Despite rosy forecasts for U.S. crude output this year and next—the EIA sees production hitting almost 10 mbd in 2018—there are some warning signs beginning to emerge in the shale patch, even from what is the hottest and most prized shale basin of all—the Permian Basin. The industry may struggle to ratchet up production as rapidly as many analysts forecast due to a number of unforeseen problems, including sharper-than-expected decline rates.
First, there are bottlenecks for oilfield services, which could lead to a hike in production costs. Second, some signs suggest that the ever-increasing productivity gains for the Permian are starting to stagnate. But perhaps most worrying of all is the potential acceleration of decline rates at some shale wells, an ominous sign that the drilling bonanza in West Texas should not be taken for granted.
Production problems and decline rates
Shale wells typically see their production levels decline rapidly after an initial burst of output. Unlike a conventional oil field, which usually enjoys relatively stable production for years, output from a single shale well can fall off drastically within months. More shale wells need to be drilled just to keep production flat.
In the Permian, the rate of decline has accelerated recently. The decline from legacy wells has grown dramatically in 2017.
In the Permian, the rate of decline has accelerated recently. The decline from legacy wells, which are already in production, has grown dramatically in 2017. In September, according to the EIA, the Permian will see production from legacy wells fall by 158,000 barrels per day (b/d) month-on-month. That means that the shale industry will need to add at least as much new supply just to hold steady. That decline rate is 40 percent larger than a year earlier. Across the top shale basins in the U.S.—the Bakken, Eagle Ford, Haynesville, Marcellus, Niobrara, Permian and Utica—the decline of oil output from legacy wells will have jumped by about 25 percent from September 2016 to around 400,000 b/d for the same month this year, according to the EIA.
To be sure, the higher decline rates are largely a function of more drilling. Legacy decline necessarily grows when drilling activity increases, since there are simply more wells online to contribute to the depletion rate. Because drilling really ramped up over the past year, it is not surprising that the legacy decline has also surged.
Nonetheless, some analysts argue there is more to the sharper decline rates than just a greater number of wells in production. According to Russell Clark of Horseman Capital Management, shale drillers in the Permian Basin are placing wells too close to each other. Such a practice can help shale drillers innovate and cut down on costs, but putting wells too close together can actually undercut production by slicing into well pressure. These “frack hits” are apparently on the rise. “New well production is increasingly cannibalizing legacy production,” Clark wrote in a report, cited by Bloomberg. “The decline rate looks to be accelerating.” Damage to well production by a drop in pressure can be permanent.
In other words, the frenetic pace of drilling in the Permian, to some degree, may be self-defeating. Shale drillers will add more supply in the near-term, but at the expense of longer-term production.
The frenetic pace of drilling in the Permian, to some degree, may be self-defeating. Shale drillers will add more supply in the near-term, but at the expense of longer-term production.
Another sign of recent trouble is companies producing more gas than crude oil. In its second-quarter results, Pioneer Natural Resources, one of the top drillers in the Permian, said that it posted a higher natural gas-to-oil ratio (GOR) than it expected, a development that troubled investors. Oil wells tend to produce relatively more gas as they mature, so the higher GOR was taken as a sign that Pioneer’s wells are performing worse than expected. On top of that, Pioneer reported that it had pressure problems with some “train-wreck” wells, which led to delays, higher costs, and a lower-than-expected production guidance for the rest of the year. Pioneer’s CEO Timothy Dove downplayed the problem, saying it’s a “solved” issue. But investors were not assuaged—the company’s stock price is down roughly 17 percent since it announced its earnings on August 2. Moreover, because Pioneer is considered to be one of the stronger drillers in the Permian, the company’s recent troubles could be a harbinger of deeper problems within the industry.
Investors looking to reallocate capital
The choppy waters that the shale industry has suddenly found itself in have led to a flurry of spending cuts as E&Ps try to reduce risk and steel themselves for $50 oil for the foreseeable future. Market analysts have been trying to discern the price threshold that could slow shale growth, with $50 per barrel emerging as that level.
Even the huge capex reductions as of late have failed to lift oil prices, while also doing very little to boost share prices of shale drillers.
Even the huge capex reductions as of late have failed to lift oil prices, while also doing very little to boost share prices of shale drillers. “It’s a lose-lose. If you produce too much, oil prices will go down and that’s bad. If you produce too little, you’re not growing at the rate we thought and that’s bad,” Shawn Reynolds, portfolio manager at VanEck Global Hard Assets Fund, told the Wall Street Journal. “This market is really, really down on the E&Ps.”
The poor performance of shale companies recently has led investors to consider “re-allocating capital across the sector,” Goldman Sachs said in a research note. The disappointing results from Pioneer Natural Resources and EOG Resources—another highly regarded Permian shale driller—“triggered questions on positioning across well-owned, perceived high-quality Energy companies,” Goldman said. “Many saw the weakness as a sentiment indicator that generalists are still not willing to buy Energy at the index level.” In plain terms, the luster of the U.S. shale industry generally, and the Permian in particular, is starting to wear off.
If the shale industry falls short of production estimates, then the U.S. might not be able to grow production to the expected 9.9 mbd next year. Ultimately, that would be bullish for crude oil prices, as one major center of growth comes up short, leaving the market tighter than it otherwise would have been in 2018.