Cheap Oil Won’t Kill Shale

The dramatic collapse in the price of oil—currently flirting with sub-$40/barrel levels—has naturally produced an explosion of commentary on its short- and long-term effects. One curious, though predictable, narrative is starting to emerge from the environmental left: The price collapse is the death knell to shale oil, and the U.S. oil boom—which was never a real thing anyway—is now officially over.

On the one hand, there is some truth here: You can’t cut the market price of a commodity by more than 60% without causing some trouble for its producers. U.S. oil rig counts have indeed fallen and will continue to fall this spring. If the current low prices are sustained for any length of time, it’s certain some of the smaller, weaker, and more-leveraged outfits will be forced out of business. But it’s a long way from that to thinking that shale oil is a thing of the past.

The first thing that needs to be said is that boom-and-bust is the nature of the oil business, and everyone who works in it knows that. Producers that have been in business for any length of time, and especially the big ones, prepare for it carefully by hedging their production and spreading their exposure as widely as possible so they can weather the bust that everyone knows is coming sooner or later. So a sudden price collapse like this isn’t likely to have quite the dramatic effect non-industry folks might think.

It’s Not What You Make, It’s What You Spend

The second, and key point here, is that the price of oil is only one element of the mix, and there are several others that are just as important if not more so. And these elements in fact weigh heavily in favor of shale oil riding out this price storm more effectively than OPEC.

Unlike U.S. producers (the smart ones, at least), most OPEC nations have badly overextended their national budgets when it comes to the price of oil. Much of this is attributable to the Arab Spring, when the petrostates in the Middle East boosted social spending in order to tamp down unrest. Most OPEC nations, whether you’re talking about Venezuela, Iran, or the Gulf nations, are repressive autocracies that maintain order by using oil revenue to keep their populations happy. Take that money away, and some of these regimes may be in serious trouble.

Figures vary depending on whom you ask, but every single OPEC nation has fallen into the red this fall. According to figures from the International Monetary Fund, Saudi Arabia needs about $104/barrel to balance its national budget, Venezuela $118, and Iran a whopping $131. Though not a member of OPEC, Russia is also badly exposed, needing around $105/barrel to break even.

Contrast this with average breakeven prices for U.S. shale oil plays. A lot of this information is proprietary and difficult to pin down, but estimates generally range from just under $70/barrel in the Permian Basin down to under $50/barrel in Eagle Ford and parts of the Bakken. And I have seen reports suggesting there are producers who can still make money at $45/barrel.

It doesn’t take advanced math to see how this arithmetic shakes out.

Venezuelan President Nicolas Maduro is currently on a world tour trying to talk up the price of oil and seek emergency financing. Back home, state-run grocery stores have been so emptied by hoarding that police have had to limit access. The national currency has collapsed, and Moody’s has downgraded its bonds to just above default, which observers expect is on the way in a few months. Yet with even mild austerity measures having caused massive riots in the past, the government is hamstrung in what it can do to narrow the budget gap.

Iran, already battered by sanctions, is financially challenged enough that Iranian President Haasan Rouhani has been making ominous threats that Saudi Arabia would “regret” its move to allow the price to fall and that it and Kuwait “would suffer more than Iran.”

Russia, which gets 45% of its export revenues from oil, is in only slightly better shape. The ruble has fallen 50% against the dollar since July—this despite a huge hike in the central bank interest rate last month—and its economy could contract as much as 10% this year. Russia would normally be able to seek financing to weather the storm, but western sanctions over the crisis in Ukraine have hobbled its ability to do so. Government officials are putting on a brave face but have conceded that major budget cuts will be necessary this year.

The Saudis and Gulf emirates have enough reserves to ride this out for a while, but it will still be expensive.

We’ve Been Here Before

Fracking, on the other hand, isn’t getting any more expensive. On the contrary, it’s likely that this environment is going to spur producers to further increase productivity and cut costs. This is, after all, a sector that barely existed 10 years ago, and there are still plenty of soft costs and productivity gains to capture. Even a couple of years ago, industry folks would tell you their breakeven price was around $80. But there have been dramatic gains in productivity for both shale oil and gas—something I’ve reported on in the past—and there’s little sign that’s going to stop.

After all, a similar thing happened just over two years ago, when booming shale gas production tanked the price of gas. Gas rig counts crashed by two-thirds, a few companies went out of business . . . and production kept climbing anyway as productivity grew and costs fell. None of the dire predictions for the shale gas business—predictions that are sounding very familiar this week—came to pass. Shale is in fact now the largest source of U.S. natural gas production.

There will be cuts in shale oil exploration in the short term; many have already been announced. Operations in the higher-cost plays will close up, and producers will move to the most profitable ones. The fat will be cut, and stratospheric salaries will be pulled back as the labor crunch eases. Exploration activity will probably shift back to shale gas to some extent. But the oil will keep flowing from existing wells—there are bills to be paid—and you won’t be seeing oilfield workers rioting in the streets.

The multinationals and big independents can weather a year of $40/barrel oil, especially given that many of them are hedged well into 2015. Even if oil stays that low that long, my bet is that we’ll still see a resurgence of shale exploration by the end of the year as producers find ways to keep making money. The oil will still be there, the technology isn’t going away, and the expertise they’ve developed won’t be forgotten.

But can Venezuela survive it? Iran? Russia? That’s anyone’s guess.

Here’s betting that OPEC will blink before the shale business does.

—Thomas W. Overton, JD is a POWER associate editor (@thomas_overton, @POWERmagazine)