Financial questions seen for US shale gas, tight-oil plays

Financial problems of operators in US shale gas and tight oil plays might hold production growth below current expectations, according to the author of a March comment published by the Oxford Institute for Energy Studies (OIES).

But a reorientation of the industry toward “the most commercially sustainable areas” of unconventional-resource plays might extend the period of growth, writes the analyst, Ivan Sandrea, an OIES research associate and senior partner of Ernst & Young London.

The producing industry has demonstrated it can create opportunities, innovate operationally, and address environmental issues despite evolving government policies and questions of public acceptance, Sandrea writes.

“What is not clear from higher-level company data is if the industry (both large players and independents) can run a cash flow-positive business in both top-quality and in more marginal plays and whether the positive cash flow could be maintained when the industry scales up its operations.”

Sandrea cites asset write-downs approaching $35 billion since the shale boom began among 15 of the main operators.

“While most of the companies that have made write-downs are not quitting, many players in this industry have already noted that the revolution is not as technically and financially attractive as they expected,” the analyst writes. “However, to deem the [business] model flawed due to the investment write-downs of some large companies would be misleading and too early in the evolution of the business for some players.”

Sandrea also cites a recent analysis by Energy Aspects, a commodity research consultancy, showing 6 years of progressively worsening financial performance by 35 independent companies focused on shale gas and tight oil plays in the US.

“This is despite showing production growth and shifting a large portion of their activity to oil since 2010, presumably to chase a higher-margin business,” he adds. Oil and gas production by the companies represented 40% of output in unconventional plays in last year’s third quarter.

Sustainability concerns

According to the Energy Aspects analysis, total capital expenditure nearly matches total revenue every year, and net cash flow is becoming negative as debt rises. Other financial indicators “add to concerns about the sustainability of the business,” Sandrea says.

Still, shale-gas and tight-oil development remains “a fledgling industry” with hope for “a positive inflection point for cash flow and a full-cycle risk-adjusted return.” Some operators see that point as still 5 years away.

Meanwhile, the industry will remain challenged.

Sandrea says “above-ground reasons” include the need to constantly acquire and drill leases, infrastructure needs, transportation costs, increasing costs to manage environmental considerations as operations grow, and “the fact that drilling and hydraulic fracturing costs respond to fluctuations in gas and oil prices as well as demand, leaving little excess profit for long.”

Below ground, he says, rapid production declines and low recovery rates, despite technical improvements, remain problems in many plays and might worsen as operators move into increasingly challenging acreage.

Unless financial performances improve, capital markets won’t support the continuous drilling needed to sustain production from unconventional resource plays, Sandrea suggests, asking, “Who can or will want to fund the drilling of millions of acres and hundreds of thousands of wells at an ongoing loss?”

More likely, he says, “Parts of the industry will have to restructure and focus more rapidly on the most commercially sustainable areas of the plays, perhaps about 40% of the current acreage and resource estimates, possibly yielding a lower production growth in the US than is currently expected—but perhaps a more lasting one.”