It Don’t Come Easy – Low Crude Prices, Producer Breakevens and Drilling Economics – Part 1

By Friday (January 9, 2015) crude prices had fallen 55% since June 2014, natural gas prices are at the lowest since 2012 and natural gas liquids are suffering as well. The potential revenues from U.S. shale oil production in 2015 would be a whopping $66 billion lower at $50/Bbl than when oil was  $100/Bbl last year. In this new world where prices may not return close to pre-crash levels for a number of years, producers are scrambling to reconfigure drilling budgets and locations. The exercise is all about rates of return and figuring out breakeven prices. Today we start a new series looking under the hood at production drilling economics including results from our own models.

Back in early November (2014) we speculated about the likely impact on U.S. shale oil production of falling crude prices (see Stop in the Name of OPEC). In that post we pointed out that shale production was not going to grind to a halt as soon as prices reached a level that made new drilling in existing fields seem uneconomic. We cited the example from a few years back of drilling for dry natural gas in the Haynesville basin in Louisiana, where production continued to increase for several years after gas prices crashed. In our more recent New Year prognostications we predicted, “Crude prices won’t recover or rebound anytime soon” and that “with no production cuts in the offing and a significant demand response years away, oversupply looks to be with us for a while”. At the same time we also re-iterated that “U.S. crude oil production won’t decline anytime soon” and gave 4 reasons why reductions in drilling in response to lower prices will take a while to work through the system (see Top Ten RBN Energy Prognostications). But the realities of lower prices for crude, natural gas and natural gas liquids (NGLs) certainly make some new drilling uneconomic now and subject more new drilling to careful scrutiny. The trigger for producer drilling pullbacks (that are already underway) is not just one price threshold. Rather they will look closely at break-even drilling economics to determine where to stop drilling and where to concentrate new activity, based on expected rates of return. The challenge for producers and analysts alike is to make sense of the complex calculations and assumptions that underlie drilling economics. Numbers from various providers are all over the place. That makes the analysis difficult to interpret because the assumptions being made vary considerably and are rarely explained in detail. Our goal in this series is to increase your understanding by explaining the assumptions behind our production economics modeling process.

Before we get into the analysis and the RBN basin rankings we’ll examine more closely two realities that underlie shale economics and help to explain different rates of return in shale plays. The first of these realities is the general rule that typical shale producers are independent companies that do not possess bottomless pockets when it comes to drilling and exploration. That means cash flow returns from drilling assume high importance – especially when oil and gas prices are falling. The second reality is that rates of return are tied closely to both the relative prices of the hydrocarbons produced (oil, gas, NGLs) and well productivity.  Well productivity is primarily determined by the volume of oil, gas and NGLs produced, when those hydrocarbons are produced, and the cost of getting those hydrocarbons out of the ground and to market.

Cash Flow Impact of the Price Crash

Funds for most producers to pay for continued drilling and increased production relies heavily on cash flow generated from existing operations. That cash flow is either used to pay for new drilling or to pay down borrowing for existing well development. With less operating cash or financing available, new drilling will be curtailed. Because of this reality it is important to understand that there has been a sea change in the fortunes of U.S. shale producers as a result of the price crash. The following high-level estimate of the cash flow impact illustrates the scale of the challenge.