The Fuse

Oil Majors Take Over Where Shale E&Ps Cut Back

by Nick Cunningham | August 06, 2019

The second quarter was a rough one for many U.S. shale companies, and the recent plunge in oil prices has only deepened the pressure. By and large, financial returns continue to disappoint, and investors are stepping up their demands for capital discipline and a slowdown in drilling.

At the same time, the oil majors continue to ratchet up activity in U.S. shale, and in the Permian basin in particular. The result is a form of consolidation, with the majors scaling up as small, medium and even larger drillers cut back.

U.S. shale stress
U.S. energy stocks were wiped out in the last week of July, after a series of disappointing reports cast deeper doubts on the industry. Concho Resources, for instance, reported a 25 percent decline in profits and also said that a highly-anticipated drilling experiment – a densely packed 23-well project – led to disappointment. “The 30 and 60 day production rates were consistent with our other projects in that area, but the performance has declined,” Concho Resources CEO Tim Leach told analysts on an earnings call. “It’s just too tight.” The company said it would drill and complete fewer wells on the same budget as a result. The company’s stock sunk by 22 percent on August 1.

This is not a problem that only concerns Concho Resources. Investors interpreted the result as a bit of an indictment of shale drilling writ large. Concho’s “unfavorable spacing tests and lower than forecast capital efficiency raise justifiable questions whether we are further down the path to when shale no longer becomes as relevant a driver of global supply growth,” Goldman Sachs analysts wrote in a note. The investment bank said that bad result from Concho offers some evidence that the inventory of remaining drilling locations “stops rising and starts falling.” It could also be an indication that capital efficiency is degrading, which could mean that supply costs could rise going forward.

That is an ominous sign for the shale industry. A common theme from a range of oil executives on earnings calls with investors was a focus on “capital discipline” and a cautious approach to drilling. The rig count continues to erode, with oil rigs down more than 13 percent from a recent peak in November 2018. More than a few are trimming their spending plans.

Despite the retrenchment, investors have lost faith in the sector as a whole, which has badly trailed broader financial indices. “Investors continue to view greater rationalization and deceleration in US oil and natural gas supply growth as a prerequisite to becoming more positive on the oil/gas macro and on Energy equities,” Goldman Sachs wrote. “While we are seeing deceleration in both oil/natural gas production, it is not yet clear to us that we are at sufficient levels for a more bullish 2020 environment.”

A July report from S&P Global Ratings said that financial stress was rising in the shale sector. “After a relatively quiet 2018 for oil and gas defaults, the sector appears to be back in the spotlight this year with 10 rated oil and gas issuers downgraded to ‘D’ or ‘SD’ so far in 2019,” the report said. “Many of the more speculative names in the sector are exhibiting signs of distress and appear increasingly vulnerable to Chapter 11 bankruptcy, selective defaults or out-of-court restructurings.” While low oil prices were in part to blame, the ratings agency said that weaker companies failed to operate “within internally generated cash flow” and also suffered from “investor fatigue.” As access to capital is becoming more difficult, struggling companies could face “liquidity constraints.”

Oil majors keep spending
But one reason that U.S. production is not grinding to a halt is because the oil majors continue to step up their drilling programs, and a handful of them are increasingly shaping the narrative in the Permian. ExxonMobil said that its production in the Permian grew by 90 percent in the second quarter from a year earlier. Chevron’s Permian output jumped by 55 percent to 421,000 barrels per day. “The strong performance demonstrates our track record of consistent execution and we expect to deliver 900,000 barrels per day in 2023 with a relatively steady rig count,” Chevron’s executive vice president Jay Johnson said on an earnings call.

Goldman Sachs stuck with its U.S. supply growth forecast of 1.3 million barrels per day (Mb/d), despite deep financial stress spreading among U.S. E&Ps. The investment bank said that despite the problems bedeviling Concho Resources and other shale companies like it, the majors are in a better position to capitalize on productivity gains, using technology and contiguous acreage.

The oil majors have deep pockets and can stomach losses on individual shale projects because of profits earned elsewhere, such as offshore or from downstream units. But even the largest integrated companies are not immune to a market in a deep state of flux. For instance, even as ExxonMobil earned $3.1 billion in profits in the second quarter, it still had to borrow in order to cover its dividend. “During the quarter, the company increased production by 7% worldwide,” Tom Sanzillo and Kathy Hipple wrote in a report for the Institute of Energy Economics and Financial Analysis. “And so it goes with the energy sector. Oil and gas companies increase production even as they lose money. Put simply, the more oil and gas they produce, the more money they lose.”

The upshot is that rising production from the oil majors in the Permian could offset cutbacks and financial stress among smaller shale E&Ps. The two-track dynamic is borne out in the latest forecast from the EIA. The agency “expects monthly growth in Lower 48 onshore production to slow during the rest of the forecast period, averaging 50,000 b/d per month from the fourth quarter of 2019 through the end of 2020, down from an average of 110,000 b/d per month from August 2018 through July 2019,” the EIA wrote in its August Short-Term Energy Outlook.