U.S. Oil Producers May Drill Themselves Into Oblivion

Remember the fall of 2008? As the world spun out of control and the price of everything crashed, a barrel of oil lost 70 percent of its value over about five months. Of course, prices never should’ve been as high as $146 that summer, but they shouldn’t have crashed to $40 by the end of that year either.

As the oil market has recovered, there have since been three major corrections, when prices have fallen at least 15 percent over a few months. We’re now in the midst of a fourth, with oil prices down more than 20 percent since peaking in late June at around $115 a barrel. They’re now hovering in the mid-$80 range and could certainly go lower. That’s good news for U.S. consumers, who are finally starting to reap the rewards of the shale boom through low gasoline prices. But it could spell serious trouble for a lot of oil producers, many of whom are laden with debt and exaggerating their oil reserves.

In a way, oil companies in the U.S. are perpetuating the crash by continuing to drill and push up U.S. oil production to its fastest pace ever. Rather than pulling back in hopes of slowing the amount of supply on the market to try and boost prices, drillers are instead operating at full tilt and pumping oil as fast as they can. Just look at the number of horizontal rigs in the field:

Over the past five years, the amount of horizontal rigs deployed in the U.S. has almost quadrupled, from 379 in early 2009 to more than 1,300 today. This is of course purely a fracking story. Almost all the recent gains in U.S. oil production are the result of horizontal drilling techniques being used across much of the Midwest, from Texas to North Dakota. Unlike conventional vertical wells, where more wells do not always equal more oil, the strategy in a shale field appears to be to drill as many as possible to unlock oil trapped in rock formations.

As the number of horizontal drill rigs has exploded, the number of vertical rigs in the U.S. has gone in the opposite direction, falling almost 70 percent over the past seven years.

So will U.S. oil producers frack their way into bankruptcy? That’s a real possibility now. They’ve certainly gotten more efficient at drilling, and don’t need the same price they did to remain profitable. But we’re getting pretty close. Back in July, Goldman Sachs estimated that U.S. shale producers needed $85 a barrel to break even. That’s about where we are right now. The futures market points to even lower prices next year, with contracts for oil next April trading at about $82 a barrel. Certainly, some producers need higher prices than others. Those at the bottom of the cost curve could benefit from a potential wave of bankruptcy that spreads across the oil patch; they could then scoop up some assets on the cheap.

One final note of caution: The U.S. natural gas industry ran through this same cycle a few years ago with companies getting themselves into trouble by flooding the market with gas, crashing the price and themselves in the process. By mid-2012, the price of natural gas got too cheap to drill. The number of natural gas rigs in the field still isn’t anywhere close to returning to where it was a few years ago.