There was a strong consensus in the U.S. oil industry that the drop in oil prices would spur Saudi Arabia to cut production and bring prices back up. That consensus was wrong. Instead Saudi Arabia cut prices, putting North American oil production in a bind, and has contributed to the downward spiral of oil prices.
In much of North America oil comes from shale, which has to be fracked. Water and chemicals are pumped into the well to create pressure that forces oil out of the ground. It’s a lot like squeezing a sponge, says Robert McNally, president of the Rapidan Group. At first a lot of liquid comes out.
“You get a rush up front,” he says. “Your initial production rates are very high compared to conventional oil.”
After that initial squeeze, output declines sharply says McNally, “so in order to keep the overall flow, you are having to drill and drill and drill.”
All that drilling is expensive. This is how shale oil got the nickname “tough oil.” If the price of oil continues to drop — it’s currently at $86 a barrel — it could make tough oil too expensive to drill for.
“You could pretty easily put out a number of, say, $75 a barrel. That’s kind of your break even when you consider all of your development, production costs, etc.,” says Chad Mabry, an analyst at MLV & Co.
Some regions in North Dakota and Texas — the “sweet spots” Mabry calls them — would likely remain profitable even if prices continue to drop. “I think one of the first places that you are going to see budget cuts are more on the exploration side of things.”
The demand for new wells would likely drop significantly if prices stay low, but that is largely dependent on outside forces.
“It always comes down to what Saudi Arabia’s decision is,” says Mabry. “That’s going to be the real driver on where prices go.”