The boom in American shale oil has played a substantial role in the nation’s economic recovery and in lowering the price of oil globally. By exploiting fracking technology, shale oil companies have contributed to the dramatic increase in U.S. oil production, which has risen from 5 million barrels a day in 2010, to over 9 million barrels a day currently. However, the price of crude oil plummeted by over 50 percent in 2014, which may spell disaster for many shale oil companies.  

Already, four shale oil companies have declared bankruptcy: American Eagle Energy, Quicksilver Resources, BPZ Resources, and WBH Energy. If low oil prices persist, can investors expect to see more shale oil companies going bust? 

Drop in Oil Prices

The decline in oil prices was caused by a number for factors. Decreased global demand for oil was caused by weakening economies and new efficiency measures. The key decision by OPEC not to cut oil production put downward pressure on oil prices and many analysts viewed it as strategic move to hurt the profitability of American shale oil companies (though Russia may also be a target). Finally, the surge in U.S. shale oil production itself played a role in the fall of oil prices in 2014 through increase the global supply. (See also What Determines Oil Prices?)

Shale oil companies are particularly vulnerable to low oil prices because of the nature of their productivity over time. Shale oil production is very different from the conventional oil wells in the Middle East or the North Sea which have a long operational life. These wells typically see their production of crude oil falling by less than 5 percent per year and can reliably provide oil for decades.

Shale Oil is Currently More Expensive to Produce

By contrast shale wells have a very short window of productivity. Within two years, shale wells will typically lose over 70 percent of their output. To maintain or increase output, Shale oil producers have to continually find and drill new wells.

Conventional oil wells with a long lifespan will keep pumping oil even after prices sink, because prices rarely fall below what it costs to extract the oil. They will keep producing oil as long as they are covering the costs of extraction. Since the wells last much longer, they are more likely to survive volatility in oil prices.

However, sharply lower oil prices can make shale oil production unviable. A study by Rystad Energy and Morgan Stanley Commodity Research estimates that the average break-even cost for U.S. hydraulic shale is $65 per barrel. Crude oil prices fell far below that level recently, to as low as $42 a barrel in March 2015. This places shale oil companies under tremendous pressure.

Adding to their problems is the fact that many shale oil companies are already deeply in debt from the ongoing need to drill new wells. The current climate of lower oil prices also makes it harder for them to secure financing for new wells.

Fracking Technology Will Improve

Despite these challenges shale oil companies have reasons for optimism. Fracking, the method by which shale companies extract oil, is a relatively recent technology. It is likely to become more efficient and cost effective over time. This could lower the price-per-barrel extraction costs and enable producers to be profitable despite lower oil prices. Another positive factor for the industry is that there is an ample supply of shale to exploit, with new drilling launching in Colorado as well as along the border of Oklahoma and Kansas.

While smaller shale oil companies may not be able to survive low oil prices, larger companies can absorb losses and wait out the volatility. At the time of writing, several of the leading companies in the industry such as Continental Resources (NYSE: CLR) and Noble Energy, Inc. (NYSE: NBL) have rebounded from recent lows.

The Bottom Line

Lower oil prices and the burden of debt pose a real existential threat to shale oil companies as evidenced by the four bankruptcies to date. The extent to which crude oil prices recover over the coming years may well determine the fate of many producers in the industry.