Tuesday, December 9, 2014

The Shale Oil Crash Could Be Worse Than the Housing Bubble Crash

David Stockman writes:
Folks, you don’t have to know whether the breakeven for wells drilled in the Eagleville Condy portion of the great Eagle Ford shale play is $80.28 per barrel, as one recent analysis documents, or $55 if you don’t count all the so-called “sunk costs” such as acreage leases and oilfield infrastructure. The point is, an honest free market would have never delivered up even $50 billion of leveraged capital—let alone $500 billion— at less than 400bps over risk-free treasuries to wildly speculative ventures like shale oil extraction.
The fact is, few North American shale oil fields make money below $55/barrel WTI on a full cycle basis (lease cost, taxes, overhead, transport, lifting cost etc.). As shown below, that actually amounts to up to $10 less on a netback to the wellhead basis—–the calculation that drives return on drillings costs.

In short, as the oil market price takes its next leg down into the $50s/bbl. bracket, much of the  fracking patch will become a losing proposition. Moreover, given the faltering state of the global economy and the huge overhang of excess supply, it is likely that the current crude oil crash will be more like 1986, which was long-lasting, than 2008-09, which was artificially resuscitated by the raging money printers at the world’s central banks.
So why is there a shale patch depression in store? Because there is literally a no more toxic combination than the high fixed costs of fracked oil wells, which produce 90% of their lifetime output in less than two years, and the massive range of short-run uncertainty that applies to the selling price of the world’s most important commodity. 
Surely, it doesn’t need restating, but here is the price path for crude oil over the past 100 months. That is to say, it went from $40 per barrel to $150, back to $40, up to $115 and now back to barely $60 in what is an exceedingly short time horizon. 
Obviously, what we have here is another massive deformation of capital markets and the related flow of economic activity. The so-called “shale miracle” was not made in Houston with some technology help from Silicon Valley. The technology of horizontal drilling and well fracking with chemicals has been around for decades. What changed were the economics, and those  were made in the Eccles Building with some help from Wall Street.
As to the latter, was it not made clear by Wall Street’s mortgage CDO meth labs last time that when the central bank engages in deep and sustained financial repression that it produces a stampede for “yield” which is not warranted by any sensible relationship between risk and return? It should not have been even possible to sell a shale junk bond or CLO that was based on assets with an effective two year life, a revenue stream subject to wild commodity price swings and one thing even more unaccountable. Namely, that the enterprise viability of virtually every shale junk issuer has always been dependent upon an endless rise in the junk bond issuance cycle.
Stated differently, oil and gas shale E&P operators are drastic capital consumption machines. Due to the lightening fast decline rates of shale wells, firms must access more and more capital just to run in place. If they don’t flush money down the well bore, they die along with all the “sunk” capital that was previously put in place.
In the case of shale oil, for example, it is estimated that were drilling to stop for just one month, production in the Eagle Ford, Bakken and one or two other major provinces would drop by 250,000 barrels per day. After four months, the drop would be 1 million bbl./day and after a one-year, nearly half the current four million barrels of shale oil production would disappear.
That’s why all of a sudden there is so much strum and drang about “breakeven” pricing. Obviously, new drilling is not going to go to zero under any imaginable price scenario, but for all practical purposes the shale revolution could shut down just as fast as did the housing boom in 2006-2007. In effect, the shale financing boom presumed that both the junk bond cycle and the oil price cycle had been eliminated.
Needless to say, they have not. So the impending “correction” may well be as swift and violent as was the housing bust.
Indeed, in the short-run the shale crash could be worse. The fantastic, debt-fueled drilling spree of the past 5-years is now sunk and will produce rising levels of production for a few quarters until rig activity is sharply curtailed and some of the better capitalized operators stop drilling in order to avoid lease expiration writeoffs.
So as the WTI market price is driven toward $50/ barrel, recall that the netback to the producer is significantly less. In the case of the biggest shale oil province, the Bakken, the netback to the well-head is upwards of $11 below WTI.  Accordingly, cash flow will plunge and that source of drilling funds will evaporate with it.
 David Stockman was the Director of the Office of Management and Budget during part of the Reagan Administration, from 1981 to 1985. He is the author of The Great Deformation: The Corruption of Capitaism in America and The Triumph of Politics: Why the Reagan Revolution Failed.

 The above originally appeared at David Stockman's Contra Corner and is reprinted with permission. 


  1. This indeed spells disaster for many businesses whose current business models depend so much in oil exploration and especially the shale-oil boom. I work for a cement manufacturing company and two of our top performing plants are selling cement to the oil business. If that goes, sales go out the door as well. Unfortunately, our prognosticators are closely following the numbers given by the US Fed and the government and are NOT looking at these other factors. We're in for a lot of trouble. I just hope this thing explodes in the face of the Statists in government before the election and not after.

  2. This is why I am such a proponent of temporary housing. We do no favors to the local communities by over-building in such a fluctuating market.