The Fuse

As Shale Hits Roadblock, International Drilling Rebounds

by Nick Cunningham | July 26, 2018

In the past few years, drilling activity outside of North America has languished, at least compared to the frenzied production increases seen in the shale patch. The result was a sort of two-speed market: The oil and gas industry poured in money and equipment into U.S. shale, which translated into a surge in output. Meanwhile, drilling activity elsewhere in the world, wiped out by the market downturn that began in 2014, struggled to rebound.

For the first time since the price collapse, that dynamic is changing. International drilling is finally picking up at a time when the blistering growth of U.S. shale is set to take a breather because of pipeline constraints.

Shale slowdown

Halliburton reported a 7 percent increase in revenues in the second quarter, compared to the first three months of the year, and its completion and production unit grew operating income by 34 percent. Halliburton noted that its margins in the U.S. are “closing in on the 2014 peak.”

Halliburton’s share price fell 8 percent on the news, the largest single-day decline since 2014, despite seeing profits rise for the quarter. The reason for the decline was not the earnings numbers, but rather the headwinds the company sees in the Permian basin from a variety of bottlenecks. Halliburton says it expects cost inflation in the second half of the year, due to constraints on trucking, sand and water. Also, the sudden surge in drilling activity means that the company’s equipment “has never worked harder than it’s working today,” Halliburton President and CEO Jeff Miller told analysts and shareholders on an earnings call. While that is a boon for the business that depends on activity, the result is higher costs for maintenance.

“Tightness is an indicator of a great resource,” Miller said. He tried to reassure shareholders, insisting that the constraints “should begin to alleviate in early 2019 as additional off-take capacity comes online.”

The pipeline bottleneck in the Permian is a larger problem. “There are customers that have moved their focus from one basin to another,” Miller said, and “other customers plan to reduce activity over the short term or adding fewer rigs than expected.” Halliburton is the leading oilfield service provider to the U.S. shale industry, so the pessimistic near-term outlook regarding midstream bottlenecks reflects an industry-wide problem. Halliburton’s CEO essentially asked shareholders and customers to sit tight and wait out the storm, striking a much more optimistic view on the long-term outlook. “Tightness is an indicator of a great resource,” Miller said. He tried to reassure shareholders, insisting that the constraints “should begin to alleviate in early 2019 as additional off-take capacity comes online.”

Schlumberger, more internationally focused than Halliburton, is less exposed to U.S., but still the company predicted that pipeline constraints in the Permian “could temper the activity growth over the coming quarters.”

Halliburton’s chief executive sees relief coming early next year, but the specific timeline is a bit uncertain. Wells Fargo said in a recent report that the pipeline bottlenecks may not be resolved until the first quarter of 2020 as some pipeline projects suffer delays. The bank had previously expected pipeline capacity to come online in the third quarter of 2019. One key project, the Cactus II pipeline, ran into trouble last week when its application for an exemption from tariffs on imported steel was rejected by the U.S. Commerce Department, raising questions about the project’s completion date.

The EIA projects the Permian basin to add 0.6 million barrels per day (Mbd) between June 2018 and the end of 2019, or about half of the total U.S. increase over that timeframe. The annual increase in production from the Permian in 2019 is projected to be 0.4 Mbd lower than for this year, the result of a midstream bottleneck. Other areas take on greater importance as shale drillers pivot away from the Permian, including the Bakken, the Eagle Ford and offshore in the Gulf of Mexico. The lack of pipeline space has already led to steep discounts for Midland crude, a problem that will persist until new pipeline capacity comes online. “The widening spread between WTI-Cushing and WTI-Midland crude oil prices signals the expectation for reduced drilling activity growth through the forecast period, which in turn is expected to slow the rate of crude oil production growth through 2019,” the EIA wrote in its latest Short-Term Energy Outlook.

International drilling activity picking up

Even as U.S. shale runs into some temporary headwinds, the “broad-based recovery in the international markets has now finally started,” Schlumberger’s CEO Paal Kibsgaard told analysts on an earnings call. Schlumberger is benefiting from growing demand for its services in Saudi Arabia, Mexico, Iraq, India, Colombia, Argentina and Brazil, among others. The largest oilfield services company said it is mobilizing all of its services and will have “no spare equipment capacity by the end of 2018.” As a result of a growing backlog, Kibsgaard suggested that the company will press oil producers for better terms.

GE’s Baker Hughes reported mixed figures, but the company agreed that signs of the international rebound are becoming more visible. “This is what people have been looking for — the inflection in the international business. It is starting to materialize now,” Societe Generale analyst Edward Muztafago, told Reuters.

There is a bit of urgency to invest in new production because years of underinvestment has led to “noticeable year-over-year production declines in 15 of the world’s producing countries,” Kibsgaard said, arguing that new investment is needed because the volume of supply set to come online over the next few years “will likely not be sufficient to meet the increasing demand.”

The IEA has repeatedly warned about a shortage of supply in the early 2020s as a result of insufficient upstream investment.

Upstream oil and gas spending rebounded in 2017, but only by a rather tepid 4 percent, and will grow by another 5 percent this year, according to the IEA’s new World Energy Investment report. The modest uptick came after a 40 percent plunge in spending between 2014 and 2016. The IEA has repeatedly warned about a shortage of supply in the early 2020s as a result of insufficient upstream investment. Even as companies like Schlumberger struck an optimistic tone regarding international activity, the offshore sector remains weak, and may not return to pre-2014 drilling levels anytime soon.

Shale still dominates

The rebound in international drilling activity occurring alongside a sudden slowdown in shale drilling has somewhat flipped the two-speed market of the past few years on its head. However, this does not signal a permanent shift. Internationally, the offshore sector is only beginning to rebound, and has yet to really recover from the damage related to the 2014-2016 market downturn. The industry is also increasingly focused on brownfield development, not new greenfield megaprojects, the IEA says. On top of that, oil producers are pivoting to natural gas, petrochemicals, refining and renewables, hoping to diversify a bit away from upstream crude oil production.

Meanwhile, the hiccups facing U.S. shale are related to midstream constraints, not because of a lack of interest in drilling. Indeed, the oil and gas industry “is shifting towards short-cycle projects,” the IEA said. Shale is expected to represent one quarter of total global upstream oil and gas investment in 2018, a record high. Indeed, the overall rebound in total upstream oil and gas spending last year was largely driven by a tidal wave of investment in shale.

Moreover, higher oil prices paired with the cost reductions over the past few years will allow the U.S. shale industry “to achieve positive free cash flow in 2018 for the first time ever.” U.S. shale production is set to grow at a much slower pace over the next 18 months, but new pipelines towards the end of next year will open the door for another wave of supply from 2020 on.

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