BRADLEY OLSON and REBECCA PENTY
VIENNA, Austria (Bloomberg) -- The refusal of Saudi Arabia and its OPEC allies to curb crude oil output in the face of plummeting prices has set the energy world on a painful course that will leave the weakest behind, from governments to U.S. wildcatters.
A grand experiment has begun, one in which the cartel of producing nations -- sometimes called the central bank of oil -- is leaving the market to decide who is strongest and how to cut as much as 2 MMbopd of surplus supply.
Oil patch executives including billionaire Harold Hamm have vowed to drill on, asserting they can profit well below $70/bbl, with output unlikely to fall for at least a year. Marginal producers in less profitable U.S. shale areas, as well as countries from Iran to Russia and operations from Canada to Norway will see the knife sooner, according to analyses by Wells Fargo & Co., IHS Inc. and ITG Investment Research.
“We’re in a very nerve-wracking environment right now and will be for probably the next couple of years,” Jamie Webster, senior director for global crude markets at IHS said Nov. 28 in a phone interview. “This is a different game. This isn’t just about additional barrels, this is about barrels that are going to keep coming and keep coming.”
Investors punished oil producers, as Hamm’s Continental Resources Inc. fell 20%, the most in six years, amid a swift fall in crude to below $70 for the first time since 2010. Exxon Mobil Corp. fell 4.2% to close at $90.54 in New York. Talisman Energy Inc., based in Calgary, was down 1.8% at 3:00 p.m. in Toronto after dropping 14% on Nov. 27.
A production cut by the 12-member Organization of Petroleum Exporting Countries would have been the quickest way to tighten the world’s oil supplies and boost prices. In the U.S., supply is expected either to remain flat or rise by almost 1 MMbopd next year, according to the Paris-based International Energy Agency and ITG.
That’s because only about 4% of shale production needs $80 or more to be profitable. Most drilling in the Bakken formation, one of the main drivers of shale oil output, returns cash at or below $42/bbl, the IEA estimates.
Many expect reductions to U.S. output to occur slowly because of a backlog of wells that have already been drilled and aren’t yet producing, and financial cushioning from the practice of hedging, in which producers locked in higher prices to protect against market volatility, according to an Oct. 20 analysis by Citigroup Inc.
With a sustained price drop to $60/bbl, shale drilling would face significant challenges, according to Citigroup and ITG, especially in emerging fields in Ohio and Louisiana, where producers have less practice. ITG estimates it will take six months before lower prices slow production growth from U.S. shale, which is responsible for propelling the country’s production to the highest in more than three decades.
“It’s going to be very producer-specific,” said Judith Dwarkin, chief energy economist at ITG in Calgary. “Companies have to revise their budgets, then you see the laying down of rigs, then you see the fewer wells being drilled, then you see the natural decline rates starting to have more of an effect.”
Drilling in Western Canada may drop by 15% in 2015, according to a report by Patricia Mohr, an economist at Bank of Nova Scotia in Toronto.
The market pressure will hit shale companies in different ways. Many have spent years honing their operations to pull the most oil out of every well at the lowest cost, a process that can be as much art as science at the nexus of geology, engineering and infrastructure. That experience means some producers, such as EOG Resources Inc. and ConocoPhillips, can turn a profit at $50/bbl.
Those companies will now capitalize on that expertise to keep drilling wells, and so far have even promised to boost production.
The idea that lower prices will pressure shale producers to produce less oil is “a fundamental error,” said Paul Stevens, a distinguished fellow at Chatham House in London. Such thinking has focused on how much it costs to drill new wells in new fields, ’’ he said. “But what really matters is the price at which it is no longer economic to produce from existing fields, and that is very much lower.”
Some companies won’t be as fortunate, especially smaller operators that rely heavily on debt and are focused on new areas, where the most efficient production techniques are in the early stages of being understood. Such producers have for years outspent cash flow to develop properties that could pay off big in the future.
Goodrich Petroleum Corp. is one example. With a market capitalization of just $269 million, the upstart producer is developing a prospect in Louisiana and Mississippi that one rival called possibly one of the last great opportunities in North America. But drillers in the Tuscaloosa Marine Shale need oil prices at about $79.52/bbl, according to Bloomberg New Energy Finance. Goodrich fell 34% to 6.05, the most ever.
Wells drilled by Hess Corp. in Ohio’s Utica formation, which has yet to produce significant volumes and is held in high esteem by many in the industry, also require nearly $80/bbl for profitability, according to Citigroup.
The punishment wasn’t limited to shale. The day’s worst performing oil producer was offshore specialist Energy XXI Ltd., which has its principal office in Houston. It lost a record 37% of its value, falling to $4.01.
With cash flow shrinking from lower prices, the company may not be able to reduce debt until the market rebounds, Iberia Capital Partners analyst David Amoss, based in New Orleans, wrote in a note cutting his rating to hold from buy. As of Sept. 30, Energy XXI reported net debt of $3.7 billion.
Plunging oil markets already have begun to pressure governments that rely on higher prices to finance their budgets, fuel subsidies to citizens and expand drilling. Venezuela’s oil income has fallen by 35%, President Nicolas Maduro said on state television Nov. 19.
Nigeria increased interest rates for the first time in three years on Nov. 26 and devalued its currency. The government is planning to cut spending by 6% next year, Finance Minister Ngozi Okonjo-Iweala said Nov. 16. Both Nigeria and Venezuela are part of OPEC.
Saudi Arabia has enough cash stockpiled to finance its budget for more than 20 years at an oil price of $80/bbl, according to an Oct. 16 analysis from CIBC World Markets Corp. Russia has about six years of financial reserves at that price, but Iraq, Nigeria and Iran all have less than two years. Venezuela has less than six months, based on the analysis.
Several countries within OPEC such as Iran, Iraq, Nigeria and Venezuela, as well as non-OPEC states such as Russia, Canada and Norway, “will end up being the real victims of lower oil prices in 2015 and beyond,” Roger Read, an analyst at Wells Fargo, said in a note to investors. The countries “are unlikely to be able to maintain their production trends in the face of today’s oil price declines.”
“It’s pretty clear to me that the Saudis are no longer interested in being the world’s central banker for oil,” said John Stephenson, who manages C$50 million ($44 million) at Toronto-based Stephenson & Co. as CEO. “It’s going to be ugly.”