The Short Cycle Advantage Of Shale

The Shale Revolution has transformed America’s energy security, with global implications. It has wrested the steady decline of crude oil and natural gas production such that we’ve moved to a net exporter of natural gas and are likely to be the world’s biggest oil producer by 2019.

The U.S. is virtually the only shale producer because it’s the only country that combines the many critical inputs, which include: the right geology; existing infrastructure; skilled labor force; adequate fresh water; access to capital; technological expertise; perhaps most importantly, privately owned mineral rights, a uniquely American concept that minimizes taxes on production and facilitates deals between landowners and drillers.

But shale has another important advantage, which makes it less risky than conventional projects: it’s short cycle, meaning a driller’s investment gets repaid more quickly.

To appreciate how much this has changed the oil business, consider the evaluation of a conventional project. Through the exploration stage wells are drilled and, based on these and other geological tests, production begins. These projects are big. In 2009, the average conventional project (defined as targeting at least 50 million barrels of oil equivalent) was $9.3BN.

Investing that large a sum and recouping it through production can take a decade or more. The many uncertainties affecting the ultimate return on investment extend beyond project-specific factors, such as how much oil will be extracted and the long term costs of production. Global GDP and oil pricing also require careful consideration. The result is a wide range of possible outcomes, some of which (such as the oil price) cannot be hedged. It’s what has made the Exploration and Production (E&P) business so cyclical, and leads to high required returns on investment.

Shale turns this on its head. The exploration stage is mostly limited to acquiring contiguous drilling leases to enable longer laterals. Wells can be drilled for generally under $10 million, and the resulting oil comes out at high pressure with a fast decline rate. The result is that capital invested in shale can be recouped over a much shorter period of time. This greatly reduces the uncertainty around the ultimate return, because most production will occur within the two year timeframe of the futures market, allowing it to be hedged.

If oil drops, shale producers can moderate their production. What can’t be profitably hedged stays in the ground, waiting for a better market. A $9BN conventional project that slows production further delays its return on capital, harming returns.

Consider how this difference in time frame is affected by Electric Vehicles (EVs). A conventional project with 10-20 years of production needs to assess how EVs might alter demand for gasoline. Improvements in battery technology and range before recharging need to be compared with greater fuel efficiency for the modern internal combustion engine. Because the development path of EVs is uncertain, it’s fair to say that conventional oil projects face even greater uncertainty than in the past. It’s probably why the average major project has fallen from $9.3BN to $2.2BN this year.

Short-cycle, or small projects include brownfield investments in existing plays, but shale remains the dominant type. EV development plays a much smaller role in decision making, because the timeframes are far shorter.

The uncertainty is driving capital towards smaller, short cycle projects. Exxon Mobil expects to quadruple its shale output over the next five years. We think EVs are a positive development for shale; by impeding competing, conventional projects they’ll limit new supply and drive oil higher. The world needs 4-6 million barrels of oil a day in new supply to offset the combination of rising demand and depletion of existing plays. U.S. shale production will grow, but not at that level. The uncertainty means conventional projects that would have been profitable won’t get done.

Elon Musk may not have intended it, but Tesla is the Shale Revolution’s friend.