In Part I of this series I discussed how the world is relying increasingly on a handful of sources of supply growth to meet both demand growth and conventional declines. One of these sources is U.S. Shale Oil.
I have remained deeply skeptical of the industry and wrote an article in 2017 to discuss some of the structural flaws in their business model and why investors were not analyzing these companies using the correct metrics:
https://palebluedot284.wordpress.com/2017/08/09/the-myth-of-shale/
Up until 2017, the industry remained heavily free cash flow (FCF) negative (operating cash flows minus capex):
Things got a bit better in 2018 thanks to higher oil prices, but through Q1 – Q3 2018, 75% of dedicated US shale companies continued to be FCF negative as reported by Ryastad: https://www.rystadenergy.com/newsevents/news/press-releases/Shale-companies-ready-to-show-they-can-grow-within-cash-flow/
During the 2010 – 2014 period, US Shale investors showed a willingness to trade off lack of near-term profitability for higher growth. With oil prices high and relatively stable, and interest rates near historic lows, investors were willing to kick the free cash flow can down the road. However, recent oil price volatility has put a dent in that thesis. Oil prices have remained comfortably below the triple digit range seen in prior years, and the US E&Ps have continued to use external capital to ‘grow at all costs’, keeping inventories elevated and preventing oil prices from experiencing a sustained increase. Investors are starting to realize that the future cash flows promised might turn out to be illusory.
The most important sign pointing to this is US E&P stock price performance / valuation. While US oil production has continued to show robust growth, investors have largely shunned US E&P stocks, even during periods of rising oil prices such as first 9 months of 2018.
The mainstream media has also been paying more attention to the Shale business model and some of the structural issues facing the industry:
CNBC on shareholder reaction to Shale’s 2019 budget and capex guidance: https://www.cnbc.com/2019/03/14/shale-oil-drillers-give-shareholders-what-they-want-then-get-punished.html
Wall Street Journal on well spacing issues: https://www.wsj.com/articles/shale-companies-adding-ever-more-wells-threaten-future-of-u-s-oil-boom-11551655588
Bloomberg on US oil production vs. investor returns: https://www.bnnbloomberg.ca/c-suite-turmoil-shows-investor-impatience-with-shale-explorers-1.1221453
For an industry so heavily reliant on external funding for growth, this turn in investor sentiment could soon spell the end of the ‘grow at all costs’ business model. Capital raising by US E&Ps fell to a multi-year low in Q4 2018:
Source: Financial Times
Drilling deeper (pun intended) into the sources of US production growth in 2018 can give us further clues on what to expect from the sector going forward.
2018 production growth was largely driven by private operators and majors (e.g. companies like Chevron or Exxon that have invested in the shale sector recently). Pure-shale public E&Ps mostly held production flat.
Based on publicly available data on capex budgets and production guidance, pure-shale public E&Ps should continue the trend of flattish production going into 2019. However, I expect private operators to slow down sharply this year. The oil price slump in Q4 2018 (heart of capex planning season) and the diminishing access to leveraged loans and high yield markets should help put a break on growth rates. The private equity backers of these companies are also going to find it increasingly hard to justify further equity injection given the persistent lack of cash flow generation and increasingly few exit opportunities to monetize their investments (see zerohedge article on this topic). This leaves the majors as the only significant source of supply growth for Shale this year, making a repeat of the high production growth in 2018 unlikely.
Also important to note is the composition of current production by vintage. As Ryastad pointed out in their Feb 2019 report, the shale oil wells completed during the two years leading up to Nov 2018 represent a whopping 72% of total light tight oil production. What this implies is that current US oil production is extremely ‘young’, and the base decline rate is extremely high. Ryastad estimates that if no new wells are drilled in 2019-2020, US production will decline 62%!
This brings us to the central problem behind the US shale oil business model, the impact of which goes beyond 2019 and into the long term supply/demand outlook for oil: Because of high initial decline rates (~70%), US Shale production suffers from a ‘treadmill’ effect. Imagine a treadmill whose incline increases as you walk faster. As you walk faster, you have to expend more and more energy to maintain your velocity. Similarly as Shale production grows, a greater percentage of the overall production consists of ‘flush’ production with high decline rates that pull the overall decline rates of the production base upwards. The more you produce, the more the ‘maintenance’ capex needed to simply keep production flat, let alone grow.
The story gets even more interesting when you consider the implications of technology on the ultimate recovery of oil from shale basins. Over the past few years, companies have touted lower break-even oil prices driven by the use of technologies such as longer laterals and reducing well-spacing. Energy consultancy firm Energy Aspects, which has built a detailed long term model for US Shale growth, is skeptical with regards to the inventory available to US shale going forward:
This bring us to the punchline of this blog post: By combining what we know about the ‘treadmill’ effect of higher production growth, the increasing call for capital discipline from E&P investors, the crude quality issues discussed here and the impact of technology on the long-term recoverability of oil from the shale basins, we can see why relying on US shale to meet the world’s energy needs going forward is not a prudent strategy.
The global oil industry will eventually come to the same conclusion, and the realization that more conventional projects are required to meet the increasing oil demand from developing economies like China and India.
As I discussed in detail in my last blog post, the pipeline of conventional projects commissioned during the period of higher oil prices (2010 – 2014) is drying up quickly. If US shale growth falters now, we are likely to experience a structural supply shortage and much higher oil prices.
I have been wrong about Shale oil growth over the past 2 years, however I am a firm believer that the laws of economics prevail in the longer term. An industry that destroys capital as it grows cannot continue to grow indefinitely. An industry that’s flooding the market with the wrong type of oil (light vs. heavy) cannot meet the growing demands of the world economy. US shale growth has lured the world into a false sense of security with respect to future energy supplies. By growing at high rates with no regard for profitability or cash flows, it has forced conventional capex to the sidelines for several years now setting the stage for the next energy crisis. I think US Shale has lured the world economy into a trap.
The Pale Blue Dot 