The Fuse

Will Higher Oil Prices Lead to a Return of Reckless Shale Growth?

by Nick Cunningham | March 11, 2021

Oil prices recently rose to their highest levels in nearly a year and a half, rising to levels not seen since late 2019.

The rally marks a dramatic turnaround for the oil industry, which is still nursing wounds from the pandemic. The U.S. shale industry continues to assure investors and analysts that this time is different – that they won’t drill their way into financial disaster. Higher oil prices may put those promises to the test.

Promises of restraint

OPEC+ surprised the market on March 4 with a decision to extend the current production cuts for a little while longer. Most analysts expected the group to agree to relax the cuts, adding more supply back onto the market beginning in April. The extension led to a spike in oil prices, with Brent briefly touching $70 per barrel.

“We think OPEC+ has signaled that an overtightening of the market is likely, and is only likely to be corrected after a significant lag,” Standard Chartered wrote in a note on March 8. The bank raised its Brent 2021 price forecast by $14 per barrel to $65.

The oil market has been tightening for several months, in large part because OPEC+ has kept such a large volume of supply offline, but also as global demand has continued to rebound from the pandemic-induced drop off last year.

U.S. shale has been stagnant after last year’s collapse.

But another reason for higher oil prices is the fact that U.S. shale has been stagnant after last year’s collapse. The U.S. rig count plunged and production fell sharply from the roughly 13-million-barrel-per-day (Mb/d) peak on the eve of the pandemic, down to around 11 Mb/d. The shale industry was hit by a wave of bankruptcies in 2020, with drillers having already previously amassed mountains of debt.

Pressure from investors to keep spending in check and keep the rigs on the sidelines has become impossible to ignore, and industry executives seemed to get the message loud and clear. “I have a hard time seeing the need for U.S. producers over the next several years to get back to double-digit growth,” Devon Energy’s CEO Rick Muncrief told Bloomberg in early January. “For this management team, if we really think about 2021, let’s keep it flat.”

On a long list of fourth quarter earnings calls, shale executives promised a laser focus on cash flow at the expensive of production growth. “Investors continue to worry the industry will break ranks from its commitment towards capital discipline given the improvement in crude prices,” analysts at Tudor Pickering Holt & Co. said in January. But based on conversations with multiple companies, “concerns on this front should be put to rest this quarter as the industry is committed to maintaining a cap on growth in 2021 with the intention to use free cash flow generation to pay down debt or accelerate shareholder returns,” the bank said.

Even the oil giants are taking heed. ExxonMobil substantially lowered its medium-term Permian outlook, now expecting to produce around 700,000 barrels per day in 2025. Previously, the major aimed to produce 1 Mb/d.

Will drilling accelerate?

The market meltdown in 2020 decidedly put an end to the go-go era of U.S. shale. Nevertheless, the outlook suddenly looks more attractive – a WTI price in the mid-$60s may have seemed unfathomably high as recently as a few months ago. Despite assurances of newfound restraint (assurances that the industry also put forward during previous downturns), $65 WTI may become too tempting to ignore.

The market meltdown in 2020 decidedly put an end to the go-go era of U.S. shale.

Standard Chartered suggested that OPEC+ may be running the risk of leaving too much room for a ramp up in shale drilling. “We wonder if OPEC+ ministers are perhaps being overly reliant on analysis of the exchange-listed shale oil companies that have faced challenges during the period of low prices, and are perhaps not fully considering the responses of the major oil companies in the Permian Basin and the private operators,” bank analysts wrote.

Away from public scrutiny, private drillers are under less pressure than publicly-traded ones. Bloomberg notes that a company called DoublePoint Energy, for example, has more rigs in the Permian basin than Chevron, one of the largest Permian producers. Another private company with little name recognition, Mewbourne Oil Co., has the same number of rigs as ExxonMobil. Taken together, private drillers could amount to a growing slice of new production.

“We expect higher prices to hasten the start of the recovery in US shale oil output,” Standard Chartered said. Prior to the OPEC+ announcement on March 4, the bank expected U.S. oil liquids production to decline in 2021, now it expects an increase of 131,000 barrels per day followed by a larger 679,000 barrels per day in 2022. Moreover, the risks to this outlook “are to the upside,” the bank concluded.

A handful of shale companies surprised market analysts in recent weeks with slightly more aggressive outlooks than had been expected. EOG Resources, for example, beat profit expectations for the fourth quarter when it announced results in February, and also hiked its dividend. But its stock fell immediately after results were announced, and analysts attributed the underperformance to EOG’s higher-than-expected plan for spending.

A more glaring example was that of Matador Resources, which announced on February 24 that it was adding a rig back into the field and increasing spending. Its share price fell 5 percent on the news, which was all the more notable because it occurred on a day in which oil prices rose and most of the energy sector posted gains. Analysts widely saw it as punishment for a seeming return to profligate behavior.

The much larger Chevron announced on March 9 that it was bringing back its 1-Mb/d production target for the Permian by 2025, which was quietly scrapped last year during the pandemic.

Overall, however, the rig count remains a fraction of what it was before the pandemic, and the increases have mostly been concentrated in the Permian basin, at the expense of other drilling areas. It is too soon to say whether or not the industry will once again return to reckless growth en masse.

“Based on the recently updated FY2020 earnings and 2021 guidance, shale oil-focused companies will hold their drilling and completions (D&C) budgets relatively flat compared with a year earlier, increasing only by $100 million, or 0.4%,” Rystad Energy said in a note.

However, the firm said that the core shale basins are economic at current prices, and “there are large numbers of new commercial opportunities in other basins too in the current market environment.”