The Myth Of Cheap Shale Oil

The breakeven cost of producing oil from U.S. shale is roughly the same as non-shale, despite the tidal wave of investment into the sector.

According to the Federal Reserve Bank of Dallas, the breakeven prices for producing oil in the Delaware Basin is $49 per barrel and $48 per barrel in the Midland Basin, both of which are in the Permian. Meanwhile, what the Dallas Fed classifies as "other U.S. nonshale" has a breakeven of $49 per barrel. So, despite all the hype, shale is not more competitive on a cost basis than conventional and offshore production.

Notably, the breakeven price for the Permian outside of the Midland and Delaware basins is $54 per barrel on average. The Eagle Ford sits at $51, and the SCOOP/STACK in Oklahoma at $53.

To be sure, the Dallas Fed notes that these are high-level numbers and don't account for the enormous amount of variation. The best acreage in the Permian has breakeven prices that are "routinely lower on average than other locations." Bloomberg New Energy Finance says that breakeven prices in the Permian range from $46 per barrel in Loving County but shoot up to as high as $87 per barrel in Reagan County.

Also, there breakeven prices vary quite a bit between companies, even within the same basic location. "[W]ithin the Permian Basin, for example, individual responses to the most recent survey ranged from $23 to $70," the Dallas Fed noted.

While shale may have roughly a similar breakeven price as other conventional sources of oil in the U.S., the massive wave of shale output has succeeded in lowering oil prices more broadly. More importantly, because the breakeven price of shale tends to hover between $40 and $60, a much larger volume of oil can come online when prices rise to the upper end of that range. It used to be the case that it would take triple-digit oil prices in order to induce more supply. Related: Saudi Arabia Scrambles To Calm Oil Markets

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Another implication is that long-dated oil futures prices are likely to be correlated with these breakeven thresholds. In theory, though not in practice, long-term oil prices should be anchored to the marginal cost of supply. Because shale increasingly accounts for that marginal barrel - more supply comes online when prices rise to the roughly $50-$60 range - U.S. shale could keep a lid on prices for years to come, the Dallas Fed argues.

Similarly, the fast-depleting nature of shale ensures that prices can't fall too low. As soon as crude prices fall below the breakevens price for shale operators, drilling stops and existing wells quickly deplete, knocking supply offline. That firms up the price.

This is a version of the "shale band" theory popularized a few years ago following the 2014 oil market collapse. While oil has temporarily traded outside of the $40-$60 range - prices crashed below $30 in 2016 and spiked above $70 for WTI last year - they tend to revert back to that range.

Rystad Energy says that U.S. shale will add another 1.1 to 1.2 million barrels per day (mb/d) this year, despite the slow start to the year. Over the medium-term, the IEA says the U.S. will make up the lion's share of production growth. "This does not rule out the possibility of major oil price movements, but it does point to a strong tendency that oil prices will be range bound in the near future," the Dallas Fed concluded. Related: Bearish EIA Data Sends Oil Lower

One large caveat to this thesis is that breakeven prices often don't fully explain profitability, or the lack thereof. In fact, oil prices used to trade above $100 per barrel, but the shale industry burned through hundreds of billions of dollars. To date, despite lower breakeven prices, the industry is still largely cash flow negative.

Even last year, which the IEA expected to be the first year that U.S. shale would become profitable, drillers still burned through capital. Reuters surveyed 29 of the top independent shale companies and all but seven of them were cash flow negative. The group spent $6.69 billion more than they generated. Marathon Oil's CEO Lee Tillman said that positive cash flow was "aspirational," according to Reuters.

A separate Wall Street Journal survey from last year of the 30 largest shale producers found a combined $1.7 billion in profits in 2017, after the group burned through $50 billion in losses over the previous five years and over $100 billion in losses over the last 10 years. In reality there is a bifurcated market of companies in distress and other companies doing better.

As Bloomberg noted, this year's best-performing stock in the oil sector is Hess Corp., which doesn't have any operations in the Permian.

The drilling boom has been made possible by rock-bottom interest rates and a wave of finance from Wall Street. But with years of capital going up in smoke, it's not clear how long Wall Street will stomach the losses. The industry is inching closer to positive cash flow, and may in fact reach that goal this year.

But, for investors, there are heftier returns in other businesses, such as new energy tech.                                                                              

By Nick Cunningham of Oilprice.com

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