The United States is the largest oil producer in the world, but financial stress and operational problems are starting to throw sand in the gears of the shale machine.
Taken together, the long run of explosive U.S. shale growth is likely coming to an end
Stubbornly low oil prices are exposing a lot of balance sheets in the shale patch, while some unexpected speed bumps in drilling operations are creating new headaches for oil executives. Meanwhile, investors have lost patience with the pursuit of endless growth, and over the past year have abandoned companies that are not cutting back and prioritizing cash flow. Taken together, the long run of explosive U.S. shale growth is likely coming to an end.
Negative cash flow
The story of indebted shale drilling is not a new one. For years, much of the shale industry was unprofitable and cash flow negative, but was able to finance aggressive drilling programs through a variety of means. First, they issued successive waves of new equity and debt. Then came the introduction of novel corporate structures, such as private equity-backed drillers and DrillCos. Today, production growth is increasingly coming from the oil majors, who can subsidize drilling from other parts of their companies.
Through it all, the industry has struggled to return cash to shareholders and major investors have begun to turn away. By all accounts, struggling shale drillers have seen their access to capital significantly curtailed. The share prices of energy companies have badly trailed that of broader equities. That has finally forced a reckoning, and the rig count has plunged this year as shale companies have cut back in an effort to live within their means.
By some measures, this has led to some progress. After burning through around $200 billion in cash flow over the past decade, the top few dozen shale companies have come close to positive cash flow this year. In the second quarter, one study found that the top 29 shale companies posted slightly positive numbers, which was the best performance to date.
According to Rystad Energy, the top 40 companies spent $28 billion on capex in the first half of 2019, but only took in $23.7 billion in cash flow from operations
However, according to Rystad Energy, the top 40 companies spent $28 billion on capex in the first half of 2019, but only took in $23.7 billion in cash flow from operations. In short, the industry’s “best” performance to date is still riddled with questions and red flags.
Many U.S. oil executives themselves recognize the challenges. “The already pessimistic mood of the US oil industry appears to have darkened significantly,” Standard Chartered wrote in a note. “The latest Dallas Fed Energy Survey shows sharp falls in activity, employment and business confidence.”
The quarterly Dallas Fed survey contains comments submitted anonymously by oil executives. The comments reveal an industry consumed by anxiety regarding the multiple challenges on several fronts. “Outspending cash flow, limited access to capital markets, and higher industry bankruptcies suggest lower activity [and] flat to lower production,” one executive wrote.
“Overall sentiment is very negative due to low natural gas prices and lack of available funding for oil and gas exploration. Investors have been hard hit by catastrophic declines in the price of oil and gas securities,” another oil executive said. “Additionally, many oil shale projects are failing to meet production projections.”
However, while financial pain is spreading throughout the U.S. oil industry, and production growth is grinding to a halt, some analysts cautioned against drawing sweeping conclusions. “In a nutshell, we do not believe the recent bankruptcies that have beset a number of shale players are indicative of an industry-wide epidemic,” Alisa Lukash, a senior analyst on Rystad Energy’s North American Shale team, said in a September 25 statement.
With that said, Rystad Energy also noted that the top 40 U.S. shale companies have $100 billion in debt maturing debt obligations over the next seven years. “These numbers indicate a lack of financing to deal with the burden of the obligations. Given the low levels of external capital additions during the past 10 months, the probability of debt refinancing in the coming quarters seems relatively slim,” Lukash noted.
Drillers are also starting to run into some operational problems, which could yet turn into a major headache for the shale business model.
The problem of “parent-child” well interference has been reported on over the past year or two, and while the full scope of the issue remains unclear, the problems are proving to be affecting more than just a handful of drillers. In essence, wells drilled too close together produce less oil than previously expected, which is a serious problem since company valuations have been based on acreage, anticipated wells, and future production. In other words, if companies can’t produce as much oil as they previously expected at a given price, then perhaps they aren’t worth as much as everyone thought.
A September 3 report from Raymond James says that well productivity in general might be hitting a wall.
A September 3 report from Raymond James says that well productivity in general might be hitting a wall. “For the first half of this year, however, we estimate that U.S. well productivity gains have only amounted to about 2% (vs our 10% growth estimate),” Raymond James said. “We believe that this represents clear evidence that U.S. well productivity gains are beginning to reach maximum limits and may even roll over in the coming years as the industry struggles to offset well interference issues and rock quality deterioration.”
A few high-profile cases have been widely scrutinized. For instance, in late July, Concho Resources disclosed that its experiment to drill 23 wells in a single plot proved disappointing, and that it would space out future drilling projects. The company’s share price went into a nosedive.
More recently, the Wall Street Journal pointed to the case of Hess, which saw the average production from its wells in North Dakota in the first five months of 2019 average 82,000 barrels per day, or 12 percent below output levels for the company’s 2018 wells and 16 percent below 2017 wells.
These operational issues and productivity limits also have global ramifications since the U.S. is the largest oil producer in the world and is also expected to be the largest source of supply growth going forward. “We’re getting closer to peak production and we are reaching the peak of the general physics of these wells,” James West, a managing director at Investment bank Evercore ISI told the Wall Street Journal. U.S. oil production has barely grown at all this year.
Worse, from the perspective of the energy industry, oil prices are not rising in response to lower-than-expected production growth. “Houston meetings suggest managements on the margin are looking to spend less/grow less, leading to downside risk to our US oil growth forecasts as the rig count continues to fall,” Goldman Sachs analysts wrote in a note after a trip to Texas in late September. “Investor sentiment has not become more bullish, however, as falling expectations for US supply growth are matched with falling expectations for global demand growth.”