Eras come and go. Oil derricks at Burkburnett, Texas (Photo credit: Wikipedia)

America’s oil producers are nervous. They’ve had a great run the past few years. Domestic oil production is up 43% since 2008 to 6.5 million barrels per day, the highest level in decades. The majority of that 2 million bpd jump comes out of the two most successful new oil fields, the Bakken and the Eagle Ford. To develop these and all the other fields nationwide, the top 50 operators invested $186 billion in 2012, according to Ernst & Young. That was a record level of spending, up 20% over 2011.

You’d think that with drillers getting better, honing techniques and driving down costs, that a 20% increase in investment would bring about a more than commensurate increase in oil and gas production volumes, right? And yet according to Ernst & Young, total U.S. oil and gas production was up “just” 13% on the year.


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It’s bad enough to be spending more and more to generate ever less growth. It’s worse when that growth doesn’t even translate into profits. Oil and gas companies have spent hundreds of billions acquiring acreage, drilling wells, booking reserves, boosting supplies, but in 2012 they proved too good at their job, found too much gas and cratered the gas price. That made vast shale fields uneconomic to drill at all. In 2012 those 50 biggest companies recorded $26 billion in asset impairment charges. That basically means that natural gas reserves that were worth $26 billion the previous year became worthless because it cost too much to drill them. This led to a 58% decline in after-tax profits in 2012 over 2011.

And you’d better believe the same thing could happen to oil reserves.

It’s all a function of price. West Texas Intermediate crude has been bopping around between $88 and $98 a barrel this year and the front month futures price is at $96 this week. Its high of the last two years was $109 and its low $77. As I wrote here recently, there are plenty of reasons why oil prices should be heading up, not down.

But it’s worth thinking about what could happen to the American Oil Boom if oil prices slipped just 10-15% from where they are now. Oil drilling is generating hundreds of billions of dollars of value to the United States right now, in terms of jobs and equipment, and especially the benefit to the national balance of payments of not having to spend $200 billion a year buying foreign oil. But it must be said that when you take into account all the costs incurred in acquiring and developing unconventional oil fields today, many plays are already balanced on the knife-edge of profitability, and any down draft in oil pricing could dry up activity real quick.

What could cause prices to drop? Continued economic malaise would be the biggest trigger. The United States is muddling along through this sad excuse for an economic recovery, but with bond yields and interest rates rising suddenly in recent weeks we could very quickly see a pullback in refinancings and borrowings that could be a material drag on growth. Europe is no closer to solving its problems, while sliding equity prices in emerging markets raise the concern that the regions of greatest oil demand growth could be heading for their own slowdowns. Add to this the very public concerns that OPEC members have raised about the competition their oil faces from U.S. crudes. Nigeria, in particular, has seen less demand for its oil, which is similar in quality to that from the Bakken formation of North Dakota. The cartel announced that it would “study” the shale oil issue.

“If OPEC hopes to maintain any semblance of its cartel pricing power now would be the time for its members to boost their oil output, drive prices down, bankrupt marginal American producers and regain market share for the long-term,” says Ed Hirs, a lecturer in energy economics at the University of Houston, and a member of the Yale Graduates In Energy study group.

According to research conducted by that group, in tandem with Yale Prof. Emeritus Paul MacAvoy, a 1 million barrel per day addition to global oil supplies could push prices down by 10%. A 2 million bpd boost would bring it down 20%. If U.S. oil supply growth keeps up at the pace of the last two years, we could add 1 million bpd before the end of 2014.

“In short, if OPEC simply declines to reduce its own production quotas in the face of growing U.S. oil volumes, the American producers could grow themselves right out of the money,” says Hirs.

The big shale fields cover hundreds of thousands, even millions of acres. But the quality of the geology is not homogenous across the landscape. There are sweet spots in these fields, which the companies, naturally, drill first because they want to make back what they spent to acquire the acreage in the first place (often in excess of $10,000 per acre).

Trouble is, as these sweet spots are developed the companies have to move down the continuum of sweetness, and profitability. That costs more. Analysts at Bernstein Research wrote last month that “cost inflation continues to rise, and as commodity prices are ‘capped’ by rising supply, net income margins in the sector are now at their lowest in a decade. This is not sustainable. Either prices must rise or costs must fall.”

The alternative is that they simply cut back on drilling. Bernstein figures that the marginal cost of non-OPEC production is now at $104.5 per barrel. What’s more, the researchers found an “
unprecedented” jump in the marginal costs of U.S. fields, from $89 a barrel in 2011 to $114 a barrel in 2012. This implies that some U.S. producers were losing money on oil they brought to market — and doing so knowingly, says Bernstein. Sometimes there’s good reason to produce oil and gas at a loss — particularly if you are drilling in order to hold acreage, or if you’re in the early stages of developing a field and still working out the right drilling and completion techniques. More generally, however, independent producers want to show investors topline growth.

To be sure, the numbers that Bernstein cites are for the most marginal barrels in the entire country. On average the situation looks somewhat better. Howard Newman, legendary private equity maven behind Pinebrook Road Partners said in a recent talk at Yale that most shale oil fields in the U.S. can still generate a return at $80 a barrel, but that if prices slipped below that producers would cut capital investment in marginal plays to preserve balance sheet strength. Morgan Stanley analysts noted recently that the average marginal cost of production from the big unconventional plays is about $64 per barrel (excluding land acquisition costs).http://www.forbes.com/sites/christopherhelman/2013/06/13/why-americas-shale-oil-boom-could-end-sooner-than-you-think/