(John Kemp is a Reuters market analyst. The views expressed are
By John Kemp
LONDON Aug 28 The independent companies at the
forefront of the U.S. shale boom will finally earn enough from
selling oil and gas to cover their capital expenditures next
year, for the first time since 2008.
Free cash flow, which measures operating cash flow minus
capital spending, for the 25 leading independent oil and gas
producers is expected to show a surplus of $2.4 billion in 2015,
according to a consensus forecast in the Financial Times.
That compares with a shortfall of around $9 billion in 2013
and $32 billion in 2012. ("Shale oil and gas producers' finances
lift growth hopes" FT, Aug 27)
During the years of negative free cash flow, independents
relied on equity issues, borrowing and asset sales to sustain
their drilling programmes. That led some analysts to conclude
the shale boom was unsustainable or even liken it to a Ponzi
scheme, which will collapse when fresh capital inflows cease.
"It is not clear that the U.S. independents are profitable,"
Steven Kopits, managing director of Princeton Energy Advisers,
wrote recently for Platts. "An industry can see a boom
irrespective of profits or free cash flow if banks and investors
are willing to underwrite the promises of future profits. The
Internet bubble showed us that" ("Hamilton has it right on oil"
"What is not clear (is whether) the industry (both large
players and independents) can run a cash-flow positive business
in both top-quality and in more marginal plays and whether the
positive cash flow could be maintained when the industry scales
up its operations," Ivan Sandrea wrote in another sceptical
piece for the Oxford Institute of Energy Studies. ("U.S. shale
gas and tight oil industry performance" March 2014)
Annual capital expenditures associated with shale oil and
gas plays surged to $80 billion in 2013 from just $5 billion in
2006, according to Sandrea.
Capex outstripped operating cash flow, resulting in large
negative free cash flow, as shown by a chart from hedge fund
Astenbeck Capital. (here)
For doubters, the forecast of a small surplus in 2015, after
deficits more than 20 times that amount between 2009 and 2013,
does not dispel concerns about the long-term sustainability of
the business model.
Concerns about financial viability merge with older worries
about the shale boom's physical sustainability. Sceptics worry
the industry will have to drill an ever increasing number of new
wells just to offset the declining output from existing holes.
The problem has been likened to Lewis Carroll's "Red Queen's
Race", where "it takes all the running you can do, to keep in
the same place".
It is a problem common to all oil and gas fields. Eminent
U.S. geologist Carl Beal worried about it as long ago as 1919.
But sceptics claim the problem is especially serious for shale
plays given the rapid decline rates on most shale wells.
The problem with all these analyses is that they conflate
shale oil and shale gas production. The conflation is
understandable: all wells, whether in conventional or shale
plays, produce a mixture of oil, gas and natural gas liquids in
varying proportions, which are then marketed. Even an oil
company specialising in drilling oil wells will probably be
selling some gas, and vice versa.
For regulatory and tax purposes, companies must identify
which holes are predominantly gas wells and which ones are oil
wells. But the truth is that all wells produce a range of
It is impossible accurately to identify free cash flow
attributable to gas production from free cash flow attributable
For this reason, most analysis focuses on aggregate cash
flows from all independent oil and gas producers, irrespective
of whether they are producing gas, oil or in most cases, a mix
The problem is that the economics of shale gas and shale oil
wells have differed sharply since 2011, as oil and gas prices
The performance of many shale gas plays has been dire, while
the performance of oil plays has been much brighter. Even in the
gas industry, loss-making dry-gas operations are being conflated
with the healthier performance of wet-gas plays, which produce a
mix of methane and more highly valued ethane, propane and
Aggregate statistics about cash flows and capital
expenditures provide almost no useful information about the
performance or business model associated with individual plays,
companies or wells.
SHIFT FROM GAS TO OIL
In response to price signals, most independent oil and gas
companies have switched focus to producing oil and
condensate-rich wet gas, rather than dry gas.
In August 2014, more than 1,500 drilling rigs were targeting
oil-rich formations currently across the United States, up from
fewer than 400 at the start of 2009.
Over the same period, the number of rigs targeting
predominantly gas formations has shrunk from nearly 1,300 to
just over 300, according to drilling statistics published by
The drilling shift from lower value gas to higher value
condensates and crude explains most of the improvement in free
cash flow in 2012 and 2013, and the move into an expected
surplus in 2015.
Texas illustrates the transition. In the Barnett shale, the
birthplace of the fracking revolution, just 15 rigs are now
targeting gas formations, down from more than 60 at the start of
In the meantime, the number of rigs targeting oil in the
Eagle Ford has quadrupled from 50 to 200, according to Baker
But the switch to more wet gas and oil takes time, which
explains why the aggregate free cash flow statistics looked so
terrible between 2009 and 2013.
In most cases, leases for oil and gas are held by drilling.
Provisions in the contract require the leaseholder to commence
boring one or more wells within a specified period or pay delay
rentals to defer the start of drilling.
Independent oil and gas producers had already paid bonuses
to lease acreage, and their contracts also forced them to either
start drilling, pay delay rentals, or abandon the lease. Many
producers simply could not afford to shut down all their
gas-focused operations immediately.
Independent producers faced several years of negative free
cash flow and write-offs while the old leases were developed,
not renewed, abandoned or sold. But with the subsequent slowdown
in gas leasing and drilling and the turn to more profitable oil
and condensates, the industry is poised to return to a free cash
Positive free cash flow will make the shale industry look
healthier than it has done in recent years, but in reality it
says little about the long-term sustainability of the business
model, any more than the losses did between 2009 and 2013.
(editing by Jane Baird)