Oil is weird. Production usually doesn’t decline with prices. The reason is that the big expenses for conventional wells are all up-front. Once you’ve made those investments, you can keep producing even at low prices. And usually any revenue is better than none.
Tight oil — the stuff made by fracking — is different. Wells have high decline rates, sometimes dropping as much as 80% in the first year. So you gotta keep drilling to keep up production. The logical conclusion, then, is that when oil prices drop below the cost of drilling, the amount of production will rapidly start to fall. This should serve to stabilize oil prices.
But ... there are two counterpressures. The first is a secular decline in the cost of horizontal drilling and fracking. My friends at Laredo Petroleum have become very good at this ... and the Financial Times presents more evidence here. In the Permian Basin in Texas drilling costs have fallen from around $7 million per well in 2011 to $5 million today as production per well rises; IHS estimates that breakevens have dropped from $70 to $57 per barrel.
The second is something that does in fact occur in conventional oil as well: when prices slump, so does the demand for all the specialized inputs that oil operations need. Geologists, rigs, roughnecks, all will cut their prices. So will landowners: they will offer cheaper leases and accept fewer royalties. After all, some revenue is better than none. And oil service companies would prefer to take losses for a couple of years than have no business and risk losing all their skilled people and specialized equipment.
So maybe, just maybe, the logic is wrong and the recent fall in prices will not rapidly reverse itself as unconventional production falls.