Summary

• Is the decline in oil price a replica of a paradigm shift in natural gas price?

• Is U.S. shale oil big enough to impact global oil prices?

• What are the implications for shale oil producers?

As shale oil producers struggle with the impact of the first cyclical downturn in the oil market in a decade (I exclude the financial crisis-induced oil price collapse in 2009 that proved transitory), I cannot help drawing certain parallels with the natural gas market.

What Happened In Natural Gas?

It would not be much of a risk to state that the new era of natural gas abundance in the U.S. started with the success in the Barnett Shale that became fully apparent approximately in the 2003-2005 time frame. The Fayetteville Shale and several other "junior" shale plays were discovered shortly thereafter. In that early "first phase" of the shale gas revolution, the success of early shale plays was an important, albeit only partial, remedy for the acute shortage of natural gas supply. However, it was insufficient to address the stratospheric prices for natural gas.

The second phase of the natural gas revolution was marked by the discovery of the Haynesville Shale in 2007. The significance of that discovery was in the prolific nature and scale of this over-pressured gas reservoir that resulted in a rapid supply build over a short period of time.

The Haynesville's initial success and the lease capture boom that followed coincided with the discovery of several other natural gas and liquids-rich plays, including the Eagle Ford in 2008 (of note, the Eagle Ford was initially targeted as a natural gas play), the Marcellus, numerous shale plays in Canada, and several others.

The third phase of the natural gas revolution was marked by the emergence of the Marcellus as by far the largest low-cost source of supply that overwhelmed all other sources. This third phase became manifest as natural gas price collapsed in early 2012. A new low-price paradigm for natural gas on the North American continent was firmly established and recognized by many investors and analysts as a sustainable macro trend.

So what does it all have to do with Oil? After all, U.S. unconventional oil production represents approximately one-twentieth of the total global demand.

Is Shale Oil Following In The Footsteps Of Shale Gas?

It is curious that a three-stage pattern similar to the one that I just described has already evolved in the U.S. shale oil industry. I would argue that the U.S. shale oil revolution has just entered its third phase, with 2015 being a rough equivalent of 2012 in shale gas.

So what is shale oil's equivalent to the "three-shale" sequence of Barnett-Haynesville-Marcellus in natural gas? In shale oil that appears to be Bakken-Eagle Ford-Permian.

To illustrate the potential significance of the Permian plays, I will include just one slide from a recent presentation by Diamondback Energy (NASDAQ:FANG) plotting well performance in the Lower Spraberry Shale in the northern Midland Basin. Please note that the graph shows cumulative oil production only (wells also produce liquids-rich gas). Please also note that Diamondback's leading edge AFE in the Lower Spraberry is just ~$6 million per well. (Doesn't this graph remind of Susquehanna County in the Marcellus?)

A Clarification Is In Order

Although vivid, the three-shale schematic presented above is, admittedly, somewhat misleading as a depiction of the shale revolution.

It would be inaccurate to say that "the Marcellus has won against the Haynesville." The adequate depiction is that each new phase in the natural gas revolution introduced new sweet spots and more effective extraction techniques. As a result, the industry's "core supply" was redefined each time.

It would be fair to say that in the process, sweet spots in the Marcellus, Haynesville, Pinedale and many other fields have won against Tier 2 sources of supply (often in the same fields) that were squeezed out from the market i.e., the Marcellus Core won against the Haynesville Tier 2 and the Haynesville Core won against the Marcellus Tier 2.

Given that the industry's aggregate cost of supply is defined by the breakeven price for the most marginal "core" producing area, the prevailing natural gas price experienced a "paradigm shift."

U.S. Shale Oil Revolution: Entering Phase 3

The reason to believe that the shale revolution in oil is following the same pattern as the shale revolution in natural gas is twofold:

• continued expansion of the oil industry's aggregate "sweet spot base," and

• rapid gains in well productivity within the previously delineated areas.

In terms of new sweet spot discoveries, I will use just two recent examples:

• the discovery of the Lower Spraberry Shale productivity over the past eighteen months, and

• the Springer Shale discovered by Continental Resources (NYSE:CLR) two years ago in the Anadarko Basin.

Please note that the term "discovery" has been redefined in the context of shale exploration. The presence of potentially productive tight oil or natural gas formations is typically well known and in many cases confirmed by legacy vertical production. I think of a "shale discovery" as a process that includes the primary demonstration of potential commerciality of a resource play with a subsequent confirmation via production history and additional wells.

The slide above illustrates the economic potential of the Lower Spraberry (which has been in the center of analysts' attention in the past several months).

The slide below from Continental Resources' presentation illustrates potential productivity of the Springer Shale. The early time performance graph shown on the slide indicates that Continental's four-well Jeanna density pilot is tracking along the company's 940 Mboe type curve. Please note that these are single section laterals and production is characterized by high oil yields. While the Springer Shale is still in early evaluation, Continental's estimates have suggested that this resource play has the potential of yielding some of the best returns in the company's vast portfolio.