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Shale oil's new calculus

Will producers chase growth or profits?

It didn't take long for the tight oil industry's new value-over-volume mantra to face its first test. Shale executives spent much of late 2017 trying to convince investors that they had received the message on capital discipline. Growth at all cost was out and free cash-flow was in. That was before the oil price surge. From October to mid-February, prices jumped 30% to $65 a barrel, a level that makes just about any shale well look enticing. Oil's rally, then, will prove a tempting diversion on the path to a new, more sustainable, business model.

Executives would be wise to resist the temptation to restart the drilling frenzy. The industry is at something of a crossroads. After proving its mettle in the early part of this decade, the 2014 price crash scrambled the industry. A wave of bankruptcies, layoffs and depleted budgets altered the landscape. But through the massive disruption, the industry showed it could quickly cut costs and continue delivering the production growth investors had rewarded.

Investors had long expected that the eye-watering growth in barrels would eventually yield better returns. But sustainable profits have been harder to come by than production growth. In 2017, the industry outspent its cash flow by at least $10bn, continuing its reliance on outside funding.

Even with the recent price rally, shareholders seem to be signaling to executives that they want them to hold the line on capital discipline and start generating free cash flow. While oil rallied by 30% from October to February, the main S&P exploration and production index was essentially flat. Investors want to see proof that executives will resist the urge to ramp up drilling at the first sign of higher prices and provide shareholders with some of the windfall. Some shale producers are promising just that. Pioneer Natural Resources, a top Permian producer, plans a $100m share buyback this year and has increased its dividend. Its 2018 capital plan is designed to break even at $58 a barrel and generate free cash flow at future strip prices.

There's another reason for the shale industry to get serious about putting itself on a sounder financial footing. All signs point to a series of interest rate hikes this year that will start an end to the post-financial crisis era of ultra-low rates in the US. Cheap and abundant cash on debt markets has been as important to the shale industry as any fracking breakthrough and an essential part of the business model. Costlier and harder-to-come-by debt will be a strong impetus for the industry to show it can live within its means.

Analysts at the consultancy Rystad reckon the shale industry will need around $20bn in external financing this year, assuming $60 oil, to meet spending plans. If that financing isn't available, it will force deep spending cuts. A $10bn reduction in capital spending, says Rystad, would result in around 1,300 fewer wells being drilled, trimming growth by 275,000 barrels a day.

Keeping the reins on drilling could also help head off cost inflation, which threatens to undermine reductions in break-evens. Cost inflation has already creeped into the shale patch as activity has picked up from its 2016 lows. The Bureau of Labor Statistics tracks cost inflation in oil and gas production and its index stood at 165 in December, twice what it was in early 2016. The index has historically tracked closely with WTI prices, so the recent price run-up will bring higher costs for producers as drilling activity increases. Oilfield service firms like Halliburton and Schlumberger say the drilling equipment market is as tight as it has been since the downturn, and rates for kit are set to rise faster than any time since the downturn started.

Keep pumping

None of this is to suggest retrenchment in the shale patch. Tight oil output hit 5.12m b/d in December, up a whopping 900,000 b/d from the start of 2017 and more than 400,000 b/d higher than the pre-crash high. That tight oil output alone grew by nearly 1m b/d in a year, when WTI averaged around $48 a barrel, shows just how much crude the shale industry can pump into the market—even with relatively low prices. Longer lateral wells and more intense frack jobs have allowed companies to squeeze more productivity from each dollar of investment.

Even if producers hold the line on capital discipline, another strong year of growth can be expected, especially if oil manages to hold around $60/b. Analysts are split on exactly how much new oil will come from the tight oil industry, though. The Energy Information Administration is firmly on the bullish side. The US government agency predicts a surge in lower-48 production, a rough proxy for tight oil, of 930,000 b/d this year. Analysts at Jefferies, the investment bank, think a combination of capital discipline and large declines from existing wells will see output growth decelerate in 2018 to around 500,000 b/d.

The relatively slow rise in the rig count in response to higher prices could indicate shale companies are going to be more cautious than before about ramping up drilling. The rig count has only seen a moderate uptick since mid-2017, although more than 20 rigs were added to the Permian in January, a 6% jump, indicating a new optimism to start the year. Elsewhere, the rig count has actually fallen slightly in recent months.

The rig count data show that the Permian is continuing to win capital from other US basins, a trend that could become starker if companies are choosier with their spending in 2018. The Permian continues to offer the best returns of any of the major tight oil plays and the most expansive growth opportunities, thanks to its stacked oil-rich shale formations.

Lower well costs

Even within the Permian there are standout areas. Drillers were slower to see the potential of the Delaware section of the Permian, which stretches northwest to span the Texas-New Mexico border, but it has emerged as the most attractive area within the play, surpassing the Midland. Delaware wells are more prolific than in the Midland and more productive wells are coming from shorter laterals, implying lower well costs, according to data from Bernstein Research.

Most areas of the Delaware section of the play, the most attractive tight oil target in the US, return more than 40% at $60 oil, according to Jefferies. EOG, Apache, Anadarko and Concho all have strong positions in the Delaware.

5.12m b/d—US tight oil production

Although wellhead economics have fallen behind the Delaware, the Midland remains a highly attractive area to drill. Oil at around $60/b produces returns of well over 30% in most areas. Pioneer continues to be the Midland's leading producer, but it's an area that the two US supermajors, ExxonMobil and Chevron, are increasingly focused on.

While momentum is strong in the Permian, Jefferies analysts point to slowing productivity gains in 2017 as a potential red flag. Productivity, as measured by cumulative production per well over a six-month period, improved just 2% in the Delaware and 5% in the Midland in 2017, following several years of 20%+ average improvements. One potential reason for this is that companies are running into the boundaries of their existing land positions as they look to further extend lateral wells, a key driver of productivity growth. This could prove a strong motivator for Permian producers, especially with adjacent acreage positions, to tie up in 2018.

Higher prices could simply encourage the shale industry to fall back on its instincts to pump out as much oil growth as possible, especially if capital markets remain accommodating. But a more disciplined ramp-up this time around would put the industry on a more sustainable path.

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