Domestic production represents the marginal barrel of production for the foreseeable future
DEBORAH BYERS AND VANCE SCOTT, EY, HOUSTON
WILL US SHALE production serve as a natural cap on crude prices for the foreseeable future? We believe it will — and the resulting compressed price cycles will require oil and gas companies to make significant changes in strategy in order to compete effectively.
There is no question shale plays — through the ongoing application of technology innovations and cost improvements — have disrupted the traditional supply curve. The industry has always been cyclical in nature, but those cycles have typically been long ones, usually featuring multiple years of higher-than-normal prices followed by sharp drops and long recoveries. For example, after the price of oil crashed in 1985, it stayed relatively low for more than 15 years before beginning its upward trajectory.
Shale changes the game. Because of its abundance, the number of economically rational operators involved, its short development cycle and its ability to deliver returns quickly, US shale will likely represent the marginal barrel of production, at least in the medium term.
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To be certain, there will still be other resource plays with the ability to impact both global supply and pricing. Like OPEC, for example, deciding to pull back production in an effort to push prices upward. And geopolitical disruptions are always a possibility in an industry that operates in many challenging locations.
Today, many shale operators are completely capable of drilling profitably when the price of oil is relatively low. And — for now — there is enough capacity in the marketplace, in terms of labor, equipment and associated supplies, to ramp up production quickly if prices warrant it. This capacity is also greatly enhanced by the significant efficiency gains in the drilling and completion process that is much more akin to a manufacturing process, something the nimble operators have exceled at exploiting.
When prices move above the economic break-even point — most likely in the neighborhood of $45–$50 a barrel — US operators will react quickly, locking in the economics via volume hedging, deploying the necessary capital and producing to that volume.
As US shale producers respond to price signals, their time from decision-to-drill to first oil is now around 12 months — compared with the much-longer lead time conventional plays require to come online (and with far less project risk).
With quick ramp-up, US shale production will rapidly close any gaps in supply and keep prices from gaining too much upward momentum. Then, as prices fall again, producers will pull back on drilling — or drill but allow wells to remain uncompleted — until the next supply shortfall. These wells remain in inventory and can cycle back even quicker within a three- to six-month time horizon.
As a result, the oil market clearing price will be set by US shale. This quick response means the commodity price cycle will likely be compressed, compared with historical trends. And we'll see more time spent in the trough versus the highs.
Ultimately, US shale will set a natural balancing point.
Shale still attractive
While this may not sound like an exciting business model, US shale is still an attractive investment opportunity for a number of reasons.
For starters, the US remains one of the few places in the world where investors own the rights to underlying resources. That, of course, incentivizes rights owners to allow drilling and reduces project risk due to lack of governmental involvement.
Second, shale drilling is low-cost, and getting lower. The typical authorization for expenditure on a shale well is less than $5 million, and producers continue to peel away significant costs from production while increasing volumes — a trend that has picked up pace during the recent downturn.
Third, shale drilling has short cycle times, less than two months in many cases. Some companies have reduced to fewer than 20 days from start of drilling to production. That allows shale producers to be much more responsive to market pricing.
And fourth, a typical shale well can achieve payback in approximately 1.5 years. That significantly de-risks projects by allowing producers to use hedging to lock in favorable economics.
Compared with offshore wells, for example, shale wells require less project lead time and less up-front capital expenditures, and cash inflows begin much sooner. And although shale's steep well decline rates require additional wells to be drilled on an ongoing basis, stretching out capex over time allows producers to adjust the scope of their projects as market conditions change — drilling more if prices are high and canceling new wells if prices decline.
Finally, the industry may get a shot in the arm from energy policies if President Trump holds true to his campaign promises. This could come in the form of regulatory policy as well as comprehensive tax reform. Companies are well-advised to retune their legislative efforts as this unfolds.
Options for producers
In this new environment, producers that find themselves with a relatively high-cost portfolio have two options. They can find ways to take out costs and make existing opportunities more profitable, or shift a portion of their portfolio to lower-cost production such as shale.
That latter option may be easier in the longer term. Onshore drilling inventory in the US today is in short supply, and expensive. Companies can find "great rock" for shale drilling, but they will pay handsomely for it.
However, as the lower-for-longer price environment adds stress to the industry, an uptick in transaction activity is inevitable, and there may be increased opportunity to acquire shale reserves with favorable terms in the next few years. Research shows, for example, independent shale producers with a focus in one major basin have outperformed those with scattered assets, which may eventually cause some companies to consider selling or swapping assets to streamline their operations — providing new M&A opportunities.
Companies currently involved in shale will also need to change — adopting and refining an operational model that is better suited to unconventionals, with flexible, timely decision-making and constant portfolio rebalancing. The top-down, centrally planned approach that works well for huge, complex projects hinders shale production and leads to suboptimal capital deployment decisions.
Steps to success
Risk mitigation in managing portfolios will be key for conventional oil and gas producers learning to compete in a world where prices fluctuate from $40 to $60 (and spend more time at the lower end of that range).
That is especially true for portfolios with large numbers of deepwater or onshore conventional assets, particularly those that will require complex, high-cost projects to reach production.
The first step is improving the ability to accurately identify the risk-adjusted return of every project in their portfolios. Today, too many companies utilize a rudimentary approach to planning that fails to incorporate all actual project risks involved in developing the resource.
For example, some studies show as many as 60% to 65% of capex projects in the oil and gas industry run overschedule and over budget, significantly reducing the economic value the project will deliver. That's an issue with both planning and execution, but properly identifying those risks up-front can help companies avoid painful — and expensive — lessons.
Obviously, the more technically complex the project, the more risk it carries. The same holds true for projects in regions where tax, royalty and local content laws can change rapidly. But companies don't always incorporate these risks fully into their pre-drilling analysis.
Reducing reservoir risk is another critical success factor. Conventional onshore and offshore projects require more sophisticated modeling and simulation analyses than shale opportunities. Companies must fine-tune their decision-making capabilities by properly characterizing reservoirs earlier in the process to eliminate the need for expensive and time-consuming planning and design to accommodate a wide range of outcomes.
These decisions are often impacted by the human factor, too. A team that believes in a project will overlook obstacles and push to drill, even when risks are high. Reducing the human factor can help companies pursue the right projects with the maximum opportunity for financial viability.
Another critical success factor will be employees. In this short-cycle environment, producers will need to develop a more flexible business model to eliminate the hire/fire scramble related to pricing changes. Smart companies will develop a core team of employees at the bottom of a cycle and utilize contractors and temporary employees as prices rise and activity increases. Notably, this will require companies to step up their employee training and knowledge transfer activities so they are ready and able to move quickly when prices rise.
Finally, integrated companies must learn to maximize the built-in advantage of being involved in both upstream and downstream. In a low-price environment, integrated companies often outperform independents because they capture value from the wellhead to the customer. For example, integrated companies can utilize the product knowledge embedded in the organization to help upstream personnel understand how various types of crude can be blended and what specific refiners focus on. Understanding the hydrocarbon value chain can lead to an upside of 10 to 25 cents a barrel in the marketplace, which can add up substantially over time. As a result, in the future, we may see trends turn away from the separation of upstream and downstream assets, with more midsized companies forward-integrating into LNG and petrochemicals to improve the economics of their upstream production.
Other opportunities
The growth of shale as the marginal barrel of production could also open up opportunities around the globe.
For example, governments that rely heavily on petrodollars may reach the realization that heavy taxes and royalties are hampering investments in their country, as capital continues to flow to US shale with its relatively stable regulatory climate and other benefits.
Rethinking their fiscal regimes to spur new investment — and recapture much-needed revenues — would open up new markets for oil and gas companies and make previously uneconomic projects viable again. This could, in the long term, fundamentally reset the cost structure of deepwater and conventional drilling in some countries.
Still, the days of outsized returns are likely over. With prices remaining relatively stable for at least a decade, and supply being plentiful, even big discoveries won't deliver huge premiums. When there are plenty of opportunities to drill, but no financial incentive to do so, undeveloped reserves aren't nearly as valuable.
Fundamental change
Some in the industry still believe the price of crude will soon run back up to the $100-a-barrel threshold. But those believers lack a full appreciation for how the fundamental structure of global supply has changed in recent years.
With US shale leading the way, there is long-term stability of supply — and the opportunity to increase production as needed to smooth out shifts in demand. This new era presents a challenge for domestic producers, certainly. But it is also an opportunity for executives to rethink their business model and create lean, agile and responsive organizations that can compete effectively at any price.
ABOUT THE AUTHORS
Deborah Byers, US Energy Leader of Ernst & Young LLP, is based in Houston in the firm's Transaction Advisory Services practice.
Vance Scott is the Americas Oil & Gas Leader for Transaction Advisory Services at Ernst & Young LLP. He also serves as head of the Chicago office of Parthenon–EY.
The views reflected in this article are the views of the authors and do not necessarily reflect the views of the global EY organization or its member firms.
