The Dangerous Economics of Shale Oil

Note: The tables in this article have been updated since its initial publishing.

For years, we’ve been warning here at PeakProsperity.com that the economics of the US ‘shale revolution’ were suspect. Namely, that they’ve only been made possible by the new era of ‘expensive’ oil (an average oil price of between $80-$100 per barrel). We’ve argued that many players in the shale industry simply wouldn’t be able to operate profitably at lower prices.

Well, with oil prices now suddenly sub-$60 per barrel, we’re about to find out.

Using the traditional corporate income statement, it is difficult to determine if shale drilling companies make money. There are a lot of moving parts, some deliberate obfuscation at some companies, and the massive decline rates make analysis difficult – since so much of reported profitability depends on assumptions made regarding depreciation and depletion.

So, can shale oil be profitable? If so, at what price? And under what conditions?

I try to deconstruct all this here.

Technology

A shale well consists of a vertical shaft that drives down into the earth to get to the right geological layer where the oil is located. Then the shaft bends 90 degrees, and extends horizontally 5000-10000 feet. It is in the horizontal section where the magic takes place. At intervals along the horizontal section, the “frac stages” happen, each of which fracture the surrounding rock to release the oil locked inside the rock.

Constructing a shale well happens in two stages. First both the vertical and horizontal sections of the well are drilled, and that costs around $4 million taking perhaps 20 days. Then, the well is “completed” – this is where the frac stages are placed. Each frac stage costs around $70k, and there are often 20-30 frac stages per well. The entire completion process costs around $4M. Once completed, the well starts producing oil and gas.

The initial production (IP) of a new well is a critical number for estimating the total amount of oil likely to be produced over the lifetime of the well (“Estimated Ultimate Recovery” = EUR), along with the expected decline rate. While the EUR is a theoretical number and assumes a recovery time of 10-30 years, from a practical standpoint, companies need to recoup the costs of drilling the well within 3 years.