The Shale Revolution may be changing some core structural dynamics in the oil and natural gas markets, in large part because shale production is believed to be more flexible and responsive to market conditions than most forms of conventional production. Shale production is more likely to be shut down when oil prices drop well below break-even points, and it can be ramped back up again more quickly than conventional production whenever prices rise. This is likely have significant long-term effects on the oil and gas industry — as well as countries that rely heavily on energy resources to fund state coffers.
The shift stems largely from certain core differences between shale and conventional production. For starters, shale wells typically can be drilled and completed more quickly than their conventional counterparts. In 2014, for example, wells drilled by EOG Resources in the Eagle Ford shale formation in South Texas took on average less than nine days to drill.1 By comparison, most deepwater wells in the Gulf of Mexico take months. This allows shale drillers to respond much more quickly to dramatic swings in oil prices.
Differences in the production profile of tight oil create incentives for drillers to respond more immediately to current oil prices. Shale wells have a much sharper decline profile than conventional wells, with the majority of value being extracted within the first year of production. For example, wells in North Dakota’s Bakken shale formation generally lose around 65% of initial output in the first 12 months.2 The front-loaded nature of shale output creates a major incentive for drillers to shut down production whenever oil prices drop, since the majority of the value that can be extracted from a well must be done over a very short period of time. It makes financial sense for shale drillers to put production on hold until prices rise again.
By comparison, conventional output often results from decade or more of exploration, and investment decisions are typically made years in advance. Production is governed less by initial capital costs and more by operational costs, creating less of an incentive to halt production whenever prices drop. Thus, current prices matter less in conventional production. Even in an environment of low oil prices, conventional drillers typically will complete wells to recoup their development costs. Conventional plays in the early stages of development are still likely to be put on hold by low prices, but existing wells are generally insulated from market changes for 3-5 years – and even longer for more expensive and challenging offshore projects.3 Indeed, between October 2014 and February 2015, the number of oil rigs drilling in the Eagle Ford formation and the Permian Basin in Texas dropped by 27%, while rigs in North Dakota’s Williston Basin dropped by 32%. Over the same period of time, the number of conventional oil rigs in the Gulf of Mexico dropped by just 14%.4
Shale production can also ramp back up again more easily than conventional production, since there is often a glut of of unfinished wells ready to be restarted as soon as a certain price point is reached. Boom-and-bust cycles may accelerate in this environment, and prices are unlikely to stabilize until the industry adjusts to the new market dynamic. However, the ability of U.S. output to ensure that markets stay well supplied has led industry analysts to conclude that the Shale Revolution has created a new ceiling for oil prices that will likely be somewhere far below $100 per barrel. If this dynamic proves true, countries that rely on high oil prices to sustain government spending will be forced to adjust.
[1] http://www.ft.com/intl/cms/s/0/8c3198e2-b288-11e4-a058-00144feab7de.html
[2] http://www.reuters.com/article/2015/01/07/shale-drilling-prices-kemp-idUSL6N0UM21320150107
[3] http://blogs.platts.com/2015/01/29/shale-conventional-oil/
[4] http://www.ft.com/intl/cms/s/0/8c3198e2-b288-11e4-a058-00144feab7de.html