Shale Oil & Gas Production Costs Spiral Higher As Monstrous Decline Rates Eat Into Cash Flows

(by Dr. Heinrich Leopold)

If you believe the recent surge in U.S. oil production suggests that good times are here once more, think again. While the U.S. oil industry continues to increase production by adding a great deal more drilling rigs, there is serious trouble taking place in the shale patch that very few are aware. This has to do with the rapid deterioration of oil and gas economics as horrendous decline rates eat into company cash flows.

The Economics Of Oil & Gas Production

By Dr. Heinrich Leopold,

The advent of shale oil and gas production, which created the vision of ‘ US energy independence’ , has brought renewed interest in the economics of oil and gas production. What are the key parameters for productivity and costs?

In short, it is the cost per produced barrel and not – as often referred in the media – the absolute cost per individual well.

To demonstrate my point, I want to use a standard well which costs $10 million to drill and produces initially 200 barrels per day as a simple example. The costs of $10 million tell very little as the most important fact is how much this well can produce over its lifetime. Assuming a 10 year life span and implying a 5-10% yearly decline rate – which is the standard for a conventional well – , the well produces roughly 500,000 barrels during its life. This gives then the drilling cost of $20 per produced barrel. Maintenance, taxes, license, transportation… have to be added and divided by the amount of produced barrels. This gives then a production cost of roughly $40 per barrel. This is the standard model of a conventional oil well. In theory, the true cost can only be determined when a well is shut down and the actual amount of produced barrels is known. Therefore, all of the studies for production cost are guesstimates as they are based on an estimate about future oil production of the wells.

If now the life span of a well is much shorter than the above standard well – say for the sake of simplicity – just five years implying a yearly decline rate of 10-20 %, the amount of produced barrels sinks to 250,000 barrels and the drilling cost increases to $40 per barrel and the total cost surges towards $80 per barrel. This comes despite the drilling cost as well as the maintenance, overhead, … are the same as in the above example.

As a conclusion, the true costs are strongly dependent on the life span (or the yearly decline rate – referred to very often as ‘legacy’ rate) of the well. So, if a company boasts it has decreased its drilling costs from $10 million per well to $8 million per well, it is just half of the truth as the well may decline much faster and thus produce less oil over its life span and the drilling cost per barrel could be actually much higher, despite the reduction in costs per well.

And this is exactly what is currently happening in the shale patch. Despite considerably lower costs per well, the wells decline much faster and thus the costs per produced barrel are spiraling accordingly.

As it is difficult to assess the future performance of wells, we can luckily see a trend from the history of performance from existing wells. In its monthly drilling report, the EIA publishes the performance of new oil and gas wells versus existing wells. This gives an excellent insight into the status of the shale industry.

Below chart 1 depicts the addition of new wells (blue line) in the Permian versus the legacy decline of existing wells (red line) and the resulting net growth for the field in million barrels per day (yellow bars right hand scale).

The massive addition of nearly 2.5 million barrels per day and year of new production (blue line) is mitigated by the already equally monstrous decline of existing wells (red line). Furthermore, chart 1 shows a fast growing legacy decline rate, which is actually growing faster than the addition of new production. Therefore, the monthly production growth has been already decreased over the last two months. As a strongly rising decline rate reduces cash flow of companies very swiftly, I expect new production will decline considerably over the next few months.

As chart 1 shows, there is still considerable growth left in the Permian. However, as the legacy decline rate increases now very fast, the decline rate as percentage of total production rises accordingly as shown in chart 2. The ratio of legacy decline versus total production increased from 0.3 (or 30% decline) towards 0.7 – or 70% percent decline over the latest few years.

This implies the wells in the Permian have just a few years life span left. After what has been said in the introduction of this article, this means nothing else than the economics of Permian wells have dramatically deteriorated, more than doubling the cost per produced barrel over the last few years. This is, however, mitigated by lower drilling cost per well, which admittedly took place over the last years, yet the overall picture is that of a strongly rising cost structure in the Permian and other shale oil and gas fields which should give much concern for investors and shareholders.


This was a guest post by Dr. Heinrich Leopold.  When I saw Heinrich’s charts and data, I was quite surprised… and it takes a lot to surprise me.  Actually, I had never really thought about Shale oil and gas economics based upon the huge decline rates.

Heinrich explains that the huge increase in the legacy decline (how much production is being lost) is seriously eating into the cash flows of the companies drilling these shale oil and gas wells.  Thus, the higher the legacy decline rate, the more negatively it impacts the company’s cash flows.

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37 Comments on "Shale Oil & Gas Production Costs Spiral Higher As Monstrous Decline Rates Eat Into Cash Flows"

  1. “When I saw Heinrich’s charts and data, I was quite surprised ….”

    why? that this dynamic would be present was well-known long before shale production even began. as shale production ramped up numerous people were pointing out how limited production would be. but lots of infestors desperately needed skimmed returns and there was no-where else to go, so they just piled in anyway and partied like it was 1999. because it was. and here we are.

    • gman,

      What would we all do without your SUPERIOR INTELLECT to set us all straight? It amazes me just how much effort you put forth to make sure that everyone knows just how much smarter-better you are than everyone else.

      Keep up the good work.

      steve

      • the information was out there in public for anyone who cared about the facts. but most just cared about the returns, everything else was … dunno, invisible to them.

        • gman,

          LOLOL… you are a piece of work. I got to hand it to you. On the other hand, I would bet that you had no idea about the details of the Shale Oil & Gas Industry until you read the energy articles on this site.

          steve

          • “I would bet that you had no idea about the details of the Shale Oil & Gas Industry until you read the energy articles on this site.”

            no, exxon oil company guest lecturers at college in … 2001? and business articles about then too. business hype of “hey, shale’s gonna be great!” were answered with “no, it’s not, because of this and that and the other reasons.” and of course there was a reason why shale bonds were junk-rated. I’m impressed you missed all that, it was no secret.

    • DisappearingCulture | May 23, 2017 at 1:10 pm | Reply

      “… but lots of infestors desperately needed skimmed returns and there was no-where else to go, so they just piled in anyway and partied like it was 1999. because it was. and here we are.”

      For clarification probably few individuals made the decision to invest in shale oil; it was fund managers for groups of investors. Like a retirement fund manager.

      • “For clarification probably few individuals made the decision to invest in shale oil; it was fund managers for groups of investors.”

        sure. but their customers handed over their money and said, “get me more money, I don’t care how, just get it now.” and the managers went to their front line people and said, “get me more money, I don’t care how, just get it now.” and the front line people pointed to the only game left with the required “rate of return”, junk bond shale, and said, “are you sure?” and the boss said, “get me the money now or you’re fired”, and so they did it, and everybody got their bonuses that quarter.

  2. The best shale oil and gas sites have been drilled in the past. No one saves the best for last.

  3. Diogenes Shrugged | May 23, 2017 at 1:32 pm | Reply

    Ordinarily, one might anticipate somewhat linear decline rates for whole fields, reflecting average declines of large numbers of wells, each individually in its own variable state of decline. Decline rates for the individual wells aren’t by any means linear, however. The first two or three years of highest production typically yield enough hydrocarbon to recoup the all-in cost of the well. After that, production drops off more rapidly, asymptotically approaching zero. This is why wells must be drilled constantly and forever, otherwise field production would drop exponentially in just a few years. So, two factors play into field decline. One is the diminishing resource, the other is diminished drilling of new wells. Diminished drilling usually results from diminished exploration.

    The people responsible for levitating these companies with astronomical debt (CEOs, banks) certainly know what the score is. I am of the opinion that a gigantic conspiracy is afoot. The only thing we don’t yet know is WHEN they’ll pull the rug out and watch this building collapse. At that point, take heart: drillers can remain employed by drilling into the secret underground tunnels. Fracking slurries can then be injected under extreme pressure with positive result.

    Just trying to bring some levity to this issue.

  4. Diogenes,

    I know this sounds crazy, but I wonder if the Deep State is deliberately keeping these shale oil drillers “solvent” in case there is a sudden need for a domestic source of oil, above what could be supplied by the SPR, for example if a war broke out and our import supplies were “disrupted”

    Keeping this “insurance” (shale oil production) is indeed costly but could theoretically explain why they keep drilling. I just can’t believe that the banks would be so stupid as to pile in with all the financing unless there was another reason besides just the short term profit from making wild loans. But then again, greed can make you stupid as well as careless.

    • Diogenes Shrugged | May 23, 2017 at 3:54 pm | Reply

      You might be right. Or maybe they’re merely maintaining the illusion of boundless surplus in order to keep the herd passive. With respect to the SPR, see this:
      http://money.cnn.com/2017/05/23/investing/strategic-petroleum-reserve-trump-budget-us-emergency-oil/index.html

      • I am glad he is selling off the SPR. In the event of an emergency, I would never have gotten a drop of it anyway. The MIC would have slurped it all down. Maybe if it’s not there, the MIC will think twice about creating some mischief.

        Yeah, right.

    • “I know this sounds crazy, but I wonder if the Deep State is deliberately keeping these shale oil drillers “solvent” in case there is a sudden need for …”

      … oil for the “deep state” itself? sure, and no you’re not crazy at all.

      “I just can’t believe that the banks would be so stupid as to pile in with all the financing”

      the united states dollar is a fiat debt pyramid scheme, meant to suck the wealth out of any system that uses it. it’s not that the lesser banks and other infestors are stupid – they’re not – it’s that the pyramid scheme is reaching its peak and everyone is becoming desperate for skim/rent/return, any skim/rent/return, any promise of skim/rent/return, any ephemeral gossamer hope no matter how remote for skim/rent/return. that’s all. really, there’s nothing complicated about the cause of all this wreckage.

  5. Guys, all America has left is fraud. After 10 years of zero rates, lying about inflation, lying about jobs – it’s all a scam. Just waiting for the lights to go out.

    • “Just waiting for the lights to go out.”

      the parasites sucking this country dry won’t intentionally kill the host outright until there is another host the parasites can infest first.

      ‘course there is always “unintentionally” ….

  6. I remember reading about the short life span of shale from the likes of Dr. Colin Campbell and Prof. Ken Deffeyes when I became interested in peak oil back in 2005. I think the main point of your article here is to point out the urgency of the energy problem we are entering. I may be wrong, but I think shale just bought us an extra decade before we all go downhill. Google Olduvai curve 1979. Thanks for yet another great article, Steve.

    • “I remember reading about the short life span of shale from the likes of Dr. Colin Campbell and Prof. Ken Deffeyes when I became interested in peak oil back in 2005.”

      thanks for putting some concrete names and dates to this. I read similar material back then and just assumed that nominally-interested people would absorb and remember the knowledge.

  7. Thanks Steve, reagrds

  8. Another presentation saying disaster is imminent but the world just keeps on rolling on.
    How many years now have you been making these dire predictions without anything happening?

    • Diogenes Shrugged | May 24, 2017 at 1:38 am | Reply

      It should have happened in 2008. So the better question might be “how long can they postpone the bulk of the debt collapse that began in 2007-2008?” And even, “what happens after that?” Well, to that last question, you’re right. The world will keep rolling on. But it might do so with a lot fewer of us. That might or might not be a good thing for the survivors. But there is a hard transition coming up that’s destined to last for years. Don’t yearn for it. It’ll be here soon enough.

      • I’m not yearning for the transition or happening or collapse or whatever you want to call it. I don’t think it will happen at all. Remember when peak oil was all the rage about 15 years ago? Now its just a memory of another failed disaster prediction. The current ROEI is another phase that will also be put in the dustbin as new technology, wind, solar, lithium, new energy technology, etc. make ROEI irrelevant.

        Gold & Silver stackers have got nowhere preparing for the end of the world and never will.

        • Careful, NEVER is a very long time.

          If nothing ever happens as you say, how are you going to be worse off by keeping 20% of your family’s financial reserves in gold and 10% in silver? Do you really believe that gold and silver will go to zero? Or some ridiculous price point like $200 per ounce of gold and $5 per ounce of silver?

          And if something happens, you can then send love letters to Steve to have saved your sorry a-s-s by instructing you not to rely 100% on a system that has all the signs of a collapse coming written all over it.

          But similarly to gman, people like you have nothing to offer, just arrogance and hope in some non-existent new technology that will surely bail you out some day. Well, good luck with that.

          • “NEVER is a very long time.”

            financially, so is ten years.

            “How many years now have you been making these dire predictions without anything happening?”

            there appears to be no particular limit. 1968 – “the future’s uncertain and the end is always … NEAH!” maybe we need to do what st. augustine did to the expected second coming of christ which was delaying for centuries – spiritualize it and treat it not as an expectation but as a lifestyle.

          • “Or some ridiculous price point like $200 per ounce of gold and $5 per ounce of silver?”

            (looks at the charts) don’t you mean _return_ to those prices?

  9. Initial production and 24 month cumulative production is higher in newer vintage Permian wells. At a given oil price, cash flow is higher and front end loaded in newer wells, assuming the percent decline rate amongst vintages equalizes after 2 years of production.

    https://www.eia.gov/todayinenergy/images/2016.02.11/main.png

    • marmico,

      I plan on doing an update of the Permian in a few weeks using some of Jean Laherrere’s graphs. The spike in Permian oil production won’t last long, and I would imagine U.S. oil production will be down 50-75% within the next 5-10 years.

      Most Americans are not prepared for what is coming.

      steve

      • That’s roughly the same timeframe for production declines in Mexico without additional discoveries being brought online.

  10. The spike in Permian oil production won’t last long, and I would imagine U.S. oil production will be down 50-75% within the next 5-10 years.

    Whatever. There is no historical evidence for such a dramatic inward shift in the supply curve in the historical record.

    https://www.eia.gov/todayinenergy/detail.php?id=30952

    • marmico,

      I appreciate you stopping by here and offering your opinion. However, I gather you are not too familiar with theory of the SENECA CLIFF and how things fall apart quite quickly OUT OF THE BLUE. Regardless, I will be posting Jean Laherrere’s charts on the Permian in a few weeks. Most energy analysts tend to forget or leave out the massive amount of debt and derivatives in the system. They look at energy in a vacuum or with tunnel vision.

      Also… forecasting the future by looking the the REAR VIEW MIRROR may not work as the future will be nothing like the past.

      steve

  11. I look forward to your articles.
    Common sense has me siding with you. But I wonder what you would say about this email which, ironically, appeared not long after yours? We truly are a land of wishful thinkers.

    ” John Mauldin | May 24, 2017
    International Inflation Cycles Sync Up

    My friend Lakshman Achuthan, Co-Founder & Chief Operations Officer of the Economic Cycle Research Institute (ECRI), has done some really interesting work on international inflation cycles, and in today’s Outside the Box he shares it with us. This is a special treat – ECRI does not normally make its material available outside of its client base. I am truly grateful that he allows me to share this. Lakshman will be joining us at SIC this week in Orlando, to the great benefit of the attendees.

    It turns out that inflation volatility has been greatly dampened in the 11 OECD (advanced) economies in the 21st century, as compared to the late 20th century: It’s now only about a quarter of what it was then. Additionally, the domestic inflation cycles of these countries have increasingly come into sync. These two trends have made it possible for ECRI to devise a leading index of global inflation cycles that offers earlier and more accurate forecasts of cyclical turning points in international inflation.

    In concluding this short but groundbreaking piece, Lakshman adds,

    The synchronization of international inflation cycles highlights the importance of global factors in assessing domestic inflation prospects. Our analysis underscores the 21st-century reality that the timing of inflation cycles may be beyond the control of any individual central bank. Yet this very development makes it possible for ECRI to provide even earlier signals of peaks and troughs in the inflation cycle.

    Lakshman’s piece runs with an argument that my friend John Vogel wrote about this morning, highlighting another piece of research. I’ve been arguing for years that the world is basically in a long-term deflationary trend, despite all the monetary intervention and money printing. It’s a bit difficult to measure, but the cost of producing goods is dropping. Which means that the cost of living will continue to fall – at least as far as purchasing goods is concerned (as opposed to buying services like healthcare and education). As John writes (somewhat controversially):

    What I think is more interesting is the productivity created by CHEAP oil and natural gas. We don’t measure this, no fault of men like Prof. Gordon who think in straight lines.

    As the price of energy came down in the US, energy companies didn’t go out of business as some had forecast. They have pressed hard to find ways to find, drill and lift energy out of the ground in cost effective ways. While this effort may have hurt short term profits, it has also ensured the survival of service companies and E&P companies.

    Next, as the price for natural gas has come down and stayed down (with no sign of supply shortages), the industries that thrive on natural gas, such as chemicals, plastics, etc, have become more profitable. Third order: Lower feedstock may also lead to lower chemical prices that will feed into clothing, agriculture, etc, in the form of more competitive pricing of high quality stock to many industries. Organic chemistry applications are being reborn as reduced cost leads to more or better applications.

    This entire process means that we should be able to recreate entire industries that had gone to other countries, as wages no longer pose impediments to competitive pricing.

    In short, what we are seeing is the same ripple effect that lower cost semiconductors had on computer and electrical applications; now we are seeing it in industrial applications. However, it now has to be measured as a secondary or tertiary effect, rather than a direct application.

    Further, this helps explain why deflation is needed economically; it may be a salvation for employment…. If deflation can lead to a lower cost of living, we can recreate industrial jobs outside high cost of living cities. It is the opposite of the mega trends that others keep point to. The latest rage is co-living, where small living spaces with a bath replace an entire apartment. Gone are living rooms and kitchens. But even with this, rent in Chicago is $1000 per month and in NYC $1900 per month. In fact, the developers make more money this way than they do in conventional 1 and 2 bedroom apartments.

    Deflation will force relocation of jobs and therefore will force geographical redistribution. Because this is not being touted as a good solution, the transition will be rocky. But it must occur. It is the future of economic success for the entire country.

    The future is changing the world around us, but it’s a gradual transition that is not readily apparent on a day-to-day basis. If you pay attention to the long-term data, as Lakshman does, you can see that change is happening faster than we think.”

  12. So, year over year in the USA, 125% increase in rigs (wells, don’t know) and an 11% increase in production. That’s good, right?

    If that is good, rig counts better go up at least 50-60% per year to keep USA production at its current level.

  13. Twice in past comment posts on this site, I have presented in layman’s terms detail the physics behind the steep decline rates in shale wells. I also explained how application of horizontal drilling and hydraulic fracturing increase initial production rates but do not change the reservoir physics that determine steep declines. The only ‘change’ is the starting rate at the beginning of the decline. Maybe Steve can find the posts with little effort and repost here; I think either post would be useful for understanding what is going on and why shale is not going to be a long term solution to the US energy needs unless some unknown technology is developed.
    The economic evaluation methodology is correct as stated, but one very important fact was left out; that being the investment to drill a well is not considered in determining when to abandon as uneconomic. If the price per barrel is greater than the cost per barrel to operate, the well is generating positive cash flow on a current basis. When the current total operating cost exceeds the current price received on a per barrel basis a well is considered uneconomic and shut in as it becomes cash flow negative on a current basis. In the 10 year life example, the total cost per barrel is $40, but the operating cost is $20, the oil price when the well would be shut in. Typically, a thorough engineering evaluation is performed before a decision to plug and abandon is made.

  14. Also… forecasting the future by looking the the REAR VIEW MIRROR may not work as the future will be nothing like the past.

    Your forecasting record is the epitome of looking at energy in a vacuum with tunnel vision.

    A blast from your July 14, 2013 past:

    However, once the world realizes that Shale Oil & Gas are not the energy saviors, we will see how serious annual decline rates of 40-50% impact the energy supply.

    US oil production has risen almost 1.6 million barrels per day since the blast from the past.

    https://www.eia.gov/dnav/pet/hist/LeafHandler.ashx?n=PET&s=MCRFPUS2&f=M

    • DisappearingCulture | May 25, 2017 at 8:45 am | Reply

      Steve didn’t include a date prediction with that comment from 7/14/13. And he is aware and has noted why production has risen in the last few years.

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