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Will $80 Oil Open Shale's Spigots?

Copyright © 2021 Energy Intelligence Group
WEO ONLY -- US Shale Oil's Midlife Crisis

US crude’s march above $80 has left many wondering how the country’s short-cycle shale suppliers might respond. Frenzied drilling by the sector in the last decade punished prices — and returns. So is the stage set for a repeat? Energy Intelligence examines the factors in play.

  • “$80 oil” doesn’t tell the whole story.

West Texas Intermediate (WTI) futures soared above $82 per barrel on Friday, hitting fresh seven-year highs and fueling speculation that US shale’s capital discipline may soon unravel. But these robust price levels only apply to the front-month contract. As time passes, crude gets cheaper.

In fact, December 2022 WTI is trading more than $7.40 below its January 2022 counterpart, pegging late 2022 crude below $73/bbl. Prices fall further from there.

If WTI does end up averaging close to $76/bbl as the current 2022 strip suggests, it would be the highest annual average since 2014 and far above the sub-$45 break-evens major US E&Ps have established. But it's key to remember that a fuller pricing picture is considered when companies plot 12-month budgets.

  • Capital discipline doesn’t preclude growth — but it will limit it.

Shale producers will raise capital spending next year. But it doesn’t have to sound any alarm bells.

Investors are keeping US E&Ps on a tight leash and will pull their support if reinvestment in the drillbit isn’t done responsibly. “Responsibly” here means keeping capital spending within cash flows, actually earning a decent return on that investment, and returning a healthy chunk of cash to shareholders via dividends and share buybacks.

Critically, “responsible” investment was defined in even more limited — and arguably unsustainable — terms this year: Only invest enough to hold oil output flat.

The world didn’t need shale to grow given millions of barrels per day of Opec-plus spare capacity and eye-watering oil inventories following last year’s pandemic-led lockdowns. US E&Ps also needed to fix badly broken balance sheets.

But the insistence that publicly traded producers avoid growth regardless of oil price does not need to hold as firmly in 2022.

The Opec-plus producer group should finish unwinding its supply cuts next year, and concerns are emerging around what new supply can enter the market after that, assuming demand growth remains robust.

Most major US producers — a.k.a. the ones who move the needle on output — have promised to limit capital expenditure to 60%-70% of operating cash flows and will send remaining funds to debt repayment and shareholder returns. Although that will put a ceiling on spending, it still allows for a healthy chunk of additional capex at $70-plus oil.

This year’s “maintenance” investment rates equated to less than 50% reinvestment in the first half of 2021, Energy Intelligence calculations show. That figure will fall even further as the year progresses given higher cash flows from rising oil and gas prices. WTI averaged $62/bbl in January-June.

  • Producers will have to spend more for their next barrels due to declining DUCs …

The extra capex will not be able to be as effective as the money invested this year, further limiting how much shale will grow.

One reason US producers have been able to stabilize output this year with such small budgets is their reliance on drilled but uncompleted wells (DUCs).

US producers have drawn down nearly 36% of the country’s DUC inventory in major shale basins and 43% of the inventory in the Permian Basin since June of last year, US Energy Information Administration (EIA) data show.

The EIA still counts over 2,000 DUCs in the Permian and 5,700 DUCs across all shale basins. But industry players consider many of those to be “dead DUCs” — that is, wells drilled on marginal acreage or placed suboptimally earlier in shale’s history, and thus not viable given the industry’s current returns focus. That means producers will have to put more rigs to work to add attractive barrels.

Significant efficiency gains should allow companies to rely on far fewer rigs than before Covid-19 to get the job done. But expect the rig count to march continually higher.

  • … And cost inflation.

Another dampener on capex effectiveness is cost inflation.

This has been felt most acutely in the oil-field services sector so far, but services providers will work hard to pass on as much of these increases as possible to producers as activity ramps up.

The Dallas Federal Reserve’s third-quarter energy survey had a record number of executives in the oil-field services sector report quarterly increases in raw materials and labor costs, as well as longer lead times for both their own supplies and their ability to deliver services.

Some respondents offered anecdotally that they are paying “all-time high” wages to attract workers and noted a shortage of qualified drivers.

  • Amid these factors, Energy Intelligence sees US crude output rising by 700,000 barrels per day across 2022.

Energy Intelligence’s Oil Markets Service expects US crude output to end 2021 at 11.3 million b/d — roughly flat with current levels — and exit 2022 at around 12 million b/d. That growth assumes WTI averages $75/bbl next year and would peg full-year 2022 output at 11.7 million b/d.

US crude production touched an all-time high near 13 million b/d in late 2019 before the Covid-19 pandemic struck. It should average 11.1 million b/d for 2021, Energy Intelligence forecasts show.

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