Now that President Donald Trump has officially exited the Iran nuclear deal, it’s time for oil markets to refocus attention on other variables that influence prices. As a bona fide – albeit imperfect – swing producer, America’s shale sector merits close attention.
Lost in all the Iran hoopla was the announcement of stellar first-quarter financial results from America’s leading shale producers. Most are now generating significant free-cash flow, meaning incoming revenue exceeds a company’s capital investment, giving them the option of paying down debt or rewarding shareholders with dividends or stock buybacks. This development is a big deal and could be a major inflection point for a sector that in recent years has been criticized for its “cash burn,” most famously by hedge fund manager David Einhorn in 2015.
Of course, higher oil prices are having a significant impact on shale producers’ financial results. But the sector is also showing discipline by not pumping all of its cash back into new drilling projects. Exploration and production companies have a long history of outspending cash flow since investors have traditionally rewarded them almost exclusively based on their growth rates.
But as top shale producers, including ConocoPhillips, EOG, Apache, Devon, Anadarko, Continental and Whiting, announced first-quarter results in recent weeks, there were no blockbuster announcements about big hikes in capital spending or major increases in production guidance.
Whiting Petroleum, a top producer in the Bakken, has been generating a steady $100 million per quarter of free-cash flow recently, while Devon’s first-quarter report was highlighted by the announcement of a $1 billion share buyback program and a 33% hike in its dividend.
The shale industry is often broken down to the “haves” and the “have-nots” – in terms of those who hold the best rock in the premier shale basins. However, with West Texas Intermediate (WTI) prices trading around $70 a barrel – or as much as $15 a barrel above shale companies’ budgeted levels for 2018 – even the “have-nots” are performing well.
A recent survey of more than 40 domestic producers showed incremental capital spending at $2.3 billion for 2018, leaving over $22 billion in incremental free-cash flow for the year to date.
Whether the focus on returns persists across the shale sector in the face of rising oil prices, especially now that the Trump administration has shown it is serious about re-imposing sanctions on Iran’s energy industry, remains an open question.
This now becomes an even more critical question for oil markets, nearly as important as how long OPEC maintains its 1.8 million barrel-a-day production cut deal. One thing looks clear, investors for now aren’t backing away from their demands for higher cash returns from producers.
Wall Street watched more cash burn in past years then many were comfortable with. Now they would like to see the sector mature to the point where they don’t need to worry about slashed dividends or buybacks being halted due to fluctuations in oil prices. Investors seek a smarter, more efficient shale sector. But if prices push past $80 a barrel or higher – many are forecasting a global supply shortage after all – investors could reverse course and demand growth once more. Such is the impulsive, push-pull relationship between Wall Street and the shale sector.
Given the pipeline and infrastructure rates emerging in key basins, it should also be asked how much faster the shale sector could grow if under higher prices. Constraints in the oil and gas industry’s “midstream” sector – pipelines and terminals – are already forcing producers in West Texas’s Permian to sell oil for as much as $12 a barrel below the WTI pricing hub in Cushing, Oklahoma. Many foresee Permian takeaway capacity for natural gas – which, unlike oil, can’t be trucked – hitting a wall next yearand stunting the play’s production.
Midstream companies, saddled with debt and dividend obligations that are preventing them from investing in long-term solutions to transportation bottlenecks, are not faring as well as their upstream cousins. Investors may have to accept lower dividends from midstream firms in order for the sector to invest in the necessary infrastructure. Producers will also need to accept higher rates from oil services companies – drilling contractors, pressure pumpers and frac-sand providers – which have yet to reap the fruits of the economic recovery and bounce back of oil prices.
Ultimately, these higher costs could eat into producers’ profit margins. The interplay of these dynamics across America’s oil industry merits closer attention as prices continue to march upward, particularly now that OPEC’s number three producer once again faces potentially crippling sanctions.