[Editor’s note: Opinions expressed by the author are his own.]
The U.S. shale revolution has been the story of an anti-hero, producing benefits, to no applause. And so, I am rarely surprised by new examples of the unpopularity of—or apathy towards—U.S. oil and gas producers.
NIMBYs (not in my backyard) will remain NIMBYs, anchored to decade-old scaremongering on water safety. American environmentalists opposed to fossil fuels, full stop, will always reserve their sharpest contempt for the oil produced by their fellow Americans, rather than Angolans. And Americans of all politics seem to become particularly annoyed at having to pay for gasoline, even though gasoline prices are about the same in real dollars as they were 50 years ago.
But I was stunned by last week’s reaction to the most violent events to befall shale producers since the shale revolution began. With prices cut in half in two months, with the coronavirus causing the sharpest fall in oil demand in recorded history, with the Saudis and Russians finding this an appropriate time to increase production in an escalating production war, the President tweeted, “Good for the consumer, gasoline prices coming down!”
But even that glibness—haphazardly reversed in policy—is nothing compared to the smug reporting and market analyses of some energy reporters and economists. Usually long-time shale skeptics, these analysts are rising to a moment of crisis by saying “I told you so.” They are broadcasting a “Return to Normalcy” thesis. It goes, more or less, like this: Russians purposely and the Saudis erratically are doing the rational, even praiseworthy, thing of restoring the oil markets to their natural order by refusing to any more “allow” “high-cost” shales to supply the world with oil and gas.
All very reasonable sounding, except that the thesis is historically ignorant, wrong on the facts, and morally bankrupt.
A world without shale?
The historical ignorance starts with an amnesia of where the global oil markets were in 2007-2008 and North American natural gas market were earlier that decade. We worried then that the world was running out of oil and North American gas. The current generation of economists at Goldman Sachs say good riddance to the “OPEC+” production cuts made in 2016 by Russia and the Gulf Trio of Saudi Arabia, United Arab Emirates (UAE) and Kuwait because those cuts had been “inherently imbalanced” and “economically unfounded.” Their predecessors 13 years ago predicted a super spike of oil prices to over $200 per barrel.
Those spikes didn’t happen, in the short term, because of the 2008 global financial crisis. They still haven’t happened because U.S. tight oil and NGL production increased by 9 million barrels per day (bbl/d) from 2010 to 2019, meeting three-quarters of the world’s increased demand, which stood last year at over 100 million bbl/d of crude and other liquid hydrocarbons.
The Return to Normalcy pundits ignore that there is no counterfactual scenario in which the world enjoyed its relative prosperity over the last decade without the incremental oil and gas—and era of cheap energy—provided by the U.S. shale revolution. Producers outside the Big Three (Russia, Saudi Arabia, and the United States) have tried to grow, in aggregate. Their failure has been due to geology (conventional exploration gets harder every year), politics or national instability. Saudi Arabia increased production by 2.5 million bbl/d from 2010 to 2019, and Russia by another 1 million bbl/d. Could they have produced even more, replacing the oil supplied by the U.S. shales?
Of course not. Saudi has reported spare “sustainable” capacity of another 2.5 million bbl/d, although there is a debate on what production level is sustainable and how many billions of dollars it would take to get there. Saudi’s increased supply in the current market share war is coming from inventory. Barclays recently estimated that Saudi could sustainably increase production by only 1 million bbl/d from pre-crisis levels.
And the Saudis may prefer to maintain some spare capacity rather than produce all that the country can. There is the empirical evidence for this. The current reactive—or overreactive and definitely performative—play for aggressive market share is only the Saudi’s third in forty years. Two weeks does not prove a “seismic,” “permanent” shift, as some pundits declare. There is also commonsense: maintaining and using spare capacity, as Saudi has done more often, allows the country to avoid price spikes that could dampen long-term demand for the product on which the Kingdom wholly depends. (It also saves capital otherwise used for development of expensive new production capacity.)
And Russia? Saying that Russia has ceded market share to the shales is like saying I ceded my place in the NBA to Giannis Antetokounmpo. The last time Russia “cut” production, it did so only from temporarily inflated levels. Experts believe that the country, producing flat out, could maybe supply another 400,000 to 800,000 bbl/d before entering secular decline. (And I wait for the experts to update their forecasts of either Russian and Saudi financial capability, or desire, to increase production at long-term $30 oil.)
In other words, even if the “old world order” had been in control with no shale revolution, the world would have still have needed 6 million or 7 million bbl/d of oil from other sources to meet demand. Or realistically, in a world without shale, that demand would never have happened as oil would have remained on its climb to super spikes.
Who really sets the price?
The second incorrect tenet of the Return to Normalcy thesis is the idea that the low-cost producer “should” set the price of oil. This rarely happens anywhere. The suppliers in any industry have one basic task: to meet customer demand.
The oil industry is an incredibly weird one in which there are millions of wellbores, some drilled 70 years ago and some yesterday, into reservoirs with wildly different geological, lithological, and cost characteristics, all selling versions of the same commodity. It’s a unique one in that the depletion of reservoirs requires new capacity to be developed to offset natural declines. There may be markets in which the low-cost producer is in in the position to supply all market demand. Coke for soda? Disney for princess movies? We can applaud those potential monopolists for their good luck (and make sure they don’t violate anti-trust laws). But in the oil industry, we need production from all reservoirs, varying in age and costs and quality, to meet demand—not just oil from the Gulf states and Russia.
And thus prices must be at a level not just to keep low-cost legacy reservoirs producing but to incent new supply. This is the main answer to a complicated question of why shale operators didn’t cut production instead of Russia and Saudi when the oil markets were oversupplied, as they have modestly been since 2016. The shales shouldn’t have grown, the Return to Normalcy thesis proponents remind you ad nauseam, as the world didn’t need all of the incremental supply from shale.
But shale production grew over the last five years because, unlike the economics of long-known legacy conventional reservoirs, shale operators were still trying to figure out the productivity and economics of individual wells, by experimenting with completion techniques and wellbore spacing.
Shale still grew because it is not supplied by state oil companies but from hundreds of independent uncoordinated entities for whom it’s illegal to coordinate.
Shale still grew because, yes, some marginal, globally immaterial operators threw Hail Mary’s by drilling obviously dumb wells (to save their companies, because they were paid on growth).
Shale still grew because Saudi didn’t mind having spare capacity, because the Gulf Trio and Russia cut production first, because their “state-even” prices, as I call them—the oil price necessary to allow oil-dependent rulers to provide basic governance and social services—were higher than shale operators’ breakevens.
But shale mainly still grew because the economics of core shales are tightly bunched—what’s good in the Permian for Concho Resources is good for Chevron—and thus a global price was needed to bring forth production from the source of 10% of the world’s oil supply. And in the free world, you can’t fine-tune that supply to the barrel.
What’s strange about the longstanding exasperation of the Return to Normalcy crowd is that none of the above is a new phenomenon. This is how the oil business—how the economics of a lot of businesses—has always worked. The criticism of the shales as some unnatural source of supply produced only with the forbearance of Saudi Arabia and Russia is valid only if the shales’ volumes were immaterial to the world’s supply—or if their costs were outside the world’s norm.
The latter objection is also not true. Groups like RS Energy Group (RSEG) do sophisticated analysis of relative “three-quarter cycle breakeven” economics—the commodity price necessary to generate a 10% internal rate of return when accounting for all the costs of drilling, completion, infrastructure, and overhead. RSEG estimates that the big five U.S. liquid shale plays have about the same three-quarter cycle breakeven costs as other major new supply sources: offshore fields in the North Sea, Latin America, and the Gulf of Mexico. All required around $45 to $60 per barrel at the end of last year—numbers going down with the coming oilfield service pricing implosion.
Yet shale skeptics refuse to see this. A few may be anchored to data from five years ago, when shale breakeven costs were much higher. A few robotically repeat that shale wells have higher decline rates than conventional wells—but forget to mention the offsetting factor of fewer dry holes and quicker returns on capital. But most shale skeptics are blinded to the relative costs of supply because they conflate cost-of-supply issues with issues around the shale industry’s historic and future consumption of outside capital.
To date, the shale industry has consumed more capital than it has generated for investors, as measured by free cash flow. If ultra-low prices persist, there is no question that the entire shale revolution will have destroyed hundreds of billions of dollars. Most of the decade’s tight oil wells were drilled under different revenue assumptions than turned out to be the case, given declining commodity prices (in part driven by unyielding productivity gains from shale wells). And, as in any technological revolution, enthusiasm got ahead of itself in certain areas. The shales don’t make money everywhere.
But like every tech industry that has required external capital to finance revolutionary change and industrial retooling, there is a cash flow profile in the early years of a revolution and a cash flow profile in the mature years of more normal supply. Before the current crisis, shale operators had reached that inflection point. They were poised to generate competitive returns on capital and material free cash flow, in the highest volume-potential shale plays (primarily the Permian Basin), at $50 to $60 per barrel oil. Shale operators were listening and responding to commodity price signals and the loud investor demands. They were already cutting capex and growth plans as they focused on returns and tempered production growth.
Even before this Armageddon came, the marginal shale producers—which shale skeptics love to harp on, as falsely representative—were already being culled. Yes, few operators, and almost none outside the Permian Basin, were able to generate free cash flow below $50 per barrel. But the data is clear that operators in most major shale basins generate healthy free cash flow at $65 per barrel, which has been the average Brent crude price since 2000.
Can Russia eliminate shale forever?
Which brings us to today. Demand has crashed with unprecedented swiftness. Analysts are worried, for good reason, that the world cannot physically store all the excess supply. U.S. producers, which were already cutting spending, are making huge further spending cuts, causing tremendous pain within the sector, for companies and communities and families. Forecasters expect U.S. shale production, due to the capex response, to decline by 10% or more this year—and maybe a similar amount again in 2021. Saudi Arabia and its Gulf allies sought to do the responsible thing of cutting production in the face of the demand drop.
Its recent actions in the oil market, at a time when the world desperately needs international cooperation, are in character for a country now newsworthy primarily for election interference, supporting rogue regimes, and hacking. Its recent actions seem to be a continuing part of Vladimir Putin’s strategy to change the topic from the facts that Russia’s energy power has been shrinking (with the shales, with decarbonization), its population has been 30-years stagnant, and its GDP per capita is now 61st in the world—tied with Malaysia, slightly higher than Mexico.
But if you can create havoc in other countries, then everyone can start to look like you.
Now, in Russia’s mild defense, it’s not clear if Putin knew how Mohammed bin Salman of Saudi Arabia would respond to Russia’s initial intransigence around production cuts. While Saudi Arabia still seems to want to be a “responsible” market participant in an oversupplied world, the negotiation tactics of its hothead new dictator were straight out of “The Untouchables”: He pulls a knife. You pull a gun. He sends one of yours to the hospital. You send one of his to the morgue.
Hypermasculine Russia has not backed down, rhetorically. It brags that it could withstand low prices for six to 10 years. But what, exactly, are its goals? A child can do the basic math: a 10% drop in production that prevents a 50% drop in prices is a good thing for a supplier. So, we must assume the goals are as stated, to knock out the U.S. shales. If Russia is delusional, it might believe it can eliminate shale production forever and return permanently to the time when oil and gas were scarce—leading to higher prices and a bigger stick to bully non-Russians. Or maybe Putin and the oligarchs just want one last period—three years! five years!—of energy scarcity, the last hurrah before the gig is up.
There are two ways to talk about Russia’s strategy. You can analyze whether it is likely to work. And you can talk about whether it’s good if it does. The Return to Normalcy proponents, in their world-wise tone that claims to be sophisticated and free of American bias, aren’t doing a great job of either.
My opinion is the chances of this Russian knockout punch working are slim. Yes, Russia can reset their oil and gas operating costs by causing domestic inflation and devaluing the ruble. (Sorry, poor people, but the decision-makers have offshore accounts.) Yes, the Russian federal budget is “only” 60% to 65% supported by oil and gas revenue, unlike Saudi Arabia at 90%. But there is more to a country’s dependency on oil and gas than its fiscal budget. (Is the tech industry important to the U.S. economy only by how much taxes it pays?) Yes, Russia has a $170 billion sovereign wealth fund, $570 billion in reserves, and $100 billion in foreign currency reserves gold. At $30 per barrel less realized oil price, $170 billion, if drained, can buy you a year and a half of stable oil-related income—excluding all the other impacts around service cuts, lower natural gas and NGL prices, and currency. But $30 per barrel lower realized oil price adds up to $120 billion per year in a country whose GDP is only $1.7 trillion. If the United States lost a proportionate amount of GDP, it’d be like eliminating the economy of Texas or New York.
Whose side are you on?
While there will be major negative economic effects on shale-dependent regions, the U.S. economy is over 13 times larger than Russia’s, its tax base orders of magnitude more diverse. Even though, per BP’s 2018 statistics, the U.S. produced last year 29% more natural gas than Russia and 49% more oil and other liquids, the harm of the oil price collapse to the United States as a nation is incalculably smaller.
And look at recent history. The tough guys of Saudi Arabia and Russia lasted about two years in the last self-inflicted oil price collapse, launched by Saudi Arabia to November 2014 to then, too, reportedly teach shales a lesson. In the oil business, the math of state even prices are always more unforgiving than the math of breakeven prices. National oil companies still account for a majority of the world’s oil and gas. Resource-cursed nations are still too dependent on oil revenue to ensure minimal—in some cases, very minimal—material prosperity to protect their rulers’ legitimacy. And there is the specific Vision 2030 program of Mohammed bin Salman to use oil revenue to transform the Saudi economy. That program, as awkward as has been its start (WeWork, Uber, et. al.), depends on massive excess oil profits, not a rapid drawdown of cash to fund basic social services.
And we saw, six years ago, how real markets, grit, and entrepreneurial energy work. What the men and women in Midland, Texas, and other U.S. energy centers showed then, as they will show again, is that you can knock out a person’s job, his company, his life savings but you can’t knock out the geology of the shales or the know-how to restart them when the time is right.
And the shales will have to, eventually. For, once again, Russia has no plans, breakthrough reservoirs, or technical insight, to “take” market share by supplying the world with more energy. Russia has been good at minimizing declines from its legacy fields (but for how long?). It has a few new 100,000 bbl/d projects coming online every year. But all that adds up to a capability to, maybe, produce 5% more.
And Saudis most optimistic projections (or, frankly, bluffs) are to supply the world with 13% of the world’s oil needs. Anyone who believes Saudi is calmly executing a plan to have $25 per barrel oil long term as part of some strategic shift must come up with an explanation of how that happens if the rest of the oil business, including Russia, is permanently dead and all of Saudi’s less financially secure neighbors spiral into chaos.
Yes, relying on the U.S. shales as the marginal source of supply comes with short-term, disorganized sloppiness, of oversupply or undersupply. But the benefit is a huge source of mid-cost, flexible, growing supply that has put the world in an immeasurably improved place—morally, environmentally, and economically—than when that marginal barrel was a high-cost source of supply like a greenfield Canadian oil sands project or a high-malice source of supply like any barrel coming out of Russia.
Which is why I scratch my head at the Return to Normalcy thesis and its claims that Russia’s actions are “economically” founded. What are U.S. shale producers doing? U.S. oil companies (like Norwegian, Canadian, Brazilian companies, etc.) are trying to supply the word with energy at some reasonable amount of profit. Russia is making a short-term bet that it can have long-term revenge, by bringing forth a world with fewer oil and gas producers, higher prices, and more opportunities for Russia to assert energy power.
If that improbably happens, it would restore the old, “normal” energy world. But that was a bad energy world. And to not recognize it, or call it out, in a world with a better energy present does not make you sophisticated, does not make you a neutral observer, does not make you a clear-eyed economist. It makes you wrong.
I doubt the believers in the Return to Normalcy thesis will change their mind anytime soon. They are too anchored to their ideas that the shales were always a bubble, that London and Manhattan are always smarter than Houston and Dallas. But for those not anchored to that thesis, with Russia shouting its intentions, there is a simpler question in this moment of national crisis: Whose side are you on?
Gary Sernovitz is the author of The Green and the Black: The Complete Story of the Shale Revolution, the Fight over Fracking, and the Future of Energy.
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