It's no secret that global oil prices have fallen dramatically from $115 last June to settle around $50 this month, a downward trajectory spurred on by oil cartel OPEC's November decision to maintain its own output. But is this the beginning of the end of the U.S. shale revolution, or just a bump in the road?
Unless oil prices drop more dramatically, the evidence suggests the latter. But given the importance of the shale revolution to the American economic recovery, and to America's sense of resurging geopolitical power, it could be a painful bump.
The unexpected collapse in oil prices over the last six months is helping Americans feel richer when they drive out of the gas station. But they are unsure whether to rejoice or lament, given the increasing contribution the oil and gas industry has been making to their economy in recent years.
Production figures show that the U.S. rig count — a good indication of production activity — had been stable up until December. This is because it takes time for price swings to work their way through to supply.
Established rigs are not being mothballed. Heavy costs are sunk into oil and gas projects, and shutting down a well can cost thousands. But the costs required to keep a rig producing are relatively low.
Instead, it is the reported fall in permit applications — a precursor to falls in the rig count — that is more revealing. Drillers have been adopting a "wait and see" approach as they assess the new price environment.
Indeed, the latest reports from oil services company Baker Hughes suggest that rig count is now beginning to drop off more sharply as we move into 2015, falling by 61 in the week ending Jan. 9, the biggest decline in the U.S. rig count since March 2009.
No one saw this year's developments coming. Following failure after failure, traders have stopped trying to second guess oil price movements. However OPEC's decision in November to abandon its role as price stabilizer on the global market suggests we can expect a low oil price scenario to continue for some time.
What we are seeing is no temporary dip amid volatile economic times, as was the case with the 2009 plunge to $35 per barrel, but a structural change in global supply-and-demand dynamics that does not look like changing through 2015. The International Energy Agency (IEA) has cut its outlook for global oil demand growth for 2015 on the back of weakened demand in both developed economies like the U.S. and emerging ones like China and India.
The million-dollar question is: What is the break-even oil price at which U.S. oil producers can still make money? Production costs for shale are higher than for conventional projects, and a flurry of estimates for this breaking point in the media range from $80 right down to $30 per barrel, a process described by Edward Lotterman as the "fallacy of false precision."
Most put it around the $60 mark, but the reality is there is no single break-even price for shale, as is easier for conventional industries like those in Russia or Mexico. Each shale formation is different, and there are significant regional variations, with Bakken wells being particularly costly. There is also a big difference between new and existing wells.
And the picture is not always clear. The shortfall in pipeline infrastructure for many shale projects to transport the crude to markets obliges many shale producers to sell their oil heavily underpriced, resulting in negative economics predating the oil price drop.
Crucially, these operating costs are not stable. Costs have already been falling as the new technologies that underpin the shale boom become more advanced.
According to consultancy IHS, the average shale project in October required $57 a barrel to break even, compared with $70 during summer of 2013. Global price movements are outside the control of energy companies in the U.S., but technological innovation — the same unexpected phenomenon that allowed the shale revolution to take off in the first place — may now be key to their survival.
The U.S. prides itself on innovation, a characteristic which arguably distinguishes the country from its oil and gas rivals in less entrepreneurial countries. This time new technologies will be targeted at cost-cutting and efficiency as the shale boom enters its next phase.
Now we are seeing further downward pressure on costs as the industry readjusts to the new circumstances — as premiums for services are eliminated and service companies are hit with more demanding clients.
I do not wish to play down the realities of oil at $50 and below. In many ways the good times are over, and some weaker, highly leveraged companies are likely to go bust.
However, this will leave the stronger, more resilient players (and the innovators) competing in a stronger market. The shale industry as a whole is not on the edge of bankruptcy, even if these price levels are sustained for several years.
There is a high degree of uncertainty, and we must not forget what is at stake here. Even if U.S. production levels remain flat rather than falling, these readjustments will come on the back of a six-year period in which breakneck oil production has shot from 5 million to 9 million barrels per day, underpinning the American recovery.
Given the complacent expectation until now of further production rises — and the job and wealth creation that accompanies them — this "new normal" will be difficult to swallow. America's best hope is that technological innovation will save the day again.
