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The Discounts Are Over: U.S. Shale Is About To Get More Expensive

Texas hydraulic fracturing

The U.S. oil rig count has surged for the better part of three quarters, rising by 281 rigs since bottoming out in May 2016, an increase of nearly 90 percent. The rebound in drilling activity promises a swift return of the U.S. shale industry, with output coming back even though oil prices are trading 50 percent lower than they were a few years ago.

The return of U.S. shale at lower oil prices is possible because drillers have successfully lowered their breakeven price during the downturn. Improved drilling techniques such as longer laterals, more wells per rig, more wells per wellpad, and drilling only at the best spots have all led to higher output and lower costs. That means that companies can turn a profit even though oil prices are much lower than they were in years past.

In that sense, even though the downturn in prices forced some companies into bankruptcy, the industry is healthier than it was before. Leaner and meaner shale drillers can now survive in a world of cheaper oil, and they are giving OPEC members heartburn as the cartel tries to balance the market by cutting production.

But the lower breakeven prices might not be permanent. In fact, some of the savings were, if not illusory, temporary at best.

Even as drilling techniques improved, one of the largest sources of “cost savings” that producers achieved over the past three years came from squeezing oilfield services companies. Producers demanded price reductions for well completions, cheaper rates for rigs, and so on. Oilfield services companies – the largest of which are companies like Halliburton and Schlumberger – shouldered the burden, swallowing lower prices for their services in order to hold onto business. The dearth of drilling activity meant that beggars couldn’t be choosers. Related: India’s Oil Demand Is Set To Break More Records

But now with drilling on the rebound, oilfield services companies are no longer submitting to the demands of oil producers. For the first time since 2012, the cost of drilling is set to rise. Oslo-based Rystad Energy projects that the per-barrel cost of production will rise by an average of $1.60 across the shale patch, climbing to $36.50.

Oilfield services companies have more leverage not just because drilling is picking up and the supply of services has tightened, but also because of the geographic concentration of the drilling. Everyone is drilling in the Permian basin, putting additional strain on the market for services in West Texas.

Rystad says that oilfield services companies are demanding price increases on the order of 10 to 15 percent. On an earnings call in January, Chevron’s CEO John Watson acknowledged that they would have to pay more this year. “In the Permian, activity has picked up, and going forward we would expect to see some pressure," Chevron Corp's (CVX) Chief Executive John Watson said on an earnings call last month.

Some think cost inflation will be even higher. In January, investment bank Tudor, Pickering, Holt & Co. pegged the cost inflation from higher oilfield services costs at 20 percent. That could raise the breakeven costs for some shale drillers at $10 per barrel, Tudor Pickering said. “There’s going to have to be a convergence between the growth aspirations of oil companies and the margins of the oil field service industry,” Bill Herbert, an analyst at Houston investment bank Simmons & Co., told the Houston Chronicle in January. “The system is already getting tighter and strained.” Related: Natural Gas Bulls Crushed As Prices Tank

Reuters pointed out that Pioneer Natural Resources, a Texas shale driller, has its own hydraulic fracturing crew, a fact that could insulate it from cost inflation. Other drillers would have to contract out that work, and as demand rises for fracturing crews, prices will rise. "I believe we will be able to keep our inflation numbers down to more like approximately 5 percent, but the internal plan is to make sure that cost inflation is offset by our efficiency gains," Pioneer Natural Resources CEO Tim Dove said on a February earnings call.

Reuters also reports that oilfield services company Baker Hughes admitted that much steeper price increases won’t be forthcoming until drilling rises to the next level. "[A]ctivity needs to increase meaningfully before excess service capacity can be substantially absorbed and meaningful pricing recovery takes place,” Baker Hughes wrote in a securities filing in early February.

But that suggests that if oil prices rise a bit further, and if the rig count continues to rise, then there is much more room for cost inflation. Only about half to two-thirds of the “cost savings” achieved over the past three years will be permanent, industry experts told Reuters.

By Nick Cunningham of Oilprice.com

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