There Will Be Blood…

Edited by Nicholas Eckart.

Proofread by DT. In contact with Heather.

The shale gas question is brought back to the fore with the new drop in the price of crude oil (WTI and BRENT). In fact, what was abnormal was the pusillanimous increase witnessed in February 2015. Nonetheless, an upward trend will occur as soon as summer 2015, as announced in my previous article from last Jan. 1*. Here is the latest regarding this catastrophe silently raging in the USA. One remembers the movie “There Will Be Blood” and one could add “Yes, It Will.”

The Economics of Shale Oil Production

The production of shale oil obeys a particular set of rules. One of the characteristics of this production is the particular shape of the production curve. The production peak is reached between the first and second month following the startup of the rig. The production volume then decreases very rapidly. In fact, only 25 percent of the production peak is obtainable between 19 months (2010) and 15 months (2013). Here’s a graphic showing the average shale oil production in a 48-month period: number of operating months (X axis) and barrel per day (Y axis).

The production level improved between 2010 and 2014, but maintains the same characteristics. This rapid rig exhaustion demands a rapid renewal of the rigs, and therefore constant investments.

The shale gas industry in the U.S. and Canada is essentially comprised of small companies, where the “American dream” subsists. Nonetheless, the conditions of profitability of these small companies (which manage about 85 percent of the existing rigs) are very different from the big ones (like Exxon), which have also invested in this sector. If the break-even point of some Exxon rigs is $45/barrel, the break-even point of the smaller companies is a lot higher and estimated between $70 and $75.

The latter are financed through highly leveraged bank loans. As soon as they purchase a dealership, they ask for a bank loan that can cover between 90 and 95 percent of the needed investment. Repayments are covered by the production brought during the first year by the oil rig in service, where the yield is highest. Nonetheless, this implies guaranteeing the price. In fact, by including the interests, a company earned money as long as oil prices were above $80/barrel. The insurances taken by the aforementioned companies insured them for a price between $80 and $90. Nonetheless, these insurances only cover up to six months of production, and they have not been renewed since October 2014, when facing a plummeting oil price. It means that they will not be covered beginning at the end of March 2015.

From April, only the big companies will be able to sell with an oil price (WTI index in the U.S.) between $43 and $45 per barrel. This implies a collapse in investments, ergo new oil rigs, and ultimately the end of oil production in the U.S. Indeed, almost half of the oil produced in the U.S. comes from shale gas.

The Collapse of Investment and Production

Factually, the collapse of investments is taking place. The number of rigs is now diminishing very rapidly. It means that old rigs (ending their lifecycle) are being taken off the market and that new rigs are not replacing them. The fall started mid-December 2014.

See Graphic 2: Number of Rigs using Rotary Drill bits in the U.S. and Canada Graphic 2

Besides, we can see that this fall, very abrupt since the beginning of 2015, hurts Canadian production even more than their American counterpart. We had 430 rigs in Canada in October 2010 and about 200 in March 2015. In fact, compared to mid-August 2014, when the fall in prices started to amplify, the depletion of rigs reached 41 percent in the U.S. The most affected shale fields are in Texas and also the Dakotas. (Table 1: Number of Rigs using Rotary Drill Bits –**

The difference between mid-August 2014 and mid-March 2015 is spectacular, since it dwells on the disappearance of 788 rigs out of an initial total of 1,913 for the U.S. The Texan case, with its large shale field exploitation areas, is an archetype of this general phenomenon. Nonetheless, it must be noted that it is in Texas that big companies’ dependent rigs dwell. Nevertheless, the depletion rate there is higher than anywhere else in the U.S. with 44 percent.

This is Graphic 3: Evolution of Rigs in Texas Since September 2013 Graphic 3

Therefore, a considerable shrinkage can be witnessed and will be likely to carry on in the following months — notwithstanding a slower speed. From this vantage point, we can indeed say, like the hero in the movie, and thinking about the consequences of the shrinkage of rigs: “there will be blood” …

Consequences for US Industry and the Economy

The consequences of this shrinkage have to be evaluated. First, the matter of price. On this point, there is overproduction (excess supply). Nonetheless, this does not necessarily translate into an available excess supply. The theoretical supply can be blocked by conflict (Libya, Iraq, etc. …). This is what explains the timid rebound of the price per barrel by the end of February. Nonetheless, in order to substantiate a real upward trend, American and Canadian production has to stabilize and start to decrease. Previsions show, on the basis of rigs evolution, that it will occur around May-June (for the stabilization phase) and around July-September (for the decreasing phase). The impact on price should be substantial and the barrel, WTI index, should go back up close to U.S. $70 beginning around November. Nonetheless, let’s denote several uncertainties:

• How fast will the price go back up?

• How will the market react to an upward trend?

We cannot completely rule out a strong rebound (around U.S. $85) followed by a correction (around U.S. $65) linked to the liquidation of currently existing important stocks, before stabilizing around U.S. $70. Nonetheless, the price should stabilize on average to 50 percent above its current price in mid-March 2015.

The financial consequences of the current evolutions must be taken into account. A lot of small companies will be unable to service their debts or even declare bankruptcy. Regarding the debts (between U.S. $250 and $400 billion, including the outsourcing related debts), banks will be forced to reclassify them as “non-performing loans” or write them off. This shockwave is manageable for the U.S. banking system, but it is important. The dollar would suffer from it and would lose value once again starting July-September 2015. Subsequently, the Fed should postpone its rate increase for a period of three to six months. The Euro-USD exchange rate should go back up to 1 Euro to U.S. $1.15, unless the ECB intensifies its interventions.

Two central mechanisms will testify to the impact on U.S. economic activities: first, the increase (though limited) of the price of oil; second, and more importantly, the end of the shale industry bonanza. The first mechanism will impact growth since, on the one hand, fuel prices are not as dependent on taxes as they are in Europe and, on the other hand, oil companies rapidly adjust to a large increase or decrease in the price of oil. The second mechanism is even more important. The profit generated by the shale gas industry largely irrigates the U.S. economy, on the basis of the volume of activity given to outsourcing companies and the income raises given to a portion of the population that entailed a strong expansion of services. These two mechanisms had a considerable impact on U.S. activity for four years. Yet, if (as anticipated) the shale gas industry collapses, and the price of oil starts to go back up, a considerable deceleration can be expected in the U.S. (and Canada), starting the second quarter of 2015.

Besides, this will entail the restructuring of the shale industry, with the empowerment of big companies, to the detriment of small producers. This restructuring could lead to a reshuffle of the economic norms ruling oil production, since big companies have the means of bringing top-notch technologies to this sector.

The Consequences on the Rest of the World (Eurozone and Russia)

This situation leads us to investigate the two zones likely to be affected by the consequences of the fluctuating oil price and by the economic activity of the U.S., the Eurozone and Russia. The Eurozone is linked to the U.S., first because to this day, the latter is still an important exporting market for countries such as Germany and Italy. From this vantage point, the high likelihood of an important deceleration of U.S. activity is bad news. Moreover, it is obvious that the current mid-March situation, where the Eurozone is today sugar-coated by a depreciation of the euro and a considerable drop in oil prices, will not carry on throughout the second quarter of 2015, with the expected consequences on economic activity. These different parameters hint that the latter would slow down by the end of the year, yet it is still impossible to tell if this deceleration will be visible as soon as the fourth quarter of 2015 or the first quarter of 2016. In total, it not impossible that the shale gas industry crisis will entail a loss ranging from 0.3 percent to 0.5 percent of the aggregated GDP growth for the Eurozone. This deceleration should affect Germany, but also countries such as Italy and Spain, which are heavily dependent on imported hydrocarbons.

For Russia, an oil value rebound (close to USD $75 for the BRENT) will translate as a stability regain on the exchange rate — 40 Ruble to $1 USD. With regard to the speculative pressures that will surely carry on for many reasons, the effective rate should be comprised between 52-35 rubles to $1 USD. We can assume that Russia wants to stabilize the ruble between 45-50 rubles to $1 USD if it wants to remain competitive industry-wise. Nonetheless, a 20 percent appreciation in the exchange rate market is to be expected by the end of the year. It should have a beneficial effect on inflation while allowing production to spike rapidly. In this scenario, 2015 will end up with a -1.5 percent recession (and not -4 percent as announced in January), and 2016 could be graced with growth ranging from 1.5 percent to 2.5 percent.

*Translator’s Note: This is the link to the abovementioned article –

**Translator’s Note: This link leads to the original page. Scroll down to see the table.

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