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How American frackers plan to beat OPEC

Rick Newman
Senior Columnist

Gary Evans, CEO of Houston-based energy firm Magnum Hunter Resources (MHR), has a blunt message for OPEC oil ministers hoping to force down prices and drive American competitors out of business. “OPEC is making a huge mistake,” he says. “We made a lot of money with oil at $100 (per barrel), and we’ll become more efficient and make a lot of money at $50.”

For now, the U.S. energy industry is reeling from oil prices that have plummeted from about $105 a barrel last summer to $50 or so now. The profits and stock prices of energy firms are plunging, with job losses beginning to mount. The global supply of oil has outstripped demand for several reasons, but a big one is the unexpected move by Saudi Arabia—lead member of the OPEC oil cartel—to keep pumping oil amid the glut, a change from its usual practice of curtailing production during soft spells to boost prices. Many analysts believe the Saudis are deliberately undercutting their new competitors in North America, who have been producing record amounts of oil thanks to new hydraulic fracturing technology, or fracking.

A truck passes a large bust of President Abraham Lincoln on highway 85 in Williston, N.D.

The Saudis are right when it comes to costs: Extracting so-called tight oil from shale deposits in America is considerably more expensive than Saudi Arabia’s own drilling costs, which by some estimates is as low as $10 per barrel. What the Saudis may not have counted on, however, is extreme cost-cutting underway at many drillers, which is making them far more efficient and pushing down the price at which they can turn a profit. The Saudis’ market-share move could even backfire, as U.S. frackers become more efficient competitors. “We will figure out how to operate in a lower price environment,” Evans says. “Anybody who thinks our costs are too high – that’s absolute bull crap.”

Lower rig counts

Big adjustments are already occurring in the shale-oil regions of North Dakota, Texas, Oklahoma, Ohio, West Virginia and other states at the center of the fracking boom. The U.S. oil rig count, which measures the number of active drilling rigs, surged from about 800 at the beginning of 2011 to a peak of 1,609 last October, according to energy firm Baker Hughes (BHI). In less than six months, however, the rig count has plunged by nearly 50%, to 825. The cost of pulling oil from the ground varies sharply by location, on account of geological differences and other factors. Drillers, among other things, have stopped operating high-cost wells that are unprofitable with oil prices at $50 or less.

The sharp drop in the rig count leads to the logical assumption that U.S. crude production will decline as well. But that isn’t happening. In mid-March, the International Energy Agency reported that “declines in the U.S. rig count have yet to dent North American output growth." And now, research firm Wood Mackenzie predicts U.S. oil production will actually rise by about 1% this year and next, even though fewer rigs are operating. “Overall productivity per rig has gone up dramatically,” says Cody Rice, senior research analyst at Wood Mackenzie. “Returns have been surprisingly robust.”

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Every company cuts costs when times get tough, but firms in the fracking industry seem to have an extraordinary ability to streamline, perhaps because the technology is so new and most operators haven’t had to focus aggressively on cost control until now. New research by Wood Mackenzie finds that drilling costs in the lower 48 states have already fallen by 10% to 30% in 2015, with further improvements likely.

In this photo taken Dec. 19, 2014, oil pump jacks work in unison, in Williston, N.D. Never mind dropping oil prices. U.S. producers are pushing harder than ever for the right to sell U.S. crude oil overseas. It might seem counterintuitive: Oil prices are as low as they have been at any point since 2009 and the height of the Great Recession. Depending on the projection, prices could drop further still with slowing economies across the world. Oil producers are playing a longer game, betting that long-term demand remains strong and new markets offer lucrative rewards for U.S. producers. (AP Photo/Eric Gay)

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One of the first ways to cut costs is to shut down exploratory operations and shift equipment to lower-cost production. The falling price of energy, meanwhile, obviously hurts revenue, but it also saves money on the back end, since fracking tends to require lots of diesel fuel. Drilling firms are also renegotiating contracts with insurers, oil-services companies and other vendors, driving down those costs. And they’re focusing more on technology breakthroughs that could push costs even lower.

Cost-cutting measures

As energy prices began plunging last year, Magnum Hunter began to make some dramatic decisions to slash costs. The company had already begun to shift from oil extraction to gas, which it felt would be more profitable. In 2014, it sold $210 million worth of properties and other assets it decided were no longer essential to its core business. It closed offices in Calgary and Denver and made plans to move its Houston headquarter to Dallas, where it will merge with another office. And beginning Jan. 1 of this year, Magnum Hunter stopped drilling any new wells, to save money and wait for the cost of contracting services to fall. “Why spend capital today when service costs are going to be a whole lot less in 60, 90, or 120 days?” Evans told analysts on a January conference call.

Evans expects to slash Magnum Hunter’s costs by 40% by this summer. Citigroup, by comparison, only cut costs by 29% between 2008 and 2009, a period when the huge bank nearly collapsed, dramatically restructured and announced 50,000 layoffs, one of the biggest bloodbaths in corporate history.

The sun begins to rise behind a pump jack and natural gas flare near Williston, N.D.

It’s not just smaller operators that are slicing costs by that magnitude. Exxon Mobil (XOM) CEO Rex Tillerson said recently that costs for some of the oil giant’s drilling projects in the eastern U.S. have fallen by nearly 50%. “North American tight oil is going to be more resilient than some people think it’s going to be,” Tillerson declared.

A few U.S. energy companies, such Quicksilver Resources and Dune Energy, have gone bankrupt in the last few months, mainly because they got pinched by high debt loads and falling revenue. Some analysts still expect a cascading series of failures as drillers go broke and bring suppliers with them, while a mushrooming crisis spreads to lenders who dispersed money too freely when the fracking business was booming. Private-equity firms have reportedly raised funds ready to swoop in and buy distressed energy assets at fire-sale prices.

Magnum Hunter is one of the companies facing concerns about liquidity, due to a relatively high debt load; its stock has fallen 66% during the last 12 months, even though Evans insists the company has plenty of liquid assets at hand.

But it now seems the much-anticipated fracking meltdown — which would certainly please the Saudis and other OPEC members — may never happen. “As prices dropped, there were quite a few smaller companies that many people thought would just fall over and die,” says Rice of Wood Mackenzie. “That has just not been the case.” Most drillers that need financing have been able to get it. The ability to slash costs is one reason lenders have doubled down on many companies.

The oil bust, meanwhile, is making U.S. drillers more competitive. Cutting costs by 30% lowers the break-even price for a driller by about $15 per barrel. Many drillers can now break even with prices for West Texas crude below $60 a barrel , and some can do so below $50. Those break-even points will continue to come down as long as prices remain low, keeping the pressure on.

The Saudis could probably produce even more oil, and push prices lower still. A few analysts think prices could go as low as $20 per barrel. But it seems more likely prices will stabilize for much of 2015 and gradually rise going into next year. Moody’s Analytics, for instance, predicts that crude will end 2015 around $75 per barrel, which would put most U.S. frackers back in the black. This oil bust might be just the thing to launch another boom.

Rick Newman’s latest book is Liberty for All: A Manifesto for Reclaiming Financial and Political Freedom. Follow him on Twitter: @rickjnewman.