The continued growth in US Oil production has been one of the key factors moderating global oil prices over the past few years, seemingly mirroring unplanned oil production outages from other large oil producers affected by geopolitical problems. Shale oil production appearing to be more price elastic than from conventional wells. With oil prices (WTI) down by $20 per barrel since June to almost $85 per barrel will output now be similarly flexible in the face of price falls?
The cost of production is often thought to be the floor for many commodity prices, but in reality this may not be true, at least not in the short term. As a general rule of thumb, if prices start to fall below the 90th percentile in the cash cost curve then production is likely to be curtailed.
However, there are numerous cases in the commodity world when a market price remained well below the cost of production for months or years at a time.
Even if a particular mine or oil well is operating at a loss, there is a good chance it will continue to operate for some time. The primary reason for this is that it costs a significant amount of money to close and eventually re-open a mine or a well — so producers will tend to keep operating it for much longer than they would ideally want to. The question is will US shale oil producers react in the same way?
According to IMF estimates oil from shale formations costs $50 to $100 a barrel to produce, compared with $10 to $25 a barrel for conventional supplies from the Middle East and North Africa. Etimates from Deutsche Bank suggest that as much as 40% of US shale oil production would become uneconomical below $80 per barrel.
Given this high cost business model many of US shale oil producers are likely to have hedged against oil prices falling below their marginal cost. Although this may delay a supply reaction, the length of the price protection clearly depends on how long it is in place. However, given that oil prices have been incredibly stable over the past few years this may have lured many into believing that oil prices would continue to stay high, forgoing price protection.
In contrast to conventional oil production, shale oil producers are likely to react much more rapidly to lower prices. Aside from the relatively low engineering and cost impact from curtailing output from a well relative to conventional oil production, the high level of leverage among US shale oil producers may also serve to hasten a supply reaction. The high depletion rate of shale oil wells has meant that producers have had to go on a drilling treadmill, funded largely by debt in order to maintain production volumes.
Investors have been beguiled by the US shale revolution and have ploughed billions into shale – $156 billion in 2014 alone according to estimates from Barclay’s. Of the 97 US energy exploration and production companies rated by S&P, 75 are rated as below investment grade. According to an analysis of 37 firms junk-rated exploration and production companies spent $2.11 for every $1 earned last year. With US interest rates set to increase in 2015, raising the cost of borrowing and lower oil prices reducing returns a switch in investor sentiment may yet force shale oil producers hand.