The American project of fracking and horizontal drilling of unconventional and difficult to access tight oil reserves doesn’t have much of a future. The reasons have nothing to do with the many environmental concerns that arise from this process, but rather entirely for economic reasons. Tight oil (aka shale oil), its composition, its service to a globalized economy, its methods for extraction, its production decline profile, and its economic viability are unlike conventional oil. For all these reasons, tight oil production will soon peak and go into terminal decline.
Conventional oil by contrast has historically represented a staggeringly concentrated form of cheap, portable, easily transportable, liquid energy. The myriad refined products derived from this oil have powered modern civilization, as well as having been used in producing a wide variety of essential industrial and commercial products. It’s hard to accurately comprehend the concentration of energy in the refined products derived from oil. A useful thought experiment to convey this would be the following: add one gallon of gasoline to your car, drive it till you run out of gas, then push your car home; likely around 35 miles. Then ask yourself, “What is the monetary value of pushing a car 35 miles?” Or alternatively, add a gallon of diesel to a backhoe, use it to dig a trench until you run out of fuel, then using a pick and shovel, dig a trench of equal proportions along side the original trench. Again, how much would your services be worth to dig a trench of equal dimensions to that dug by the backhoe? The answers to these questions should inform everyone that the energy provided by conventional oil has been extremely cheap for over a century. In fact, as exploration, extraction and refining technologies have improved over the last 150 years, oil has gotten progressively cheaper, adjusted for inflation. This was true as long as extraction rates for conventional oil could continue to rise, which they did until 2006. Conventional oil is now in decline, but tight oil came to the rescue just as conventional oil was peaking. This has kept the price of oil manageably low ever since.
The world has thus experienced a partial reprieve from the most consequential impacts from declining conventional oil by accessing non-conventional sources of oil; tight oil (AKA shale oil) representing the most important unconventional source of oil. Due to the development of five different geologic basins where the twin technologies of horizontal drilling and fracking can be employed, America has reversed decades of declining oil production, and has reached a new production record. However, the business model used to achieve this new domestic production peak is not sustainable.
Producing tight oil is an expensive proposition. In part this is because the wells experience a staggering decline rate of up to 70% in the first year. This contrasts with a 5% first year decline rate for a typical conventional well. So in order to keep production rising, wells must be drilled and fracked constantly; a phenomenon sometimes called “The Red Queen Syndrome”, alluding to the Red Queen in Alice Through The Looking Glass, who had to constantly run faster and faster in order to stay in the same place. In other words, any let up in a constant increase in the rate of drilling and fracking will cause production rates to fall.
Constant drilling and fracking burns through a huge amount of cash. In fact the majority of companies drilling in the tight oil patch, have been, and are experiencing negative free cash flow. This means that their CAPEX (capital expenditures) exceed the revenue they receive from the sale of oil. The industry as a whole is -280 billion dollars negative free cash flow since fracking began in 2008. What then is permitting this industry to rack up larger and larger debt loads for eleven years with no end in site?
The sources of revenue that fund the fracking boom are Wall Street and private investors. For years money was thrown at the tight oil project with little attention being paid to the consistent negative free cash flows of most operators. Only now are private investors becoming wary of an industry that doesn’t provide adequate returns. Some companies, in a desperate attempt to sustain investor confidence were using money borrowed from private equity firms to pay dividends to individual investors; a classic borrowing from Peter to pay Paul scenario. This of course was done to deliberately create the illusion that all was well in the shale patch, even as debt loads continued to grow larger.
When companies go into debt, they must service that debt, meaning that they must make arrangements to pay the interest on their debt. When a company is negative free cash flow and needs to service its debt, is has no alternative but to keep drilling at a feverish pace in order to produce “some” revenue so debt can be serviced, but more money must be borrowed in order to keep drilling so that NEWER debt can be serviced. It is a never ending cycle. The great hope is that through a combination of improved drilling and fracking technologies that lower the break even price, and higher prices per barrel of oil, they will one day break into a consistent, dependable free cash flow positive era. It should be noted that when oil was $100 per barrel in 2011-2014, operators were negative free cash flow. It turns out that the costs of production tend to rise with the price of oil.
OPEC has even helped the American operators in the tight oil basins by voluntarily reducing production in order to bolster the price of oil. You might think that production restraint in the tight oil basins might also follow suit to assist with keeping the price of oil higher. Remember though, they can’t reduce production because then they couldn’t service their constantly increasing debt. Their actions undermine their need to finally become positive free cash flow, as feverish drilling rates drive down prices. And now complicating this is that Tier 1 acreage( the sweet spots), where oil is most concentrated and inexpensive to extract, is becoming exhausted. This means that operators will have to move into less promising acreage with higher breakeven prices. How the hell then will these companies EVER become consistently positive free cash flow?
An unspoken issue involving tight oil concerns its composition. Tight oil has a different mix of hydrocarbon compounds than conventional oil, and far fewer refined products can be made exclusively using tight oil than conventional oil. As a result it is really unfair to compare a barrel of tight oil with a barrel of conventional oil. The barrel of tight oil doesn’t have the energy density of conventional oil. For example, one cannot obtain kerosene, diesel, jet fuel, fuel oil, or the higher octane levels of gasoline by refining tight oil alone, without first mixing it with heavier oil from another source, such as Venezuela. Tight oil’s limitations makes it incumbent upon America to secure heavy oil sources in order to mix with tight oil and refine it into the full spectrum of products needed to keep an advanced economy humming along and growing.
Possibly part of the reason that tight oil sells at a steep discount to conventional oil when compared to the current Brent Crude or WTI(West Texas Intermediate) price is due to tight oil’s limitations. The known discount would tend to undermine investor confidence. But another strategy used to keep investor confidence high is for oil companies operating in these geologic basins to report EUR’s (estimated ultimate recoveries), of individual wells which are vastly overstated. Oil companies are reporting average EUR’s in the Permian Basin of 700,000 barrels. But when one examines the production profile of existing, producing wells, then re-plots the data on semi-log paper, EUR’s really average 250,000 barrels. The problem is that oil companies use EUR’s to determine the break even price for their oil. The higher the EUR, the lower the break even price. So they are reporting break even prices to investors which are far lower than reality. This serves their interest by helping to sustain high investor confidence. However, it is a monumental deception.
As investors lose faith in the ability of companies to become consistently positive free cash flow, and as debt servicing payments come due which the companies can no longer pay with revenue from operations, and as Tier 1 acreage becomes depleted, and as OPEC loses patience with uncooperative tight oil drillers, the whole tragic, Ponzi scheme of tight oil drilling and fracking will go into terminal decline. What effects will this have on the American and global economy? That is the subject of my next essay.