The mighty shale machine is finally slowing down. The question is how concerned energy investors and consumers should be since a decline in drilling activity ultimately points to a drop in production.
Data from oil services firm Baker Hughes shows the U.S. oil rig count dropped by 17, or over 2%, during the week ended Oct. 25, putting the tally of rigs in the field under 700 for the first time in two and a half years. The drop marks the largest one-week decline in six months for U.S. oil drilling, which has essentially been on a downward trajectory for most of the past year.
What’s going on here? The capital discipline investors have demanded from shale producers is finally showing up in drilling programs. While shale producers have been successful in growing U.S. oil production to record levels of more than 12.5 million barrels a day, it has been less successful in making money for shareholders. Those shareholders are now no longer rewarding drilling companies for unprofitable growth.
The effect on producers’ stock prices is ugly. The biggest U.S. exploration and production companies (E&P) are showing roughly 35% declines in their share prices over the last 12 months, while smaller independents are faring much worse with drops of over 60%.
That kind of capital retreat will force a sector to make massive strategic changes. For shale, that means the pursuit of “value over volume” rather than growth at any cost.
The industry needs to show it can grow while keeping its capital expenditures within its cash flow -- otherwise, Wall Street will hammer it. Period.
That reality has translated to tight capital discipline across the sector. With a couple of months left in the year, many shale producers are already nearing the limits of their annual spending budgets. These companies have signaled they will not overspend under any circumstances. The result is an acceleration of the drilling wind-down that we’ve seen across domestic oil plays recently.
The fact that U.S. benchmark West Texas Intermediate (WTI) prices have remained near $55 a barrel despite intensified geopolitical tensions in the Middle East, including the devastating September 14th aerial attacks on Saudi oil facilities that temporarily wiped out more than half of Saudi production, has kept pressure on shale companies to stay within their budgets. Many shale producers break even at oil prices in the mid-$50s, so there’s little margin for error.
The good news is that the sector is making progress in avoiding “cash burn” and delivering more free cash flow to shareholders. The second quarter of 2019 marked the first three-month period on record when shale operators achieved positive cash flow from operations after accounting for CAPEX, according to consultancy Rystad Energy.
Rystad studied the financial performance of 40 shale companies and found that the group accumulated a $110 million surplus in cash flow versus CAPEX -- an industry first.
But with WTI prices on a knife’s edge and right around break-even levels, there is much more work to be done. Indeed, just 35% of the companies in the Rystad survey were able to balance their spending with cash flow, meaning a large swath of the sector still is not getting the job done.
Moreover, leading oil services companies such as Schlumberger and Halliburton have recently posted sobering earnings reports that portray a grim future for the E&P sector.
With global oil markets well-supplied and over 4 million barrels a day of production off the market due to OPEC cuts and U.S. sanctions on Iran and Venezuela, there’s little hope for higher oil prices in the short-term.
For the time being, shale producers will remain conservative. Investment bank Barclays now says that E&P spending in the United States will fall by 2% this year, including a 7% drop among shale-focused independents. Capital investment should be flat or down 5% in 2020, Barclay analysts predict.
U.S. oil production is expected to show impressive year-over-year growth in 2019 of 1.3 million barrels a day, according to the U.S. Energy Information Administration (EIA). But a closer look reveals that U.S. output has effectively flatlined at a little over 12 million barrels a day since late last year.
EIA forecasts growth to level out in 2020 because of falling prices in the first half of the year and continuing declines in productivity. The sector can only improve well-productivity rates by so much, and companies have likely achieved most of these efficiencies. Combine that with more disciplined spending, and EIA sees U.S. production growth slowing to 900,000 barrels a day in 2020 for an average of 13.2 million barrels a day.
That’s still strong growth, but there’s probably more downside risk to it than upside potential due to oil prices. The new reality in shale is that if oil prices rise substantially, any extra cash flow will be used to pay down debt or reward shareholders with dividends or stock buybacks. Many think shale drilling budgets won’t rise unless WTI enjoys a sustained recovery with producers seeing prices of $65 to $80 a barrel for at least a year ahead in futures markets.
For that to happen, global oil markets need to tighten substantially -- which probably only begins with a negative supply response from shale.
