Much to the chagrin of OPEC members, the U.S. shale sector has proven it has plenty of pluck when it comes to price fight.
American shale producers demonstrated their ability to survive and adapt to low oil prices after the market took a plunge three years ago. Since then, the industry’s resilience has been such that U.S. oil production is now at record levels – just under 9.7 million barrels per day – with government forecasts calling for a further 560,000 barrels-a-day of growth next year.
Efficiency gains, lower contractor costs, and technological improvements allowed most shale producers to withstand, and even thrive, under a new “lower for longer” price environment. But with many oil executives now openly talking about “lower forever” pricing, the question is whether shale producers can adapt once more, this time through a massive consolidation wave that will inevitably put more assets in the hands of the biggest companies.
OPEC’s recent agreement with non-OPEC producers, led by Russia, to maintain production cuts through the end of 2018 puts a floor under oil prices – the days of sub-$40 oil won’t be returning anytime soon. But shale’s potential to respond when prices rise also serves to cap prices, which could struggle to push past $65, at the top end.
As the sector matures, investors are increasingly looking for more than production growth from shale producers, most of which continue to outspend their cash flow. Despite shale’s remarkable resilience, U.S. energy companies have been among the worst performing on the S&P 500 index. That kind of performance continues to give investors pause.
The demand for capital discipline has intensified for shale producers as the lower price scenario sinks in with investors, who are making it clear they want companies to prioritize returns and measured growth that does not greatly exceed cash flows.
This is a dramatic turn for the industry, which has historically sought more than 40% of the capital it needs from debt and equity markets. Service companies will be hard-pressed to find capital for the foreseeable future, but don’t expect America’s shale juggernaut to grind to a halt.
Indeed, players in the sector have lowered their breakeven costs so significantly that many analysts believe shale can grow at rates above 600,000 barrels a day at $50 a barrel. The International Energy Agency (IEA) last month said the United States is set to enjoy the biggest increase in oil and gas production the world has ever seen over the next few years, with the United States accounting for 80% of global oil supply growth between now and 2025.
Such a boom will require enormous amounts of capital. And as investors raise the bar on shale profitability, the best companies – those with the strongest balance sheets – will hold significant advantages in accessing capital markets, while smaller, highly-leveraged players may find themselves shut out of the game altogether.
Expect a sweeping transfer in shale asset ownership to stronger companies through mergers and acquisitions over the next few years.
Such a scenario may provide an opportunity for major oil companies to improve their shale positions, which are relatively weak after a wave of divestments in the early 2000s before independent producers discovered and proved its potential.
“Short-cycle” shale projects – where investments can be ramped up or down in a matter of months depending on commodity price fluctuations and payback periods are quick – are appealing to majors in the current environment. The group has dramatically scaled back investments in expensive, “long-cycle” megaprojects in deep water, oil sands and the Arctic, where they have suffered cost overruns and delays in recent years.
Tax reform knocking the corporate rate to 21% will also spur multi-nationals to put greater focus on their U.S. operations, particularly with at least three years left in the business-friendly Trump administration. Despite the lingering regulatory uncertainty, the geopolitical risk in the United States is still much lower than in other parts of the world, particularly compared to the Middle East.
Larger, well-capitalized independents also stand to gain from industry consolidations, though they shouldn’t grow complacent as they’re not immune from becoming acquisition targets for the majors either, particularly since they hold the best “rock,” as shale producers say.
Restructuring has been predicted many times in the shale sector but has to date never materialized. Assets remain expensive and acquiring the “best rock” requires companies to pay a premium. The major oil companies, with their bureaucratic organizational structures, are unlikely to manage shale assets as well and cost-effectively as nimbler independents, who have the advantage of having acquired their shale acreage years before.
The majors notably fell short with their belated forays into America’s shale plays. The majors have also made headway cutting the breakeven costs for their own megaprojects – their bread-and-butter operations.
Everyone in the oil patch has gotten better at lowering their production costs. Still, America’s shale plays could benefit from a more consolidated approach. A shale sector governed more by majors and top independents, whose primary goal is delivering rising shareholder dividends, instead of unbridled growth, might slow U.S. production gains and help stabilize oil markets. But only to a certain extent – and OPEC can only hope for such an outcome.