Sunday, October 28, 2018

Shale oil becomes shale fail (and a nice subsidy for consumers)

I'm tempted to say the following to the writers of two recent pieces (here and here) outlining the continuing negative free cash flow of companies fracking for oil in America: "Tell me something I don't already know."

But apparently their message (which has been true for years) needs to be repeated. This is because investors can't seem to understand the significance of what those two pieces make abundantly clear: The shale oil industry in the United States is using investor money to subsidize oil consumers and to line the pockets of top management with no long-term plan to build value.

There is no other conclusion to draw from the fact that free cash flow continues to be wildly negative for those companies most deeply dependent on U.S. shale oil deposits. For those to whom "free cash flow" is a new term, let me explain: It is operating cash flow (that is, cash generated from operations meaning the sale of oil and related products) minus capital expenditures. If this number remains negative for too long for a company or an industry, it's an indication that something is very wrong.

Only nine of 33 shale oil exploration and production companies reviewed in the report cited above had positive free cash flow for the first half of 2018. This is  even though prices had risen all the way from a low of around $30 in 2016 to the mid-$70 range by the middle of this year.

To get an idea of just how bad it has been even through periods when the price of oil averaged above $100 in 2011, 2012, 2013 and most of 2014, here are the annual free cash flows in dollars of those 33 companies combined since 2010 and they are all negative: -14 billion (2010), -21.9 billion (2011), -37.8 billion (2012), -16.8 billion (2013), -33 billion (2014), -34.4 billion (2015), -18.3 billion (2016), -15.5 billion (2017).

Capital expenditures are what companies invest in future production—in this case, the  acquisition of new oil deposits and the drilling and completion of new wells and associated infrastructure. Because operating cash flow has not been sufficient to cover the drilling of new wells, companies must either issue new debt or new shares to raise money to do so. The former makes companies more likely to go bankrupt if oil prices turn down and the latter dilutes the value of the company for existing shareholders. Either way, it's not good news for investors.

So, maybe you are asking: "Why don't the companies save up enough money to drill new wells before they go prospecting?" The answer lies in understanding the decline rates of existing wells. After three years most shale wells are producing 70 to 90 percent less oil than when they began. (Compare this to the worldwide decline rate for oil production of between 4 and 5 percent per year which over three years comes to between 11 to 14 percent.) The situation has been likened to trying to run up a down escalator. The faster the escalator is going down (well decline rates), the harder it is to make any progress going up (that is, increase production). In order to keep a company's overall production growing, the company must drill continuously or risk declining production which would lead to a vicious cycle of declining cash flows needed to drill new wells. 

To avoid this scenario, such companies seek extra money every year in the form of debt and/or stock issuance in order to fund new drilling. Now here's why this is unworkable in the long run. An example outside the industry will help illustrate the problem: A company engaged in manufacturing might be able to justify negative free cash flow for years as it builds out its manufacturing facilities to make more products in more markets.

After a few years if the strategy works, the company could be well-positioned to dominate its markets and make a handsome profit for investors. Things, of course, don't always work out the way companies want them to. But there is a logic to continuous investment in such a company in the face of negative free cash flow. This is because investors have reason to believe they are building long-term profitability. Factories stick around; they suffer wear and tear but they don't deplete as oil does. And, those who run them tend to get better over time at  making their factories more productive, not less.

The same cannot be said for companies which extract shale oil because of its high decline rate. If operating cash flows are not sufficient to fund capital expenditures relatively soon after the company begins its drilling program, then the company must drill furiously simply to avoid a production decline let alone achieve the production increases which are good for stock prices.

Production increases can actually be achieved for a time with a lot of effort and expenditure. But, here's the problem: As the number of producing wells rises sharply, the number of wells that must be drilled each year JUST TO KEEP PRODUCTION LEVEL RISES SHARPLY AS WELL. At some point, the best most productive places to drill are used up. The company must move on to places that are less productive and so must drill even more wells than it otherwise would have (usually at higher costs) just to keep production level.

The shale oil companies say that technology will solve the problem. But so far, the evidence suggests that the decline curves are getting steeper. Production from new wells is falling faster than before, an indication that companies are already moving away from the best prospects to more marginal deposits. The largest independent oil company operating in the shale oil industry, Pioneer Natural Resources, suffered a decline of 56 percent in the rate of production in 2017 from wells in production at the end of 2016. That means that the company had to replace more than half its production last year with new wells BEFORE it could grow production (which it managed to do).

But as the herculean efforts to grow production face greater and greater decline rates and the need to replace falling production from a larger and larger number of EXISTING wells, it will at some point become impossible to grow production or even to maintain it. The number of new wells which must be drilled will exceed the number of suitable places to drill them and/or the capacity of drilling equipment available.

That's the point at which the jig is up. That moment could be brought forward for companies if the price of oil crashes or if the economy crashes and investment dollars stop flowing to the shale oil companies. If companies cannot finance extensive new drilling continuously, the illusion of success will be shown for what it is.

Meanwhile, top management keeps getting paid bonuses to burn investor cash and consumers get oil for less than the actual long-term cost of production. It's one of those rare instances in which the top 1 percent (and a lot of other suckers) are lured by an incomplete understanding into an investment that subsidizes the lives of the 99 percent.

But don't count on this arrangement lasting far into the future. The day of reckoning is coming. Those who can figure out precisely when or simply get lucky guessing when can make a fortune on the downside by betting against what some have call the shale oil Ponzi scheme. There is a way, however, to profit from any Ponzi scheme if you are already invested in one and you recognize it: Get out before it comes crashing down!

Kurt Cobb is a freelance writer and communications consultant who writes frequently about energy and environment. His work has appeared in The Christian Science Monitor, Resilience, Common Dreams, Le Monde Diplomatique,, OilVoice, TalkMarkets,, Business Insider and many other places. He is the author of an oil-themed novel entitled Prelude and has a widely followed blog called Resource Insights. He is currently a fellow of the Arthur Morgan Institute for Community Solutions. He can be contacted at


Joe said...

Well explained. An additional danger from shale is that after the final top of production, decline in overall shale production is likely to be rapid. This is when relying on shale as the source of all oil production growth will be dangerous to the global economy, especially if demand for oil has not already peaked.

If the day shale production begins to decline is also the day world oil production begins its decline, it will also be the day the world economy begins to decline. The global market economy can avoid recession only by substituting other non-fossil energy sources faster than oil declines. The rapid decline rates of shale will make that process of substitution much more difficult. "Energy trap" effects are exacerbated by high decline rates in fossil fuel availability. Relying on shale will ensure high decline rates at some point.

sv koho said...

Another thought is the nature of most shale oils.Shale oil is very light and yields low amounts of middle distillates like diesel and jet fuel which do the work of the industrial world. Its energy content is significantly less and it needs to be blended with heavy oils to generate a broad spectrum of refinery products and shale oil yields mostly light fuels like gasoline and Lpg.

Anonymous said...

SV koho: Light sweet oil (40-45 API, low sulfur) continues to get a premium price. That premium has SHRUNK. But it is still a premium over heavier, sourer grades. (By the way, it is amusing to look at the peak oil articles from 2005 where authors said there would not be more WTI we have too much!)


As usual, you are a smart guy and there is a lot right here. But I still have to criticize:

1. Part of the reason for negative cash flow is GROWTH IN SIZE. If a company has negative cash flow and is flat in size, that is a huge problem. If they are growing, it MAY be OK. (you have to look at the specifics to determine the MAY.)

2. You are correct that after recent growth, base decline increases (Rystad explains this well). Of course the opposite is also true. In late 2016, the decline in base decline made it easier to grow. However, it is not just an issue of number of wells (as you say) but number of recent wells. A thought experiment (can verify with Excel): if you keep production absolutely flat, drilling just enough to do so, what happens to base decline? The answer is it decreases (meaning less drilling needed with time). This is because you have "more base". So, at same production, number of wells is actually a positive in that it implies having more wells at end of life in their slow decline phase.

P.s. Let's see how long it takes you to delete this. (Can't have a debate...must have like thinkers only in comments.)

Kurt Cobb said...

Anonymous asks us to believe in two things which are not plausible or supported by the evidence: 1) the number of economically viable places to drill in shale deposits is unlimited and so growth can go on indefinitely and 2) shale wells will have decades long production. The first one is demonstrably false if one looks at the maps of where people actually drill which is in narrowly circumscribed sweet spots. If the entire deposit was economical, one would expect far greater dispersion of drilling in order to avoid high acquisition costs. But this is simply not the case. Sooner or later companies will run out of sweet spots and then either the price of crude must rise to justify the drilling (which free cash flows don't even justify at the current price) or the industry must find new techniques that vastly improve efficiency of drilling and extraction. Maybe this will happen, but no one has proposed what new technology will allow it.

As for decades long production of shale wells, since we are only into the first decade of such production, we can't know. But the decline rates are so severe that it seems unlikely that current largely depleted wells will be pumping anything 20 years from now.