It’s no secret that the U.S. shale industry is in much better shape than a year ago, but it is not out of the woods yet, of course. Companies are susceptible to the whims of oil price fluctuations, access to capital markets, cost inflation, high debt levels, credit line reassessments, and infrastructure bottlenecks.
As CEOs of U.S. independents gathered in New York at the Independent Petroleum Association of America’s (IPAA) Oil & Gas Investment Symposium (OGIS) to woo investors this week, many are well-positioned for the rest of this year. Well, sort of. Presentations showed how far many of the companies have come in the past year—the strength of their balance sheets was repeatedly highlighted—but also how vulnerable they are going forward.
Presentations at OGIS showed how far many of the companies have come in the past year, but also how vulnerable they are going forward.
At the symposium, some of the big shale independents like Hess, Continental, and EOG Resources did not present, but the 50 or so companies at OGIS this week add up to make a significant part of U.S. shale, the main center of non-OPEC supply growth this decade. Some were either in bankruptcy or on the brink at this time last year, but the industry as a whole is boosting activity, a sign of healthier balance sheets. The EIA estimates that capital expenditures for 44 U.S. companies that are focused onshore increased by 72 percent from Q4 2015 to the same period in 2016, the largest annual increase since the first quarter of 2012.
“A vast majority [of our assets] work in an environment of less than $50.”
One of the best examples of the turnaround in shale this past year and its potential moving forward is Callon Petroleum, which holds all of its acreage in the Permian in West Texas, the hottest spot in the shale patch. Permian output is up 4 percent since last December, while the rest of U.S. output got crushed before the recent rebound (see graphic below from the Dallas Fed).
In 2016, when oil prices crashed below $30 per barrel, the company responded quickly by pivoting to reduce costs, deleveraging, and accessing capital markets—raising a whopping $1 billion—to make acquisitions. This allowed Callon to take advantage of the low-price environment by strengthening its balance sheet and tripling its acreage. As a result, it can now ramp up its drilling activity, and with oil at around $50 per barrel, the company can operate within cash flow. One company official told the conference that “a vast majority [of our assets] work in an environment of less than $50.” Moreover, part of its strategy is to protect returns through “prudent hedges.”
Its strategy going forward shows the company’s confidence in the current environment. Callon, the “oiliest” operator in the Delaware Basin in West Texas and New Mexico, now produces about 18,000 barrels per day (b/d) and plans to complete 16 wells in the fourth quarter of this year, up from 10 in Q4 of last year. It’s looking to test other areas in the Delaware and Midland basins in 2018, reflecting its strategy for growth. It’s also focusing on infrastructure projects around its production areas, so they can be in place when it boosts output volumes.
Drilling and completion costs are expected to rise by some 10 percent this year.
One challenge for Callon, along with the rest of the industry, is service cost inflation. Callon admitted that drilling and completion costs ought to rise by some 10 percent this year, but said that is not unexpected and is certainly manageable. One of the biggest questions during the oil price downturn was how much of cost reduction was structural and how much was cyclical. This year, producers will find out the answer, and if costs rise sharper than expected, the industry’s balance sheet problems may return.
Restructured and ready to go?
Like Callon, many other shale companies had to regroup during the price rout of early 2016. Midstates Petroleum Company had to go through a major restructuring at the beginning of last year, and as a result was able to eliminate a high level of annualized interest expense and slash its debt. The restructuring forced the company to reduce well costs and increase efficiency while also growing core acreage: Cost savings from 2014-16 totaled 65 percent in efficiency gains and 35 percent service cost reductions. In its favor, Midstates, which has assets in the Mississippian Lime and Anadarko basins, is anticipating more well cost reductions throughout 2017.
Its strategy moving forward is up in the air, a reflection of the bind some companies are dealing with at the moment. The company is split on whether to run one rig and keep production stable at 21,000 b/d, or add another rig. Adding another rig would generate extra cash flow and help the company grow production by 6-10 percent. Even though Midstates is unsure as of now which direction to go, the company, like other independents, has a lot more flexibility in its strategy than it did a year ago.
Matador Resources, which is active in Eagle Ford, provided another example of a successful shale company weathering the storm of the price slide. The company went public five years ago when prices were just under $100. Now, even though prices are half that, the company has moved from 400 b/d to 17,000 b/d, acquired assets, and kept its debt leverage down—even though it soared during the second and third quarters of last year.
More challenges ahead
Although companies are optimistic about their health and the state of the industry, there are many challenges ahead. One investor told The Fuse that shale production growth, after over-performing from 2011-2015, may not reach expectations throughout the latter part of 2017, despite positive signals and the sharp rebound in the rig count. Up to 45 percent of shale production is hedged for this year, according to some estimates, but the industry is still vulnerable to cost inflation, access to capital markets and investment banks, and fluctuations in the oil price.
After over-performing from 2011-2015, shale may not reach expectations throughout the latter part of 2017, despite positive signals and the sharp rebound in the rig count.
At the presentations, the speakers were vague about the direction of the oil prices, emphasizing instead that their companies are poised to adapt to different situations. Even with a large amount of production hedged, oil price direction remains a major uncertainty, particularly with U.S. crude inventories at record highs.
Furthermore, lenders will reassess the credit worthiness of U.S. E&Ps this month, a factor that will be crucial in determining spending plans for the rest of the year. One source told The Fuse that lenders will likely keep credit lines relatively steady given that the NYMEX forward curve is above $50. However, a shaky fundamental outlook and questions about the effectiveness of OPEC curbs may cause some credit lines to get cut. That would ultimately hurt the U.S. production outlook for the rest of the year.
The biggest worry though could come from cost inflation. Halliburton, the large oilfield services company, is adding positions at a fast pace as activity picks up in the shale patch, but the company is getting hit by price increases all along the supply chain, such as costs for sand used in fracking. That doesn’t bode well for independent producers, who have touted their success in increasing their intensity in drilling while cutting costs in half. How they manage these costs in this new market environment will be key going forward.