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US shale producers under oil-price pressure

US tight oil companies staged a comeback at the first sign of a price recovery last year. Now, as surging US shale activity undercuts the oil price, markets want them to start putting on the brakes.

Front-month WTI futures—the US crude benchmark price—briefly fell below $43 per barrel on 21 June before recovering to around $44/b later in the month. That's an almost $10/b-drop from a year-earlier.

Bearish market sentiment from speculators—due to fears that commitment to the Opec-non-Opec production cuts may waiver—may account for some of the pressure on prices.

But the real culprit is US shale. The rig count has been on a tear, rising every week for the last six months. And a flood of crude is following. US tight oil output looks set to rise by around 1m barrels per day by the end of this year (compared to the year-earlier level) exceeding nearly all expectations at the start of the year.

Not long ago, investors were enamoured by shale companies' plans to grow at a double-digit pace this year. The thinking was that Opec would pick up the slack and tight oil would get the benefit from both high growth and rising prices. That logic helped make US shale equities some of the market's best performers in 2016, following the collapse a year earlier.

But as it has become clear that US tight oil is once again swamping the market, investors have turned sharply against go-go shale growth. Take valuations. Investor sentiment towards shale peaked in early December, in the weeks after Opec first announced its deal to rein in supply. Since then, the S&P's Exploration and Production index is down 30%. And being in the Permian, where the growth has been concentrated because of the play's strong economics, hasn't been much help. A group of 11 Permian-focused drillers tracked by Petroleum Economist saw their shares drop by an average of 27% over the same period.

Market intervention

Another sign that the market is trying to cool shale growth has been the slowdown in new equity and bond issuances. Last year, producers tapped equity markets for around $31bn as they sought to raise cash to fortify their balance sheets and fund growth, according to data from the research house PLS. That slowed to less than $5bn in the first quarter of this year. It has likely fallen further in Q2 as investors grow weary of pumping more money into the sector.

There has been a similar slowdown in deal-making for tight oil producers. The first quarter of this year was gangbusters for oil bankers, with 20 deals worth $21.36bn in the Permian alone, according to the consultancy PWC. But the deal pipeline for oil producers, especially for big-ticket items, has frozen up since then, Chad Michael, managing director for upstream investment banking at Tudor, Pickering, Holt & Co, told an IPAA conference in southern California last week.

While markets are signalling to shale operators that they should rethink their growth-at-all-costs model, it's not clear the message will get through. Not least because although the broader shale industry will struggle with sub-$50 oil, there are a lot of individual wells in the best areas of the Permian, Eagle Ford and Bakken that are profitable even at today's prices.

But there are some key indicators to watch. One is the drilled but uncompleted Duc-well count. About two-thirds of a well's total costs come in the completion stage, when the well is fracked and brought into production. A rising Duc count would indicate that companies are still drilling wells, which is evident from the rig count, but conserving cash at the later completion stage.

Ducs in a row: Drilled but uncompleted wells in top tight oil plays Source: EIA

There is some evidence of this in recent Energy Information Administration data. The number of Ducs fell throughout 2016 as companies worked through their inventory when prices were low, only to start rising again this year. The tally has increased in recent months and, if that continues, production figures may not come in as high as would be expected from the rig count.

Budgets will also be important to watch. While it is too early for most companies to start thinking about their 2018 spending plans, they may ratchet back spending in the second half of this year, a message that would come out in the next round of earnings calls. According to data from the investment bank Raymond James, if oil stays at $50/b, the shale industry is on pace to outspend its cash flow by 50%—a staggering number even by the sector's own profligate standard.

If they do start pulling back, it won't show up in the production numbers for some time. Because there is a time lag between when a rig is deployed and when it yields new output, the surging rig count virtually guarantees strong US production growth going into 2018. Still, a little discipline might go a long way for the shale industry.

Cashing Up: US upstream equity deals ($bn) Source: PLS
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