History shows that those who underestimate the U.S. shale sector do so at their peril.
That hasn’t stopped many experts from writing off shale, believing that low prices, high well-decline rates, and investor demand for capital efficiency have effectively neutered shale’s growth potential. These fundamentals existed before Covid-19, and the pandemic has only increased the pressure.
Shale could have the last laugh, though, outperforming expectations on the back of lower breakeven costs.
The U.S. Energy Information Administration (EIA), OPEC, and the International Energy Agency (IEA) underestimated shale’s growth potential last decade. These organizations now all predict U.S. production to decline or grow very slowly over the next few years. Perhaps it’s time to reassess.
The EIA expects U.S. output to drop from 12.2 million barrels a day in 2019 to 11.3 million b/d in 2020 and 11.1 million barrels a day in 2021. Recent data shows U.S. output on the rise, though.
The EIA said production averaged 11.2 million barrels a day in November – an increase from the 10.9 million barrels a day produced in October. Restoration of Gulf of Mexico production after a heavy hurricane season explains some of the increase, but the EIA appears to be undercounting shale barrels, again.
Veteran energy economist Philip Verleger sees a far stronger shale recovery underway. He puts November production at 12.4 million barrels a day. He suggests shale executives are playing possum, publicly stating that they expect modest production growth in 2021 and 2022, so the Saudi-led OPEC cartel maintains its production limits.
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As for the EIA, “One might say EIA officials are deliberately underestimating the rise in U.S. production to boost prices and facilitate hedging by U.S. producers, thereby helping to strengthen and perpetuate the industry,” Verleger wrote in his recent Notes at the Margin column.
While most market watchers think U.S. producers will have a hard time returning to 2019’s peak of 13 million barrels per day, that outcome is by no means a foregone conclusion.
Verleger and others expect falling costs and rising commodity prices could drive a more vigorous resurgence in the shale patch. The reason is that the sector continues to drive down the cost of hydraulic fracturing or “fracking,” making more wells economical at lower prices.
Unlike traditional exploration and production, fracking is a manufacturing process that benefits from proportionately falling costs as output increases — what’s known as Wright’s Law in the parlance of manufacturing economics.
Consolidation in the industry has also resulted in strong companies with the efficiency of scale to reduce costs further.
A recent survey by the Dallas Federal Reserve reported that shale firms required less than $30 a barrel in most fields to cover their operating expenses for existing wells. Many companies indicated they could operate profitably in West Texas’ Permian basin for less than $40 a barrel, drilling costs included.
The scope for future shale growth is complicated by investors’ demand for companies to increase their free cash flow — the cash available to repay creditors or pay dividends and interest to investors — and debt reduction. Shareholders aren’t in the mood for returning to the debt-fueled business model that destroyed so much capital during shale’s boom era, which has made the U.S. E&P sector a stock market laggard.
But the tide may be turning. E&P shares are up 50 percent since early November on rising crude prices and Covid-19 vaccine optimism. Investors now see the sector as a good bet to outperform the broader market in a post-pandemic world. The doors to capital markets may open sooner than many think.
After generating negative free cash flow for much of the last decade, the U.S. E&P sector offers an 11 percent median free cash flow yield next year — two times higher than the broader market — if West Texas Intermediate (WTI) averages $50 a barrel, according to Morgan Stanley.
Capital discipline explains some of the improved performance, but Morgan Stanley also cited “sustainable efficiencies that have meaningfully reduced the industry’s breakeven oil price required to maintain production.” That suggests the sector may have a better handle on the traditionally high decline rates of shale wells.
JPMorgan Chase notes that full-cycle breakevens have declined by $4 a barrel, or 8 percent, to $46 a barrel on average in the five core shale oil basins of Midland, Delaware, Eagle Ford, Williston, and D.J. since April. The investment bank also sees more running room for “incremental efficiency gains” as the sector scales up.
U.S. producers are indeed scaling up as the end of pandemic slowdowns appear close at hand. The oil rig count now stands at 264 versus its nadir of 172 operating rigs in August, while service costs remain lower than average.
Meanwhile, oil prices appear ready to push higher in 2021 as demand recovers. The OPEC-plus alliance looks to be stuck in an endless cycle of production cuts to satisfy its members’ state budget needs. WTI crude is already knocking on the door of $50 a barrel.
If oil demand comes roaring back, we could face a supply crunch after 2021 due to weak upstream investment. Shale producers would be the top beneficiaries of such a scenario.
While the members of OPEC and their allies are sitting on substantial spare capacity and high stacks of barrels in storage, it’s unlikely to be enough to offset recent weak investment in new production.
Both IEA and OPEC anticipate global producers will need to add up to 30 million barrels of oil equivalent to keep up with demand by 2022. That figure climbs closer to 70 million barrels of oil equivalent by 2030.
A new joint report by the International Energy Forum and the Boston Consulting Group finds that industry investment must rise over the next three years by 25 percent annually from 2020 levels to “stave off a crisis.” Based on the 2021 capital budgets of the world’s largest oil companies — that’s not happening.
Don’t write off the great shale story just yet. The final chapter — maybe its best — is still being written.