The U.S. shale industry has by and large refrained from a return to aggressive drilling, despite oil prices trading at their highest level in years.
But while much of the shale complex languishes, drillers continue to incrementally step up spending and activity in the Permian basin in particular, where the industry’s attention is increasingly concentrated. It remains unclear if that will result in the industry remaining in a holding pattern or if it will kick off a new phase of growth.
The collapse of oil markets last year and the loss of around 2 million barrels per day of U.S. oil production decidedly ended the shale growth story, pushing the industry into a new era that has at times been described by analysts as “capital discipline,” “spending restraint,” or some other way of describing an end to production growth.
The big question has always been whether or not it was temporary and whether or not the industry would return to old ways when oil prices rebounded. At this point, prices have indeed rebounded, back to levels that are even higher than they were at the onset of the pandemic. Analysts see the U.S. shale industry generating positive cash flow this year, essentially the first time that has ever occurred.
The answer to the question of whether shale would return to reckless ways to some extent remains unanswered. To be sure, the rig count is dramatically lower than it was in early 2020, despite WTI prices sitting well above $70 per barrel, even as it ticks up modestly week after week.
In fact, the rig count remains below levels thought to be sufficient to sustain oil production. Instead, shale companies have leaned heavily on already-drilled wells, drawing down on the drilled but uncompleted (DUC) backlog as a way of bringing oil online without having to spend too much.
Over the past 18 months, the total DUC count across all shale basins has declined by roughly 25 percent, from 8,553 wells to 6,252 wells, according to EIA data. The DUC count has declined for 12 consecutive months as the industry has consistently drilled new wells at a slower pace than they are completing older wells that were already drilled.
On that count, the shale industry is refraining from a return to aggressive drilling. But as the DUC count continues to fall, companies will need to decide whether they throw even more rigs back into the field. That is especially true given the steep production declines from which shale wells suffer.
“While some of the fall in DUCs merely reflects the lower inventory of wells in progress that would be expected with lower drilling levels, we think a significant part of the decline is due to companies seeking a compromise between maintaining capital discipline and responding to improved price incentives by choosing to work through their DUC inventory before accelerating drilling activity,” Standard Chartered wrote in a note.
The investment bank added that the EIA’s DUC count is likely too high because a good portion of those wells will never be completed because they are unviable or uneconomic.
Running down on DUCs has allowed production to remain at about 11 million barrels per day, despite a much lower rig count compared to pre-pandemic levels.
But the erosion is still evident. “The EIA forecast for the combined oil liquids output of the other six regions [outside of the Permian] covered in its report is 3.2mb/d, 1.32mb/d lower than November 2019’s all-time peak,” the bank said, adding: “Non-Permian output is still drifting lower.”
Still, the investment bank said that the market narrative that U.S. shale has not responded to price increases misses the fact that drillers have been stepping up activity in the Permian.
The EIA predicts that U.S. oil production will rise by another 42,000 barrels per day (b/d) in August, with the Permian adding 53,000 b/d, slightly offset by modest declines in most other shale basins. That will put the Permian at 4.7 million barrels per day, close to all-time highs set on the eve of the pandemic.
“The situation is very different away from the Permian Basin’s accelerating boom,” Standard Chartered noted in its report.
The global shift in capital away from the fossil fuel industry continues in a broad sense, as the energy transition gathers steam. But investors are not entirely bailing on oil and gas. Enticed by higher commodity prices, borrowing costs for drillers have plunged. Speculative-grade energy companies have issued $34 billion in bonds so far this year, a record high, according to the Wall Street Journal. The proceeds are “primarily heading toward riskier borrowers in the shale patch,” WSJ said.
The difference this time around compared to past periods when Wall Street recapitalized the shale industry is that investors do not want drillers to drill. Much of the new debt is earmarked to pay off other debts.
The WSJ cited the case of Laredo Petroleum, which raised $400 million in bonds due in 2029, which will be used to pay off other debt. For now, investors are demanding capital be used to repair balance sheets, rather than put to new drilling, where the shale industry has a long track record of losses. With share prices sharply up this year, investors are rewarding E&Ps for their “restrained” positions.
But as the DUC count falls and production declines from aging shale wells take hold, the industry will have to decide whether to continue a holding pattern, which could result in production declines, or return to higher levels of drilling. If companies do decide to increase drilling activity, they are rolling the dice on a volatile market. Leaving aside the fact that the shale industry has burned through a colossal amount of capital during the previous drilling frenzy, an indication that the entire business model is suspect, there is also a great deal of uncertainty over today’s oil prices.
“Should US shale operators follow the price signal and decide to increase production, it would take at least nine months to see a meaningful supply result,” Rystad Energy said in a note on July 9. “Therefore, boosting output carries a considerable risk due to the volatility that surrounds oil demand and price trajectories.”
OPEC+ could decide to dump a bunch of oil on the market in a few months’ time, sending prices down again. Or, some other unknown variable – a worsening of new Covid variants, for instance – could upset the market later this year or next. The energy transition also looms.
In other words, the U.S. shale industry has recovered from what appeared to be an existential crisis in 2020, but its current “capital discipline” mantra can only hold for so long.