Gary North Reviews Oil at $55 a Barrel

Shale Oil: America's Emergency Reserves

Gary North - January 12, 2015

With oil around $50 a barrel, fracking becomes problematic. Here's why.

North Dakota needs an oil price of around $55 per barrel at the wellhead and a fleet of about 140 rigs to sustain production at the current level of 1.2 million barrels per day, the U.S. state's chief regulator told legislators on Thursday. . . . Breakeven rates for new wells, the level at which all drilling would cease, range from $29 in Dunn county and $30 in McKenzie to $36 in Williams and $41 in Mountrail. These four counties account for 90 percent of the drilling in the state.

Breakevens in counties on the periphery of the Bakken play, which have far fewer rigs, range up to $52 in Renville-Bottineau, $62 in Burke and $73 in Divide.

  

But Flint Hills Resources' posted price for North Dakota crude was just $32, Helms said, compared with almost $49 per barrel for WTI. Wellhead prices, which are roughly an average of the two, are around $40 and have been falling since the start of this year.

Even before prices hit these minimum levels, drilling will slow sharply. The number of rigs operating in the state has already fallen to 165, down from 191 in October, according to the department. . . .

To keep output steady at 1.2 million b/d for the next three years, the state's producers need a price of $55 rising closer to $65 in the longer term to support a fleet of 140-155 rigs.

Helms' projections confirm North Dakota's oil output will start to fall by the end of the year unless prices rise from their current very depressed level.

When we see the price at $50, this is not the price that producers get in the shale oil belt. We tend to forget this. Or maybe we never knew.

Second, shale-oil output falls like a stone. In three years, the party is over.

Unlike conventional projects, shale wells enjoy an extremely short life. In the Bakken region straddling Montana and North Dakota, a well that starts out pumping 1,000 barrels a day will decline to just 280 barrels by the start of year two, a shrinkage of 72%. By the beginning of year three, more than half the reserves of that well will be depleted, and annual production will fall to a trickle. To generate constant or increasing revenue, producers need to constantly drill new wells, since their existing wells span a mere half-life by industry standards.

In fact, fracking is a lot more like mining than conventional oil production. Mining companies need to dig new holes, year after year, to extract reserves of copper or iron ore. In fracking, there is intense pressure to keep replacing the production you lost last year.

On average, the "all-in," breakeven cost for U.S. hydraulic shale is $65 per barrel, according to a study by Rystad Energy and Morgan Stanley Commodity Research. So, with the current price at $48, the industry is under siege. To be sure, the frackers will continue to operate older wells so long as they generate revenues in excess of their variable costs. But the older wells--unlike those in the Middle East or the North Sea--produce only tiny quantities. To keep the boom going, the shale gang must keep doing what they've been doing to thrive; they need to drill many, many new wells.

Right now, all signs are pointing to retreat. The count of rotary rigs in use--a proxy for new drilling--has fallen from 1,930 to 1,881 since October, after soaring during most of 2014. Continental Resources, a major force in shale, has announced that it will lower its drilling budget by 40% in 2015. Because of the constant need to drill, frackers are always raising more and more money by selling equity, securing bank loans, and selling junk bonds. Many are already heavily indebted. It's unclear if banks and investors will keep the capital flowing at these prices.

As David Stockman has repeatedly written, the shale oil boom is in fact a gigantic bubble that has been created by the Federal Reserve. The Federal Reserve initially pushed down interest rates through quantitative easing. But that easing has ceased, and interest rates are still falling. We have to understand, falling rates now are a function of fears of recession, which is now looming worldwide. There is a move into bonds, including treasury bonds, because people are afraid of the setback that is facing the world economy. We should not blame the Federal Reserve for today's low interest rates in the United States. Low interest rates In the United States today are a function of expectations regarding the world economy.

So, the shale oil bubble has led to a rapid depletion of American oil stockpiles. The fracking revolution is not a revolution; it is a bubble. It is a bubble that is dependent upon strong growth in the demand for oil. But this strong growth does not exist in the United States. On the contrary, there has been a contraction of demand for oil in the United States. Consumption is falling. We are finding ways to conserve oil. "Oil consumption in the U.S. has fallen by over 8% since 2010, and the shrinkage in Europe is far greater than that. Meanwhile, China and India have not proven nearly as voracious as forecast."

Output will not fall. At the margin, oil from existing wells is still profitable. Sunk costs are gone. They no longer influence the decision to pump.

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.

For fracking, the breakeven point is higher. so, there is no long-term hope for a revolutionary breakthrough in the United States regarding oil.

From time to time, we see articles about the huge increase of oil production in the United States. The people who write these silly articles think that fracking and shale oil are long-term solutions to the energy crisis. Wrong! All we are doing is depleting the supply of oil that we had in the ground. This supply of oil could have served as a backup for a major oil crisis, when oil prices move upward relentlessly. This is the true value of shale oil: stored in the ground. It is like a gigantic emergency oil reserve. But because of Federal Reserve policy, and because of today's incredibly low rates of interest, our shale oil reserves are now being consumed. This is the biggest misallocation of capital resources that is going on today in the USA. The United States is consuming its oil reserves. This would not have happened if the Federal Reserve had not entered the capital markets in 2008 and quadrupled the monetary base.

Any time that you see an article about peak oil theory's having no verification, and an appeal is made to the expansion of oil production in the United States, you can be sure that the guy writing the article knows nothing about fracking, shale oil, and the half-life of shale oil wells. He is just some guy spouting off.

If there is a breakthrough technologically in some other area of energy production besides oil, then the shale oil boom will have bought us some time. But that is all it has bought us. Time. It has not solved the peak oil problem.