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US tight oil turning over a new leaf?

A shale sector that emphasised returns over production growth would be a win from both shareholders and oil markets

Returns, returns, returns. Shale executives echoed each other on the latest round of quarterly calls with investors, promising wary shareholders and analysts that they're ready to start putting returns over production growth.

This isn't the first time investors have heard the refrain, though. As the oil price recovered from its early 2016 lows, shale companies made a similar pledge. The days of spending beyond their means to chase loss-making output growth, executives told investors, were over. Then the animal spirits took hold again. The shale industry has spent about 50% more than it has brought in this year, while production quickly ramped up. Only a few companies have squeaked out profits, and industry-wide returns on investment have been abysmal.

In justifying the spending, executives have often pointed to plunging wellhead breakevens and high rates of return for individual wells to argue that they're putting the cash to good use. A combination of plunging service costs and better well designs and fracking recipes, as well as a retreat to the most productive tight oil areas, has clearly improved economics at the wellsite. Wellhead breakevens in the Permian and in the best parts of the Bakken and Eagle Ford have fallen below $40 a barrel, an impressive achievement considering these areas needed $80 oil to work a few years ago.

However, the narrow focus on wellhead breakevens obscured the fact that the corporate breakevens, the issue that investors ultimately care about, are much higher; and returns have been deteriorating. Including things like the cost of acquiring acreage to drill on, moving oil and gas to markets and keeping the day-to-day business running, pushes corporate breakevens to more than $50/b, and likely closer to $60/b for most companies. A widely circulated report from Invesco analyst Kevin Holt pointed out that cashflow return on investment for top shale producers was -4.7% in early 2017, and the metric has been deteriorating for the past five years. Even blue-chip shale names like EOG and Pioneer Natural Resources have been burning through investor cash.

Lost confidence

Investors have clearly lost their patience. Until recently, shareholders saw shale companies more like start-ups than old-guard oil producers and were overwhelmingly focused on glossy output growth figures. If an executive could deliver production growth of 15% to 20% a year, investors were satisfied with vague assurances that positive free cash flow was just around the corner. But a look at the industry's share performance over this year shows a clear flip in investor thinking. Tight oil producers are posting growth figures as strong as ever and wellhead economics are the best they've ever been, but companies aren't being rewarded in the market in the same way they were before. S&P's oil and gas producers' index was down 12% from the start of the year through early November, while the broader S&P 500 index was up 15% and oil prices that had ticked higher by around $4/b, close to 8%. Shale has been left behind in 2017's bull run.

Another area where it has become clear the shale industry has lost the market's confidence is in the flow of new equity offerings. Through 2015 and 2016, producers could tap into equity markets at will and raise tens of billions of dollars to fund drilling programmes and new acreage purchases. But that avenue of fundraising has all but closed. Just $0.794bn was raised through new upstream equity offerings in the US in the third quarter of this year, the worst three-month span since 2010 and down 90% from a year ago, according to data from energy information service PLS. Corporate bonds are still an option, but it's costlier. For an industry that chronically outspends what it brings in, access to cheap financing is crucial to maintaining growth.

1m boe/d - Pioneer's 2026 production target in the Permian

Activist investors are even starting to push corporate boards to change the terms of executive pay. Executives are rewarded primarily for how much oil they can coax out of the ground, which the activist investors argue has perpetuated the growth-at-all-cost mindset. Executive pay, they point out, has been rising with production, even as returns to investors have been falling. They want pay packages pegged to returns and efficiency rather than barrels.

The latest round of quarterly calls were all about letting the market know that the message had got through. Anadarko set the tone. The company said it would use much of the $6bn cash pile it built up through asset sales on a $2.5bn share buyback plan, rather than on new drilling to help buoy the share price. Prior to the buyback announcement in September, the company's shares had fallen off by some 40%. Other executives will note that Anadarko's shares jumped on the news of the buyback and have performed better in the months since, even though the company missed some of its third-quarter production targets. Anadarko's board is also set to reconsider its executive compensation packages.

Anadarko hinted that it plans to de-emphasise growth in its 2018 budget. The company has pitched investors on the fact that it can expand output at 15% a year at $50 oil. But Robert Walker, the company's boss, tweaked that pitch in November. "I don't think at this juncture talking about the compounded annual growth is as important as making sure that we give you the type of returns in a $50-world that this budget will provide," said Walker. "So, growth at this point is really going to be an output, not an input."

Growth will continue

A sustained emphasis on returns over growth would be a win for both shareholders and the oil market. So, is it time for Opec to rejoice over a chastened shale industry? Not quite. While the focus is clearly on returns, and capital-spending programmes will likely be flat going into 2018, executives aren't giving up on growth. Rather, many executives argue they can deliver both better returns and strong growth.

Pioneer, a shale bellwether, isn't backing off its plans to quadruple output, mostly from the Permian, to 1m barrels of oil equivalent a day over the next decade, implying growth of around 15% a year. "Our 10-year vision remains very much intact," Tim Dove, Pioneer's president, told analysts. "But the important thing is, we're drilling very high rate-of-return wells and that's a product of our low breakevens." Pioneer says it can be cash-flow neutral at an oil price of around $57/b in 2018, but plans to add rigs even if the oil price remains closer to $50/b.

The test of executives' commitment to the new returns-over-growth mantra will come if oil prices break above $60/b

EOG, another premier shale producer, hasn't put out its 2018 guidance yet, but on a call with analysts, chief executive Bill Thomas said the previously announced 15%-to-25% annual growth at $50 oil was "still valid", and that spending would likely remain in line with 2017.

Devon Energy said spending was 12% below what was expected, and the company kept spending within cash flow, but production would be up 20% quarter-on-quarter in the last three months of the year. The company plans to hold spending steady in 2018, but says it will expand output from the Delaware section of the Permian by 30%. "We are positioned to deliver attractive, high rate-of-return growth in 2018," the company's boss Dave Hager said.

In other words, producers are saying investors can have their cake, production growth, and eat it too, higher returns.

What does this mean for US output? While top producers can continue to deliver strong growth, the Energy Information Administration doesn't see 2017's increases as sustainable. It expects output from the lower-48 to exit this year at around 7.4m barrels a day, up 0.96m b/d from the end of 2016—although it's worth pointing out that this forecast relies on a very strong finish to the year that isn't guaranteed. Growth in 2018 is expected to be tempered considerably, thanks in part to the recent slowdown in new rig additions across all the major shale plays. The EIA expects end-2018 output to be around 7.83m b/d, just 350,000 b/d of growth across the year, less than half what was seen in 2017 and hardly the sort of volumes that would swamp the market.

The test of executives' commitment to the new returns-over-growth mantra will come if oil prices break above $60/b. With the market looking tighter and geopolitical risk on the rise in the Middle East and Asia, that test could come sooner rather than later. Then executives will face the question of what to do with the added revenue: plow it back into the drilling programme where more marginal wells might add production, but at worse returns; or let shareholders take in the spoils. That decision would depend on each company's portfolio, of course. But given the sector's track record, the best bet would be that extra cash would go towards pumping more oil.

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