Source: Chevron Upstream Overview Analyst Presentation.

Oil and gas major Chevron (NYSE: CVX) just hosted its annual call with securities analysts. What we learned from the call is that Chevron, like the entire oil and gas industry, is at a major infliction point.

The age of the multibillion-dollar megaproject is over. The age of the much more flexible shale has begun.

Eliminating delayed-gratification spending
The oil and gas industry didn't race out into the middle of the ocean to drill for oil and gas because that was the preferred place of doing business. The industry ventured into that extreme environment because it had run out of places onshore in North America to look for conventional oil and gas reserves.

You can say the same thing for the oil sands and the Arctic as well. The industry became interested in tapping into these high-cost sources of oil because that was what was the best option available.

Figuring out how to economically produce from shale rocks has changed all of that. With continuous trial and error lowering costs and increasing production rates, shale keeps getting better. Shale has provided the industry an alternative to the expensive and long-lead-time megaprojects that had become the focus of the majors. 

With megaprojects including Gorgon and Wheatstone now coming online, Chevron clearly stated in its analyst call that the company would now be focusing spending on shorter-cycle shale projects. "You shouldn't be surprised, by the middle of the next decade, you could see 20% to 25% of our production could be in the short cycle shale and tight activity," said Chevron CEO John Watson.


Source: Chevron investor presentation.

From just 40% of capital spending in 2015, shale and tight oil development will increase to 65% of Chevron's budget in 2018. The OPEC-engineered oil price collapse hasn't killed shale; it has made the oil industry embrace it.

Shale provides the ability to be opportunistic
It isn't hard to figure out why Chevron would choose to do this. Major projects such as Gorgon and Wheatstone require years to build and billions of dollars. Then, between the time when the project is approved and when it comes on stream, the commodity price environment might make the project completely uneconomic. 

Like a deepwater megaproject, shale production also requires higher commodity prices than a conventional onshore discovery would. But unlike a megaproject, a shale well only takes weeks to drill, and spending can be stopped almost immediately if commodity prices turn.

With shale development, companies can be much more opportunistic and react to where oil and gas prices go. A deepwater megaproject is the opposite of this, because once companies have hundreds of millions or billions invested, they have to see the project through to completion. Not getting any cash flow from all of that invested capital is not an option.

For Chevron, the Permian is an advantaged royalty position
Chevon's objective in the Permian is to be fully competitive with other operators in terms of unit development and operating costs and then use its advantaged royalty position to give the company a leading financial performance.


Source: Chevron investor presentation.

Chevron has been sitting on this Permian acreage for decades, as the company has held it through original conventional development. Because of that, 85% of the land has no or a very low royalty rate. That will make Chevron's production more profitable than many Permian competitors or give it a lower breakeven point when prices are low.

With 2 million acres of land and 9 billion barrels of oil and gas resource, Chevron has a long runway to work with in the Permian. In the low range of its long-term forecast, Chevron believes it will be producing 250,000 boe per day by 2020.

What investors need to know
While I believe investors should be excited about the future of shale and tight oil, it's important to note that higher oil prices are going to be required. Chevron shows breakeven prices for its Permian drilling locations in the following slide: 1,300 locations break even at $40, 4,000 locations at $50, and 5,500 at $60.


Source: Chevron investor presentation

To which I say: Who wants to take the risk of drilling oil wells for the prospect of breaking even? I would also note that these are half-cycle economics, which means that this profitability gives no consideration to indirect costs such as interest expense, corporate overhead, and income taxes.

To make the Permian really a needle mover for Chevron's profits, we're going to need oil to get back into the $70 range, at least. Yes the age of shale is here, but we still need commodity prices to cooperate.


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