Long Season

By William M. Arnold 

Recent media attention questions the future of shale oil production in the U.S. Will capital discipline put a brake on growth or will domestic production rise to the point of undermining prices again? As so often in business, it’s the investors who will make the call. 

In the first inning of the shale boom, from 2009 to 2014, the mostly small players raced to lock up prospects by leasing land and drilling — but not necessarily completing — wells. These are the “DUCs” (drilled but uncompleted) described in many articles.

It was a land grab of epic proportions, the energy equivalent of “shooting the moon” in a card game of hearts. But even before the oil price collapse in late 2014, that strategy caused problems for overextended companies, such as Oklahoma’s Chesapeake Energy Corp.

In the second inning, from early 2015 to mid-2017, bravado turned into bankruptcy for hundreds of players and there was incessant pressure on suppliers to reduce costs. But the collapse of market prices also provided the focus that was missing in the early years.

Companies had to concentrate on their best prospects and exert cost discipline in all operations. Good operators found, sometimes to their surprise, that they could operate profitably with prices in the range of $40 to $50.

We are in the third inning now, with apparent oil price stability of $60 to $65 in the U.S. and topping $70 for North Sea-based Brent. Investors won’t tolerate backsliding to the practices of the first inning and will demand that producers, well, produce. They can complete those DUCs and use the cash flow to finance further activity.

Performance in future innings will depend on geology, technology, operational efficiency, OPEC and capital availability.  

Mother Nature was fickle in how she placed resources. To deal with that, companies continuously develop and apply technology to compensate. Horizontal drilling and fracking enabled production from rock-hard, linear formations rather than the “straw in the glass of Coke” that many people understand oil production to be. 

While there are concerns about rising costs from equipment and service suppliers, the industry continues to innovate with more wells on a single platform and increasingly apply sophisticated data analytics.

They have even found they don’t need to import trainloads of fracking sand from Michigan; there is plenty of sand in West Texas that meets specs.

Saudi Arabia has made disproportionately large cuts to its production to balance markets and persuade even non-OPEC countries such as Russia to participate. This is in contrast to the end of the first inning, when OPEC thought a price collapse would kill off the shale revolution in the U.S.

For more than a year, Saudi Aramco has been in discussions for an initial public offering (IPO) that reportedly might cover about 5 percent of its reserves, for about $100 billion. That has been postponed until 2019.

Saudi has a stake in keeping prices high to get the best valuation for that IPO. The question is the extent Saudi Arabia and OPEC are willing to be the swing producers to accommodate unprecedented levels of U.S. production.

Capital availability is the final element, and it covers a lot of actors. Traditionally, investors bought shares in the majors because of their long-term record, potential upside from exploration and portfolio balancing from the midstream (pipelines) and downstream (refining and marketing).

This model came under attack in 2011 when activist investors persuaded ConocoPhillips and Marathon to break up into separate companies focused on either exploration or refining. Investors increasingly want to develop their own risk portfolios, not have company management do it for them.

The shale play brought in new investors who wanted to stake qualified management teams who were unencumbered by legacy assets. They sought returns that were closer to 20 percent than the more modest returns of the majors.

What we now have is a wider range of investors with risk profiles along a spectrum. Some want steady income, stock buybacks and reliable dividends. Others want even less volatility and may settle for utility returns, which they see as possible as domestic oil production takes on manufacturing characteristics. Still others want to support higher-risk return investments, whether in West Texas or East Africa.

The reality is that market conditions, attitudes of investors and operational performance will determine U.S. oil production in the next few innings. OPEC can accept this or make a “lose-lose” decision; again.

William M. Arnold is a professor in the practice of energy management at the Jones Graduate School of Business at Rice University. 

This article first appeared on The Hill as Shale Boom Is In The 3rd Inning; Investors To Decide How The Game Plays Out.