Alexander Khurshudov: the global oil prices are not high enough for the shale oil production to pay back
Last time we defined the main trends in the technology of drilling well in shale formations. Now it’s time to see how they influence the economics. I’d like to remind you that the main source of information is the EIA’s analysis Trends in U.S. Oil and Natural Gas Upstream Costs.
- Lease cost
The sole owner of the subsoil in the US is the land owner. Before it can start drilling, the oil company has to buy mineral rights (the lease). EIA quotes the range of lease costs from $6 thousand to $72 thousand per acre. In the Eagle Ford and Permian basin a well drains a smaller area (20-35 ha) and the lease costs $1-1.3 mln. In the Bakken a single well may cover up to 180 ha, which makes the lease costs as high as $2.5 mln.
The land owner is also entitled to royalty in the amount of 11-16% of the produced oil price. Though, this money is to be paid after the well is put into operation.
- Well construction
The average cost structure per well is shown in picture 1.
The total lacks one per cent, but let’s not try to find faults, this is due to rounding the fractions. One way or the other, drilling and casing the wells amount to a little over a quarter of the total cost, and exactly half refers to hydraulic fracturing operations. I’m especially impressed with the cost of proppant and sand, the average well consumes almost a million dollars’ worth of them. The other costs include general and administrative expenses, insurance and consulting, which also comprise a good share.
The changes are understood. In the last three years the active rig count in the US has halved. The growing competition has pushed the prices down, besides the drilling rate has grown by 25-30%. Meanwhile the number of frac jobs in a well has increased 4-6 times, the proppant volume 8-10 times, followed by the increase in the volumes of liquid and chemicals. No wonder that the completion cost reaches $5.6 mln. This explains the increase in the number of the wells drilled, but not completed. The main reason is as simple as “no money”, among the other reasons are the shortage of sand, equipment and chemicals, and the fact that the frac service companies must have risen their prices due to the shortage. The full cost of the well construction in the major shale plays is shown in table 1.
The average well construction cost in the US according to EIA data
Note: this is the average data from different companies. For some wells the range of costs is higher. In the Bakken, for instance, the costs vary within $6-9.6 mln.
The most expensive wells are in the Bakken, for the depths are bigger and submersible pumps have to be run to produce the oil. The cheapest ones are in the Marcellus gas field, where on the contrary both the depths and the lengths of the horizontal section are smaller.
- Operation costs
The operation costs vary within $15 - $37.5 per a barrel of produced oil. Their structure is shown in table 2.
Operation costs structure for shale oil production, $/barrel.
The operation costs are the highest in the Bakken and the Permian basin due to the high oil transportation cost (up to 13 $/barrel). Though, this year up to a half of the oil from the Bakken is transported through a new pipeline, so this cost is going to decrease. In the Bakken the workover cost and water disposal cost are also high and they are going to rise as time goes by.
In the Permian basin 42-59% operation costs account for workover. Less productive wells in this field seem to ball-up more often and operate unsteadily. Water disposal cost (7-12%) is not too high yet, but it will increase with time.
The gas production cost in the Marcellus varies within $12.6-29.6 in barrels of oil equivalent. This corresponds to $81-190.3 per 1000 m3 of gas. Meanwhile the market price for gas at the same time was less than the operational expenses varying within $78-113 per 1000 m3. Don’t be surprised, the Marcellus formation is luckily located in the highly populated states of New York and Pennsylvania, so the company compensates some of the losses associated with the gas production by saving on the cost of transportation to consumers.
In the cost structure direct labor cost (44-59%) prevail, followed by the water disposal cost (20-33%) and the wells’ workover (20-28 %).
- Return on investment
Considering the data mentioned above let’s look at the return on investment in terms of drilling for oil and gas. Let’s assume that the average well produces 250 thousand barrels, which is quite a high indicator for the Permian, where a half of the rigs operate. The tax level is assumed to be minimal (10.5%), royalty 14 %. Table 3 shows the results of the calculation .
Return on investment for shale oil in the Permian Basin, in $ mln
It can be seen that if the expenses are at the minimum, the oil price has to be about $70 for a barrel, and it has to be $90 for the medium level of expenses.
Let’s assume that the average gas production in the Marcellus amounts to 200 mln m3, the tax level and royalty remain unchanged. Table 4 shows the results.
Return on investment for shale gas in the Marcellus, mln $
Producing the gas would pay back only if the gas price increased 1.5 times against the current level. It doesn’t pay back under the current price at all. Only the companies that both produce gas and transport it to the consumers can count on some profit from their operations. Now that we are fully aware of how unprofitable the shale “industry” is, just one question remains unanswered:
- Why are they still drilling?
There are three reasons for this.
The first reason is that the oil companies have to comply with the terms of their contracts with the land owners. Delaying drilling would result in penalties. They have to drill anyways, hoping for the better and being satisfied with what they have.
The second reason is that large companies can compensate the losses associated with the production of shale activity by their profit from downstream, as well as by their profitable business in other countries. Last year, for example, the losses of ExxonMobil associated with the production in the US ($4.15 bln) were fully covered by their income from abroad, including Russia. With the tongue in cheek we may say that Russia plays a part in financing shale projects.
And finally the third reason is that the American shale operators manipulate their reports. They do not write-off for depreciation the cost of all the wells drilled. If they counted the depreciation fully, they would never have any profit. So they pretend that a part of the wells is drilled with the loans and has nothing to do with the income. Using this trick they manage to demonstrate profit, take new loans and sell new shares. Though, it’s impossible to cheat like this forever. The wells deplete and it becomes too expensive to keep them on the balance sheet. Then the companies just write-off the wells, making the huge losses legal.
Picture 2 shows the profit dynamics for the pioneer of shale revolution, the Chesapeake Energy. During the last 13 years the company demonstrated profit 9 times, the average of $2.2 bln a year. Other times it had the total losses of $33.6 bln.
When the oil price decreased and the company realized that they wouldn’t be able to show profit anyway, they wrote-off billion dollars’ worth of assets. After all that one can only smile at the address for the management to the shareholders. I can’t help but quote a part of it:
In 2016, Chesapeake made significant progress in strengthening our financial position and improving our operational efficiencies, thanks to the commitment of our outstanding employees and the competitive advantages within our assets. While the low commodity price environment remains a challenge, we continue to make improvements and drive value across every aspect of our business.
The strength of Chesapeake’s portfolio continues to grow as we capture efficiencies and develop new ways to leverage our technology to increase the value of our assets.
The annual report made it clear for the shareholders that the company got $3.3 bln revenue from the sale of oil and gas and $4.9 bln losses. All the oil and gas and the other assets of the company are estimated at $10.6 bln, with the total debt of $9.9 bln. As soon as the report came out the Chesapeake Energy’s shares started falling (pic. 3) I think never to rise again…
Pic. 3. The dynamics of Chesapeake Energy’s shares, 2002-2017
It’s rightly so that the revolution devoir its own children. It’s been a known fact for many years and still there is a revolutionary born every minute…