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The Shale Oil Revolution is in Danger

By On January 9, 2015 9:49 am


Fortune.com 

By Shawn Tully

Oil producers and Wall Street analysts claim the setback in the fracking industry brought on by the collapse in oil prices will be brief and minor. Don’t believe them.

The shale oil revolution is providing a great gusher of profit, jobs, and swaggering entrepreneurship. It epitomizes the optimism surrounding America’s economic recovery.

Indeed, the rise of hydraulic fracking from Montana to Texas to Pennsylvania has lifted U.S. oil production mightily, from 5.6 million barrels a day in 2010, to a current rate of 9.3 million. And until late last year, it was widely accepted that our output would keep rising in 1 million barrel-plus annual leaps for years to come.

The recent drop in oil prices poses a major challenge to the frackers. But oil producers, Wall Street analysts, and most industry experts claim the setback will be brief and minor.

Don’t believe them.

The basic economics of fracking—what it costs to drill versus what oil now sells for—spells big trouble for the shale boom. At best, today’s producers may be able to hold production close to current levels. What’s gravely endangered is the advertised bonanza that virtually everyone deemed inevitable just a few short months ago.

Shale oil production is totally unlike drilling in any other part of the global market. In conventional wells, whether in the Middle East, the Gulf of Mexico, or the North Sea, the wells operate on extremely long cycles. Typically, the amount of crude oil they produce declines at between 2% and 5% per year. Hence, a well that generates 2,000 barrels a day in the first year will yield between 95% and 98% of that quantity in year two. Since the output falls so gradually, wells typically keep pumping for 20 years or longer.

The wells’ long lives help account for the extreme volatility in oil prices. Naturally, producers plan their projects expecting to recoup the upfront investment required to find the oil and install the well––their “fixed costs”––and the “variable” or “marginal” costs of extracting the oil year after year, notably labor and electricity. In a business where the risks stand as tall as the rigs, companies only invest when they forecast future prices far above the total outlay of fixed and variable costs, in hopes of pocketing big profits. The rub is that energy prices frequently fall far below what’s required to return their full costs, let alone make a decent return. That was the scenario from the mid-1980s until early 2002, when oil prices averaged $20 a barrel.

When prices drop, however, almost all conventional wells keep pumping. That’s because the variable cost of lifting the crude is still far lower than the prices it fetches on the world market. Ten-year old wells often have variable costs of just $20 to $30 a barrel, so their owners keep on producing at prices of $60 or $80, even though it would require $100 oil to generate a good return on their total investment. In other words, what they spent to drill the well becomes irrelevant. All that matters is the cash they can generate over and above what’s required to suck out the crude every day. “What drives the business is the marginal cost, not the total cost,” says Ronald Ripple, a finance and energy business professor at the University of Tulsa. “Even at low prices, the production is still contributing something to cover the upfront investment.”

As a result, the global supply of oil is what economists call “inelastic.” Even if prices crater, the oil majors and sheiks keep pumping more or less the same quantities. They’ll only stop when prices drop below the variable cost—and for most wells, they seldom sink that far.

So, the primary determinant of oil prices, especially right now, is demand. Since supply won’t typically drop with a fall in the world’s thirst for oil, a decline in demand generates big, exaggerated downdrafts in prices. Naturally, wars and upheavals in oil producing countries can cause temporary shortages that mask falling consumption, but when production inevitably returns to normal levels, weak demand takes charge and prices crater.

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