has been declining relative to a growing legacy decline since the beginning of 2019. While the net gain is still positive, as of January 2020, a slowdown in well completions means overall production will begin to decline.

High levels of debt from US shale E&Ps coming to maturity in the next several years will also put constraints on financing operations. Capital markets are basically closed for traditional financing in the shale sector. Generating free cash flow is now the priority, and under most of the scenarios, this just simply cannot happen without a drastic reduction in drilling and completion expenditures.

So, what will happen to US shale production under falling oil prices? We have forecast production through 2020 under three price scenarios.

WTI stays under $40: hardship follows

Even with around 30 percent of the major shale basin production hedged in the first half of 2020, the effects of a price under $40 will be felt relatively quickly. ESAI’s analysis of over 30 mostly oil-weighted shale producers indicates that across all basins, the average cash-operating cost is about $20 per barrel. This represents a floor that must be covered before production completely shuts down. A WTI price under $40 means cash operating costs may be covered, but capital spending (with a basin wide average of about $25 per barrel) will have to be cut back rather severely for most.

The producers with 3-way collar hedges do not have as much protection from a WTI price under $40 as those that have swaps in place or a higher floor price on a 2-way collar. Nevertheless, spending will be cut back dramatically, workers will be exposed to lay-offs, equipment will be idled. New drilling and well completions will be suspended, and legacy decline will dominate. Higher cost basins and those with higher decline rates will see the largest drop in output, but all US shale declines

at this price.

A sustained price under $40 will require significant restructuring, with many smaller producers unable to continue operating; bankruptcies will increase. This results in US shale ending 2020 almost 1 million b/d lower than at the start of the year, questioning the ability of a strong and rapid comeback when prices do recover.

WTI stays within a range of $40 - $50: painful, but hanging in there

Hedged production and a limited drawdown of drilled but uncompleted wells initially keep production flat but spending cuts will prevent enough drilling and completions to fully offset decline. Producers are generally unable to grow production when WTI is at or below $50 per barrel, but a reduced level of capex may be covered. In the short-run, this price level is painful, but not fatal.

Due to its superior economics, production in the Permian basin will end the year with moderate growth, mostly coming from the first half of the year. However, the other major shale basins are expected to decline under this price range, resulting in overall US shale ending 2020 about 330,000 b/d lower than at the start of the year, with average annual growth in 2020 still positive. Sharp reductions in capital spending this year will result in overall decline in 2021.

WTI recovers to $50 or more: Permian growth helps offset decline elsewhere

ESAI Energy estimates that to achieve growth, US shale generally needs WTI to be closer to $60 per barrel. However, if prices recover, a WTI price over $50 should be sufficient to sustain US shale. There is a lot of legacy decline to offset, and unless WTI reaches $60 and stays at that level, production growth can only be modest. Producers are likely to concentrate capex on maintaining, not growing production, paying down debt, achieving free cash flow, and maintaining a dividend.

In this scenario, US shale ends 2020 with only a slight decline of roughly 170,000 b/d, but with moderate growth on an annual basis from 2019.

A new-normal is here regardless of the price, with fiscal discipline and strong balance sheets even more important to weather any future periods of price volatility.

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