When oil prices cratered from the high $80s in 2014 to below $40 in 2016, the U.S. upstream sector went looking for a rallying cry, and “$50 is the new $80” became the mantra.
Oil prices of $80 and higher had funded massive capital budgets and expansive drilling programs across the Lower 48 in the years before the downturn, but as prices drifted lower in 2016 and 2017, the viability of U.S. shale production was called into question. It was during these darkest months of the collapse that producers started talking of a new “sweet spot.”
Oil at $50 a barrel would help generate enough cash flow to increase production and de-lever balance sheets, all while keeping a lid on cost inflation and sustaining acceptable returns for investors, whose capital was needed to keep the shale juggernaut rolling forward, or so the thinking went.
The message was born partly out of the need for shale companies to convince the markets that U.S. oil supplies would remain viable even during sustained periods of low commodity prices, and partly from the belief that unconventional assets represented a new frontier of technology-enhanced production. One where the application of modern engineering would inevitably lead to lower breakeven economics and higher returns.
If the final piece of the message was the wish to send a defiant signal to OPEC member countries that U.S. shale production could not be smothered in its crib, then success was achieved on that front as well.
In the staring contest between OPEC and U.S. shale, the members of OPEC blinked first when they agreed to production cuts for in November 2016 – the first time the cartel imposed output restrictions on itself in eight years.
Whatever the motive, the effort had the desired effect. U.S. upstream companies raised nearly $40 billion in equity during 2016, balance sheets were shored up and production recovered. U.S. output recently surpassed 10 million barrels a day and is expected to continue to increase through the end of this year. Market observers hailed the resilience of U.S. shale.
But there’s mounting evidence to suggest that it was never realistic to think that $50-a-barrel prices would be a cure-all for U.S. producers. And while the International Energy Agency’s (IEA) recent commentary on U.S. oil production has again raised fears that a shale-driven supply glut could derail the nascent price recovery, current behavior and analysis from U.S. producers indicate that the real “sweet spot” could be closer to $65 or higher.
Lost in all the noise around the $50 sweet spot is the reality that only one party in the upstream value chain – the producer – is supposedly well off at lower oil prices. Equity investors and oil service companies – which also need to reap some of the economic rewards from increased drilling activity – are left with virtually no benefit at $50.
A few data points to consider. Free cash flow – the cash a company can generate after expenditures – never came close to materializing for the industry with crude prices below $60 a barrel.
In 2017, when domestic crude prices were $51 a barrel, the capital expenditures of exploration and production (E&P) companies exceeded operating cash flow by more than 65%. With those figures in mind, it is hard to argue that $50 would have provided a sufficient incentive for increased capital investment in the shale basins.
Returns never showed up either, despite the many highlights of type curves that generated robust, single-well economics. Return on equity for the average shale producer was negative in 2016 and remained below 2% through the first three quarters of last year.
Numbers aside, recent commentary from U.S. producers is more telling and suggests that an oil price higher than $50 is required to sustain the balance sheets of operators, quench investor thirst for returns, and satisfy service companies that have yet to see the benefits of the rebound.
From small independents to larger, diversified oil companies and even Permian-pure players, a new message about the importance of capital discipline and the need for free cash flow is replacing the $50 sweet spot mantra.
The great Permian bellwether, Pioneer Natural Resources, recently suggested that oil prices in the high $50s are needed for the company to generate positive free cash flow this year.
On a recent conference call with investors, ConocoPhillips responded to a question about the effect higher oil prices were having on activity levels by stating: “even with higher prices today, we believe it is critical to maintain discipline on our capital program… that’s the key to free cash flow generation.”
Parsley Energy, an up and coming shale producer, indicated in a recent press release that “notwithstanding the recent increase in oil prices, the company continues to expect approximately 40 gross horizontal wells on production per quarter during 2018.” That number remains unchanged from the company’s original plans laid out last year.
What is becoming clear is that oil prices north of $60 a barrel are required to sustain shale production on a full cycle basis. Exactly how far north remains to be seen, but a more immediate question is what impact all this restrained E&P spending will have on the rest of the industry?
Equity investors will no doubt be pleased, particularly if shale producers can pivot from being cash burners to cash dispensers in the form of dividends or share repurchase programs.
For service companies, the impact of more stable, consistent capital spending is positive as well. That type of behavior on the part of producers sets the stage for predictable investment patterns that will help service companies plan, hire and invest in their asset bases in a more rational and returns-focused manner.
As the U.S. industry settles into this new “sweet spot” expect to see a shift away from the boom-bust behavior that characterized prior cycles and toward a more focused effort on sustaining returns where all participants can benefit.