Will Shale Oil Survive a Restructured Oil Market?
Shale faces a difficult future because the COVID-19 pandemic and the Green paradox are pushing Saudi Arabia and Russia to restructure an unstable alliance that cut production to defend higher prices to a more traditional market that favors low-cost producers. The negative effects of these changes are amplified by increased uncertainty, which reduces incentives to invest in new capacity, slows the re-opening of shut-in capacity, and increases the cost of borrowing. These changes will suppress shale oil even when the economy comes out of the crisis and demand picks up.
After Saudi Arabia replaced the U.S. as the world’s largest oil producer in 1977, the U.S. regained that role in 2018 due largely to increased production from shale. But the U.S. oil industry, especially shale oil, just suffered a one-two-punch. One, the COVID-19 pandemic reduced global demand for oil products like motor gasoline and jet fuel by about 25 percent; 35 percent in the U.S. Two, on March 8, 2020, the informal agreement between OPEC (read Saudi Arabia) and Russia collapsed; each dumped extra production into an already over-supplied market. Despite an April 10, 2020 truce, prices fell from $60 to below $25 per barrel. Low prices, along with increased volatility and worries about climate change policies, may reorganize the world oil market in a way that threatens the future of the shale oil industry.
Oil demand may eventually recover, but the world oil market may not return to its previous state. Until recently, the supply side of the world oil market operated differently from most markets. OPEC and Russia restrained production to keep prices around $60 per barrel. But these prices made it profitable for high-cost producers like oil shale to supply the market. As production of shale oil reached 9 million barrels per day (nearly 10 percent of global supply), low-cost producers were forced to restrain their production by ever-increasing amounts.
On net, selling less oil at higher prices reduced revenues for OPEC and Russia. But this high-price/low-production (and low-revenue) strategy is not sustainable. For many OPEC nations and Russia, oil revenues are an important source of revenue for the government. Significant shortfalls can lead to civil unrest, which can destabilize governments.
Furthermore, the high-price/low-production strategy may be undermined by uncertainty about climate change policy. If the world is to avoid the drastic damage caused by global temperatures rising more than 2 degrees C, policies will cause a large fraction of oil resources to be left in the ground. Worry about such policies prompted an immediate reduction of equity prices for oil companies. An economically rational response to this threat is to produce more now, increasing supply and lowering the price. Because lower prices tend to increase emissions, this response is known as the “Green Paradox.”
The threat of civil unrest and the Green Paradox may incentivize OPEC and Russia to sell more oil now, even if it means less profit per barrel. To do so, OPEC and Russia may allow reordering of the supply-side of the world oil market that parallels “merit order dispatch” in electricity markets. This procedure “turns on” ever-more expensive power plants as demand rises, and turns them off as demand falls. When translated to the oil market, merit order dispatch means that low-cost producers in Russia and OPEC produce more of the world’s supply. More expensive resources, such as oil produced from shale and tar sands, will be relegated to the margins, produced only if physical and financial conditions permit.
As part of this restructured supply side, low and highly volatile oil prices may “squeeze” shale oil from the market. Shale oil is vulnerable because its wells have a much shorter lifetime than wells drilled into conventional deposits. In the first year, production from a well drilled into shale declines 60 percent, and another 25 percent in the second year, compared to a 6 percent rate of decline in conventional fields. These rapid rates of decline imply that to merely keep production constant, shale oil firms must drill many wells, which requires frequent and large capital outlays. Estimates suggest that it costs $40 – $60 to produce a barrel of oil from shale, the so-called break-even price. When prices drop below the break-even price, firms lose money. Firms that were eking out small profits at $60 per barrel now are losing money at $25 per barrel.
Beyond economic losses, shale oil firms also are threatened by increased volatility in the oil market and beyond. Break-even prices overstate the willingness of firms to drill new wells. For shale oil firms (and businesses in general), uncertainty raises the threshold for investments above the break-even price. This effect is visible in the historical behavior of the shale oil industry; high oil price volatility reduces drilling.
The negative effects of uncertainty on shale oil also come from beyond the oil market. Even before the pandemic, overall market uncertainty (about 25 percent per annum volatility as proxied by the widely watched VIX index) delayed investments until benefits are larger than those implied by the break-even price. Now, the COVID-19 pandemic has pushed uncertainty to record levels (VIX is about double its normal levels). All this suggests that general economic uncertainty will curtail the capital that shale firms need.
Price uncertainty also affects decisions to shut-in production from existing wells. When prices drop below the break-even price, production may continue despite economic losses. This tends to exacerbate the ongoing reduction in prices. Eventually, the economic losses get too large, and companies shut-in production. If enough capacity is shut-in, lower production will stabilize or raise prices. But prices have to move well above the break-even price before companies restart production.
Low and uncertain prices threaten the long-term viability of the industry because many smaller firms do not have sufficient liquidity. Unlike their larger integrated cousins, which produce, refine, transport, and sell oil to consumers, many shale companies only drill wells and produce crude oil. With only this highly uncertain income stream, shale oil firms borrowed funds from credit markets to drill their wells. Firms will not be able to repay their high levels of debt if prices remain low; they will become insolvent and their credit ratings will suffer. These credit concerns will make it very expensive for firms to raise funds in the future, even when the economy comes out of the crisis and demand picks up.
—Nalin Kulatilaka, Affiliated Faculty, Boston University Institute for Sustainable Energy, and Wing Tat Lee Family Professor of Management and a Professor of Finance at the Questrom School of Business.
—Robert Kaufmann, Affiliated Faculty, Boston University Institute for Sustainable Energy, and professor in the Earth and Environment Department at Boston University.
The opinions expressed herein are those of the authors and do not necessarily represent the views of the Boston University Institute for Sustainable Energy.