Cracks in U.S. shale emerged earlier this year, with evidence pointing to a slowdown in the three-year efficiency campaign that began when prices collapsed in 2014. Cost cutting and new drilling techniques have helped U.S. E&Ps dramatically lower their breakeven prices, but headwinds for the industry are gaining in strength. A rebound in costs—for equipment, fracking services, rig rates, labor, etc.—started to undercut the progress achieved by the industry over the past year. U.S. oil production, however, continued to grow anyway.
Rig productivity is falling, shale companies are no longer making headway on drilling times, and cash flow continues to disappoint investors.
More signs of trouble have continued to crop up. Rig productivity is falling, shale companies are no longer making headway on drilling times, and cash flow continues to disappoint investors, who are demanding change and questioning the bullish growth forecasts for U.S. shale.
U.S. shale ramped back up after the OPEC deal was announced about a year ago, when WTI returned to above $50 per barrel for a period of time. With many shale drillers having successfully lowered their breakeven prices, analysts assumed that the rebound in production would be swift and overwhelming. The rig count soared and U.S. oil production has climbed by about 1 million barrels per day (mbd), from 8.55 mbd in September 2016 to roughly 9.5 mbd a year later. An uptick in drilling costs was a consequence of a tighter market for rigs, capital and labor, but analysts believed this development would not derail the rosy projections for the shale industry. The EIA still expects the U.S. to average 9.9 mbd in 2018.
Large oilfield services companies are trying to reclaim margins from oil producers after three years of backpedaling.
But obstacles are starting to accumulate. Drilling costs are still on the rise, and shale companies “will be hard pressed to further reduce drill-bit finding and development costs, since drilling efficiencies may be offset by higher service costs,” Moody’s Investors Service said in a report surveying 37 shale E&Ps.
Large oilfield services companies are trying to reclaim margins from oil producers after three years of backpedaling. Halliburton, one of the largest oilfield services companies in the world, saw a 14 percent increase in North American revenue in the third quarter, the result of both an uptick in demand for its services but also because Halliburton was able to charge oil producers more. “The North America completions market remains tight and we continue to push pricing across our portfolio every day,” Halliburton CEO Jeff Miller told investors on a conference call on Monday.
Rig productivity has stagnated in all of the major shale basins in the U.S.
Higher production costs have been assumed for quite a while, but more recently, drilling problems have also emerged, calling into question the durability of the shale rebound. Shale productivity, or the volume of oil output from an average rig drilling a new well, has stagnated in all of the major shale basins in the U.S. In the case of the Eagle Ford and the Permian, productivity has fallen considerably.
Productivity in the Eagle Ford, for example, peaked at 1,617 barrels per day (b/d) from a new well in October 2016, falling to just 1,065 b/d per rig per well in September 2017. Falling productivity is also affected by the ballooning backlog of drilled but uncompleted wells (DUCs), meaning a lot of production from those drilled wells has yet to come online.
However, as the FT notes, the steady improvement in drilling times is also showing signs of fatigue. Shale companies made huge strides in recent years in cutting the time it took to drill an average well—but drilling times have deteriorated in the Eagle Ford and the Williston Basin, an indication that the advances in drilling techniques are reaching their limits. Moreover, as the FT also points out, some of the efficiency gains over the past few years might have been the result of a one-off switch from vertical wells to horizontal wells, a transition that is largely complete. In other words, rising rig productivity was likely overstated in the data because the industry increasingly turned to horizontal drilling. With horizontal drilling now the industry standard, much of the low-hanging fruit has already been picked.
$50 oil is key
Overall U.S. oil production is still rising, but at a slower pace than recent gains. The EIA estimated that shale output would rise by 79,000 b/d in October, the first time in seven months that monthly gains failed to reach 100,000 b/d. In November, the EIA sees growth of 81,000 b/d, further evidence of moderation increases.
For the week ending on October 20, the oil rig count fell by 7, the largest weekly drop since May 2016. The recent declines foreshadow a further deceleration in production gains, if not a near-term peak in output.
Because there is a several-month lag between movements in the rig count and changes in oil production, the slower gains are likely the result of the recent changes in the rig count. Earlier this year, the weekly jump in the rig count routinely hit double digits, but that slowed to a crawl this past summer, and has recently gone into reverse. For the week ending on October 20, the oil rig count fell by seven, the largest weekly drop since May 2016. The recent declines foreshadow a further deceleration in production gains, if not a near-term peak in output.
The upshot of these various pieces of data is that the U.S. shale industry seems to stop and start at $50 per barrel, at least in the aggregate. “$50 oil price drives significant activity,” Halliburton’s Jeff Miller said on a conference call. The breakeven price for the Permian—the most competitive shale basin in the U.S.—is often pegged at about $40 per barrel. Some companies have boasted of even lower breakeven prices. While that may be true for individual companies, the data suggests that is not the average for the entire industry.
The shale industry has run out of ways to slash costs, and will likely need higher oil prices going forward.
An August Bloomberg survey of 33 shale companies finds that they were collectively cash flow negative by nearly $20 billion in the prior 12 months. That included 14 Permian-focused drillers that posted a combined loss of $11.5 billion. For all the hype about the Permian, shareholders are not seeing returns.
In short, the shale industry has run out of ways to slash costs, and will likely need higher oil prices going forward. “North American E&P companies’ focus on cost reduction has brought their capital and operating expenses down substantially since mid-2014, when oil prices began to collapse, but further reductions will be difficult to achieve,” Moody’s Vice President Sreedhar Kona said in a statement in late September.
Shareholders want change
With WTI stuck near $50 per barrel, investors are becoming anxious. Shale companies raised just $5.7 billion in new equity in the first nine months of 2017, according to the FT, citing data from Dealogic. That is down from a record-breaking year in 2016 at $34.3 billion in new equity issuance. Other shareholders are taking a more activist approach, demanding changes in executive compensation that aim to incentivize profitability rather than seek growth at any cost.
“Companies are paying more than just lip service to improved capital discipline.”
A new, more cautious approach aimed at shareholder returns may be gaining traction. In September, Anadarko Petroleum announced a share buyback worth $2.5 billion. Investors were clearly pleased that cash would be returned to them rather than burned in the shale patch. Anadarko’s stock jumped by 7 percent on the news. Kevin Holt, a fund manager with Invesco, told the FT that Anadarko’s decision and its warm reception on Wall Street was a sign that more shale companies would be forced into similar changes in strategy.
Third quarter earnings reports will be announced in the coming days and months, which should offer clues as to whether or not the industry is changing course due to new realities. “We believe companies are paying more than just lip service to improved capital discipline, though we still believe it is likely that aggregate capex will exceed cash flow,” analysts from Goldman Sachs wrote in a research note from earlier this month.