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Major slowdown expected in U.S. shale oil production

Drilling rigs work on wells at a pad in the Permian Basin southeast of Carlsbad. Desert scrub has been cleared off surrounding well pads in preparation for more drilling. (Eddie Moore/ Albuquerque Journal)

Last in a five-part series: Behind the Boom

Copyright © 2019 Albuquerque Journal

The shale-oil tsunami that has flooded New Mexico with a wave of petro dollars in recent years may be receding somewhat as U.S. production faces its first significant decline since the gushers began nearly eight years ago.

Signs of trouble are showing up in major basins around the country, with a significant drop in drilling rig activity and sluggish growth this year compared with the spectacular bursts of production in recent years that has transformed the U.S. into the world’s No. 1 oil producer.

A new report released in November by global research and consulting firm IHS Markit says the U.S. is headed for a “major slowdown,” reflecting today’s moderate oil prices, investor reluctance to continue pumping huge sums into companies that have shown only modest returns on capital, and significant productivity declines in shale-oil fields.

That poses substantial challenges going forward.

But a prolonged bust is unlikely, and New Mexico may be less affected than other places. That’s because the Permian Basin in West Texas and southeastern New Mexico remains at the forefront of the shale revolution, thanks to its rich resources, low production costs and the huge gushers that flow from wells drilled there.

As a result, New Mexico is well-positioned to navigate through the current headwinds, said Raoul LeBlanc, IHS Markit’s vice president for North American unconventionals.

“The Permian has an inventory of highly productive wells yet to be drilled that will last many years,” LeBlanc told the Journal. “New Mexico is in a really good spot. It’s proven extremely productive compared with anywhere else.”

Many companies are cutting back on investments in less lucrative zones to refocus on their most productive assets. That bodes well for New Mexico’s side of the Permian, where operators can still tap into rich, productive pools of hydrocarbons at lower cost than in other places.

In fact, those advantages have attracted some of the biggest players in the oil industry to New Mexico, such as ExxonMobil and Chevron. And that, in turn, means investment and production will continue to grow here in the short, medium and long term, because those deep-pocketed companies have the resources to sustain and expand activities even as smaller, cash-strapped firms pull back, LeBlanc said.

“New Mexico is one of the few places that will continue to have net investment,” LeBlanc said. “It’s still pulling in a lot of cash because of companies like Exxon and Occidental Petroleum that have big balance sheets and that continue to grow their activities. New Mexico should be a relative winner in the overall pullback.”

Indeed, New Mexico is on track for another record year in oil production. The New Mexico Oil and Gas Association projects more than 300 million barrels this year, up from 249 million last year and 173 million in 2017. That’s based on the latest state Oil Conservation Division tallies, which show a 36% jump in production from January to September compared with the same period last year.

New Mexico had 104 active drilling rigs as of Nov. 22, virtually unchanged from the start of the year.

In contrast, the nationwide rig count has dropped by more than 200 rigs since January. And that drop in drilling activity is beginning to affect oil field service companies. In October, for example, Halliburton laid off 650 workers in four states, and the company, which reported a significant drop in profits, said it would cut spending by $300 million in coming months.

Anticipating slowdown

Despite New Mexico’s resilience, local officials say some of the turmoil is spilling over into the state’s oil patch.

“I’m anticipating an industry correction, which could well result in a decline in drilling rigs here,” said state Rep. Larry Scott, R-Hobbs, owner of Lynx Petroleum. “As drilling slows down, I expect a commensurate drop in state revenue.”

If New Mexico activity is slowing, it won’t show up in state production and revenue numbers for another few months. But anecdotal evidence points to a downturn, Scott said.

“We’re seeing a lot of equipment being brought back to the yards, and we’re hearing about layoffs at some service companies,” Scott said. “We’ll see which way things go over the next six months.”

Given the signs of industry trouble, state officials are cautious about production forecasts, said Sen. John Arthur Smith, a Deming Democrat and chairman of the Legislative Finance Committee.

“There are red flags,” Smith said. “Production will likely be less than we thought going forward.”

In fact, this week the state released new revenue figures that estimated $797 million in “new” money available in the coming year, down from an August projection of $907 million.

A number of factors account for the slowdown, beginning with prices, which remain in the range of $50 a barrel, just a few dollars above the break-even point for most companies. And there’s little prospect for improvement because of world oversupply – largely fueled by surging U.S. shale oil production in recent years – plus sluggish global economic growth that’s lowered market demand.

If not for the Organization of Petroleum Exporting Countries’ ongoing agreement to collectively withhold 2 million barrels a day from the market, prices would be much lower, longtime industry expert Daniel Fine said.

“Supply remains in glut conditions worldwide,” Fine said. “The OPEC agreement is the key reason why prices haven’t crashed.”

Decreasing output

Rapid drops in output from newly drilled shale-oil wells are also a major problem. The shale revolution is based on the modern technologies of hydraulic fracturing and horizontal drilling to crack open tight shale rock formations, releasing a spurt of trapped hydrocarbons that operators couldn’t reach before with conventional drilling methods.

But those wells tend to produce a burst of initial production, followed by rapid declines of up to 70% or more over the first year of operation. To keep production up, companies drill additional wells around the original one to suck up more trapped oil and gas. But those “child” wells are generally less productive than the “parent” well, with rapid declines in output.

That forces operators to continue drilling, creating a nonstop treadmill to maintain production, LeBlanc said. And many of the “sweet spots” with the best-producing wells have already been tapped over the past eight years.

“The productivity gains have slowed, or stopped, as performance levels off,” LeBlanc said. “If operators want to keep growing fast, the only choice is to pump more money into drilling.”

Investors are tired of the treadmill, which has generally been financed with private equity and credit, marginalizing returns for shareholders as companies keep pouring money into production and racking up debt.

“Industry borrowed, like, $245 billion over the last 10 years, and they have to start paying it back,” LeBlanc said.

Stock prices for oil companies have fallen by double digits as investors demand greater discipline in capital spending and more returns.

And as private equity dries up and credit becomes more expensive, companies are reeling in spending to improve cash flow. Many are selling off less-productive assets, and most are targeting only the most-promising oil zones.

“There are plenty of places to drill, but capital markets are tired of the game, so rather than reinvest more, they want companies to start returning dividends,” LeBlanc said. “It’s not that companies can’t grow. They’re choosing not to grow to give back more money.”

IHS expects growth to drop significantly next year before flattening out in 2021. It projects moderate growth to resume in 2022.

Climate change

New Mexico may well face slower output going forward as independent, resource-strapped producers spend less. But the state’s medium- and long-term prospects remain promising, given the massive oil reserves still trapped in New Mexico’s side of the Permian, particularly in the Delaware Basin, an oval-shaped formation that stretches from southwestern Texas northward into Lea and Eddy counties.

Industry activity is concentrated there, including huge investments by major players such as Exxon, which has the resources to keep increasing production even as others pull back.

“Exxon and Chevron will increase their share of Permian production as the independents decline,” Fine said. “When output peaks, those companies will control about 50% or more of production there.”

Many industry analysts say shale oil in the Permian will hit its peak production in the early 2030s. That means another 10 years or more of stable industry growth, said NMOGA President Ryan Flynn.

Many challenges lie ahead, including world decline in fossil fuel consumption, fluctuating oil prices, and the prospect of tighter state, and even federal, regulation, depending on the outcome of next year’s presidential elections.

Climate change looms large over future production. Many industry experts expect environmental concerns, government regulations on fossil fuels, and changing market dynamics to begin significantly cutting into demand for oil starting in the mid-2020s.

“By 2024, use of gasoline in transportation will begin to compete substantially with electric vehicles,” Fine said. “That’s when the zero-emission debate will climax to radically cut carbon emissions by 2030. Outlook for the Permian Basin depends, in the long-term, on the politics of climate control.”

Apart from the potential for much stricter government regulations, consumer demand is evolving toward electric vehicles, especially as today’s climate-conscious youths become tomorrow’s mainstream consumers, Fine said.

“We can call it the ‘Greta generation,’ ” Fine said, referring to 16-year-old Swedish climate activist Greta Thunberg. “It’s a question whether the new generation of consumers will be using combustion engines or not.”

In electricity generation, state policies are already transitioning the local energy market away from fossil fuels at an accelerated pace with this year’s passage of the new Energy Transition Act, which requires utilities here to switch to 100% renewables and carbon-free generation by 2045, Rep. Scott said.

“Will we all be driving electric vehicles in the next 10 years?” Scott asked. “… I’ve stood in opposition to climate change-driven public policies, but I wouldn’t hazard a projection on that. I don’t know which way we will eventually go.”

Still, industry leaders say it will take a long time for oil demand to decline enough to impede growth in the Permian, because even if consumption plummeted in the U.S., global markets in Asia and many developing countries could pick up the slack for a long time.

In addition, virtually all market reports project continued growth in oil demand through 2030, Flynn said.

“U.S. production will play a major role in meeting that demand, with the Permian Basin leading the way,” Flynn said. “… Even with declines in growth, we’re still operating at unprecedented levels. The state is well-situated, at least for the next decade.”

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