The future of fracking

Harold Hamm, CEO of Continental Resources, recently had these words of advice for fellow American shale producers: “Save that money. Avoid selling that production in this poor market and wait for service costs to fall [further] before completing those wells.” Whether this is wishful thinking on his part or an attempt to coordinate the industry along his own lines, the question remains whether hydraulic fracturing, or “fracking,” companies will listen.

Production from U.S. shale oil hit its peak in December 2014, but then dropped 3% in January. Small- and medium-sized fracking companies in “Cowboyistan,” to borrow Hamm’s term, are saving money, mostly by cutting personnel expenses and resisting finishing new wells,  a process that accounts for 60% of drilling costs. But American producers are not capping existing wells, are continuing to pump oil from existing wells and are selling it at whatever price they can get. 

Hamm wants American shale oil companies to decrease production in a joint effort he says will usher in a period of higher prices and herald another shale boom. The problem is, most shale oil producers are not Continental Resources. 

Continental, despite taking a $7 billion hit when crude oil prices dropped, has a solid credit rating. Most of the companies involved in shale oil production have little or no cash reserves.  They are highly leveraged and need to pump whatever oil they can when they can, and collect as much revenue as possible simply to survive.

But if the future of American shale oil production is not as Harold Hamm proposes, then where is it headed? What can investors expect from the shale fracking industry?

The answer hinges on the price of oil. If oil prices have indeed bottomed out, then even heavily leveraged companies soon will be able to accelerate production once again. If Saudi Arabia reverses its policy and cuts production, if global demand for oil increases significantly, or if speculation raises oil prices, this scenario is possible. (Gasoline prices typically experience a temporary jump in the spring when U.S. refineries go offline to switch from “winter” gasoline to “summer gasoline” production, but this can offer only a transient reprieve.)

If oil prices remain stable or continue to drop, the shale oil industry will likely undergo a process of collapse and consolidation. Larger, financially stable companies like Continental Resources will survive and continue to produce oil. Heavily leveraged companies, however, will find themselves forced to sell assets, put themselves on the market or enter bankruptcy.

When the banks and other creditors take control of these assets, most will not aggressively exploit the resources themselves. Instead, they will search for buyers or hold the assets until values rise--then they might sell. Already, Dune Energy, BPZ Resources Inc., Endeavor International Corp., Cal Dive International Inc. and Gasfrac Energy Services Inc. have filed for bankruptcy, and Quicksilver Resources Inc. is likely to follow. Asset auctions are coming.

Even larger, seemingly more stable companies are feeling the crunch. Whiting Petroleum, the largest operator in North Dakota, has $5.63 billion in debt in part due to its poorly timed purchase of Kodiak Oil & Gas last December. J.P. Morgan has shopped Whiting to interested customers, and Exxon Mobil, Statoil and Harold Hamm’s Continental all were rumored potential buyers. 

If Continental purchases Whiting, Hamm would certainly come a little closer to the kind of control he needs to temporarily halt U.S. shale production. But if Exxon Mobil, Statoil or any other company decides to acquire Whiting, it will determine whether or not to produce based on its own optimization of resources. EOG Resources is another large shale producer rumored to be on the market, and seems to be drawing attention from Statoil. A company like Exxon Mobil or Statoil acquires assets for the long term, whereas small shale operators barely can see beyond next month’s payroll. 

Exxon Mobil has yet to seriously enter the shale arena. Even after acquiring XTO Energy in 2010, it operates only 45 wells in major shale regions. The company’s strategy, described by CEO Rex Tillerson, always has been long-term. Rather than jump in immediately, Exxon looked to improve its shale drilling technology, and, according to the company, has succeeded in cutting those costs by around 25%. Exxon is now poised to grow its shale resources, perhaps significantly. Acquiring Whiting Petroleum or EOG Resources at this juncture might be the perfect way to do so.  Or Exxon might find a better deal as oil prices continue their slump and more fracking companies struggle.

Large companies like Exxon Mobil, BP, Chevron, Statoil and Saudi Arabian  oil company Aramco are positioned to purchase these assets. Exxon Mobil recently raised $8 billion in bond sales, Saudi Aramco reached an agreement on a $10 billion loan, and Statoil is freeing up cash by delaying development on an expensive and complicated Arctic Circle asset. Saudi Aramco has gone so far as to advertise job openings to American petroleum engineers with shale oil experience. 

These major producers may decide to utilize the shale assets they purchase immediately, even while cutting back on large-scale projects elsewhere in the world. Or they may choose to idle the wells for as long as regulations permit. They will do what is best for them based on the optimization models of their own engineers.

The U.S. shale industry is not a cartel, and what is good for Continental is not necessarily optimal for all companies operating in U.S. shale regions. Each company is accountable to its own shareholders and each seeks its own success.

U.S. shale can never exercise the kind of swing control over the oil market that Saudi Arabia still does because it lacks centralized decision-making. Even as we witness industry consolidation in 2015, this kind of coordination is fanciful in the United States and only possible in a cartel. The oilman, as an entrepreneur, may aspire to someday unseat the oil king in Arabia; the investor must understand that the U.S. shale industry is not a monopoly but a patchwork of companies, each with their own CEOs, investors, and long-term and short-goals that they optimize according to their own best interests. 

What we are seeing is similar to a “tragedy of the commons,” in which each producer continues to frack as much as it possibly can. It might be best for the long-term success of the industry as a whole to collectively decrease production in hopes of raising oil prices--but that is not a risk most shale producers can afford to take.