What now for the oil price?

'The internet will soon go supernova and, in 1996, it will catastrophically collapse', proclaimed Robert Metcalfe in 1995. Metcalfe was no fool. As the inventor of the Ethernet, he was an early internet pioneer and part of the intellectual establishment. His ludicrous prediction tells us two things about prognostication.

Firstly, the worst predictions don't come from lunatics on the fringe; they are announced by experts and accepted by insiders. Secondly, predictions should be made sparingly and with humility.

We note the above as we embark on a prediction of our own. Oil prices have sunk 40% in a matter of weeks and the share price of energy producers has tumbled. Before we can assess whether those stocks are good value now, we must establish a view on the oil price. Are today's prices simply a short term tumble or is this the end of the great oil price boom?

While the speed and ferocity of the price fall has surprised (see Chart 1), the causes of the decline are classic. Too much supply is chasing too little demand.

It's supply, stupid

As oil bears point out, oil demand from the OECD (a club of rich countries) has fallen seven years in a row. Yet this is more than offset by growth in developing economies. In aggregate, oil consumption has been growing – albeit slowly – at about 1.5% per year. The world now consumes more than 90m barrels of oil a day.

Demand, although not strong, isn't to blame for lower prices. For that, we turn to the supply side. American oil production, in decline since the 1970s, has almost doubled in the past few years to 9m barrels per day. Shale producers have drilled more than 20,000 wells in the past five years, more than 10 times the level of Saudi Arabia. As a result, about 90% of the worlds additional output has come from America, almost all of that from shale basins (see Chart 2).

Whether the oil price remains at today's lows depends on the sustainability of the American shale revolution. Our prediction on oil depends on the predicament of shale.

Shale shock

Shale production involves different economics to conventional production because initial output is high but falls away quickly. Whereas conventional reservoirs will decline steadily about 5-6% per year, shale production can fall 60-70% in the first year before tailing off more gradually. Maintaining production requires continuously drilling new wells.

To illustrate the different production characteristics, imagine production of 1m barrels of oil a day. To extract this volume from a conventional reservoir would require a producer to sink perhaps 50 wells in total. That same volume from shale would require about 2,000 wells. Sustaining the shale revolution requires copious amounts of cash and constant drilling. There are two threats to production: lower oil prices and access to cash. Let's take each in turn.

Lower prices hurt

Two years ago, we estimated that the marginal cost of shale production required prices of about US$90 a barrel (see Is there still a case for oil?). That number needs updating because drillers are getting more productive and lowering costs.

In the Permian Basin, drillers increased output per rig by 20% last year by tweaking their method. Productivity per well in the Eagle Ford Shale is similarly up 20% as drillers get better at their art. Production costs in the best basins can be as low as US$30 and, in less productive ones, as high as US$90.

Wood Mackenzie, a consultancy, estimates that the median shale producer requires an oil price of US$75 to break even. Over time, we should expect supply to adjust to around US$80 (higher than the breakeven price to allow a rate of return) but there are reasons why production might lag prices.

Tens of thousands of previously drilled wells are still producing declining amounts of oil and, because capital has already been sunk, they incur almost no cost. A long tail of existing capacity will continue to flow and could keep prices down for a while.

Many producers also use futures and derivatives to hedge prices so prices may not immediately impact output. Pioneer Natural Resources, for example, has 65% of its output hedged at US$85 so is under no pressure to adjust volumes.

These are merely lags that delay an inevitable supply response. If oil prices stay low, output will fall. Wood Mackenzie suggests that, at prices of US$60, investment would fall by 50%. Since maintaining output requires additional wells to be drilled, falling investment is sure to lower output.

This has already begun. The number of rigs drilling the most productive shale areas – the Bakken and Permian basins – has fallen by 10% in a month. Applications to drill in the Bakken and Eagle Ford shale have fallen 30% and capital expenditure budgets are now been slashed.

These are early signs that shale output is adjusting to lower prices and we expect to see less drilling activity lead to lower output over time.

The cash crutch

While the shale revolution was born because of specific technical breakthroughs, it has thrived because of zero interest rates, easy credit and enthusiastic investors.

Last year, shales accounted for 20% of global investment in the oil industry despite accounting for less than 5% of output. In aggregate, hundreds of billions of dollars have been spent increasing shale output over the past decade yet few (we're aware of none) producers generate free cash flow.

Shale producers have accumulated enormous levels of debt. Debt for listed US producers stands at a quarter of a trillion dollars (see Chart 3) and producers rely on bond markets to fund production growth.

Prices of about US$90 are needed to allow the median US shale producer to cover their capital expenditure from cash flow. At lower oil prices, output is at risk from the whims of banks and bond markets.

Hail, shale

Earlier this year in Siberia, the single most expensive hole ever sunk was completed. It cost US$700m and took two months to drill. A shale producer with $2m and a drill on the back of a truck could start producing oil in a matter of days. The world's incremental supply of oil is likely to come from shale rather than capital intensive deepwater wells.

Bulls and bears need to adjust their expectations. If shale is the source of marginal supply, prices above US$80 will be met with new output.  The opposite is true today. Prices at US$60 will, in time, force out production. Too many firms are making too little money for prices to be sustained at current levels.