August 2021

The last barrel

Uncharacteristic restraint
Craig Fleming / World Oil

In 1979, escalating crude prices, combined with the repeal of federal oil price controls on U.S. production by President Jimmy Carter, started a drilling boom in the U.S. of unprecedented proportions. In 1981, the U.S. rig count averaged 3,970 units for the year, and hit an all-time high of 4,530 on Dec. 28, 1981. Crude also peaked at the end of 1981, reaching $37/bbl (about $100/bbl in constant dollars). Much of this drilling was financed by capital secured through limited partnerships run by unscrupulous fund managers that never delivered on promised returns (sound familiar?).

Boom turns to bust. The event that initiated the bust occurred in July 1982, when Oklahoma City-based Penn Square Bank failed, due to highly questionable lending practices by the bank’s primary loan officer (that guy’s OU frat name was “monkey brains”) that was convinced that virtually any lease or producing property was a good investment. The ripple effect caused 139 other banks in Oklahoma to fail
and led to the collapse of Continental Illinois National Bank, which had to write off $500 million in loans purchased from PSB.

Fast forward to 2017-2020. Similar to the over-drilling scenario during the 1979-1982 boom era, activity in the U.S. shale plays ran at a blistering pace, starting in the second half of 2017, leading to a crescendo of 885 rigs in December 2018. Drilling tapered down after that until the Covid event in March 2020 caused demand to crash and sent crude prices into negative territory. However, the damage was done. In May 2019, operators working the U.S. shale plays had managed to archive 8,283 DUCs, with 48% of that total in the Permian basin. What were those guys thinking? That’s a significant amount of stranded capital. How much has our industry “invested” in DUCs? And when can investors expect a return?

Fiscal responsibility, finally. Despite higher oil prices, U.S. shale operators have resisted ramping-up drilling activity and remained disciplined with capital expenditures. The speed at which new rigs have been deployed to the field is considerably less than in previous up-price cycles. Most U.S. shale companies are being conservative, as priorities remain focused on protecting balance sheets and generating free cash flow. For many operators, this has led to a drawdown in their DUC inventory during the last six months, which has helped to reduce capital expenditures while maintaining production levels, said upstream analyst Steven Ho. And, according to the July 2021 tally by EIA, the DUC total stood at 5,957, a reduction of 2,326 wells since May 2019. In the Permian basin, operators have completed 1,682 DUC wells during the May 2019-July 2021 interval, a reduction of 42%. Also, an analysis by Rystad Energy shows that drilling discipline has reduced the number of “live” DUCs (less than two years old) in the major shale regions. The number of “live” DUCs stood at 2,381 in June 2021, the lowest level since 2013, as the industry continues to frac more wells than it drills. Despite the good news, it means that there are approximately 3,576 DUCs that are two years old that most likely will never be completed.

But for now, operators are utilizing their DUCs inventory to maintain production levels and protect capital. Shale producers also recognize the volatility in the oil and gas market and have encouraged investors to hedge their production. This will protect them against a downside risk, while also capping the maximum price at which they sell their production, Ho continued. U.S. shale appears to be finding a way to remain resilient and prepared for whenever oil demand requires more crude oil from unconventional developments. However, uncertainty around the pace of economic recovery in some regions, due to the Delta variant, and OPEC’s decision to gradually increase output throughout 2021, is expected to restrict oil price. But approximately 33% of U.S. unconventional production is protected against a drop in price, due to hedging strategies that are in place for the remainder of 2021. Conversely, this means that some operators will not benefit if there’s a higher-than-expected spot price, as their hedging puts a cap on the maximum price they can receive.

Path forward. Operators must implement a multi-pronged strategy to generate free cash flow, optimize hedging strategies, reduce debt, while meeting carbon reduction targets. Moreover, there is an expectation for increased consolidation across the shale sector, where bigger companies can acquire smaller operators, which now are generally healthier in their balance sheets and can increase the competitiveness of larger companies.

Too much focus on debt reduction? Shale drillers are showing so much financial self-discipline that next year’s oil production forecasts may be in peril, according to Tudor, Pickering, Holt and Co. The company warned it probably will reduce its 2022 outlook for onshore U.S. crude output growth, given the signals emanating from executives at publicly traded shale companies. After listening in to second-quarter earnings conference calls in recent weeks, Tudor is no longer confident that the companies will lift production by 350,000 bopd next year. “We are surprised, companies largely avoided the allure of talking about growth in 2022.” Management teams continue to display capital discipline. Shale explorers are funneling record free cash from this year’s oil rally into share buybacks, dividends, debt reduction and acquisitions rather than drilling new wells. Ultimately, if U.S. growth is headed lower and demand remains on track, our confidence continues to increase that 2022 crude will average $65-$70/bbl.

Striking a happy medium. I am pleasantly surprised (shocked) that our industry leaders are acting responsibly and not repeating the painful mistakes of the past by ramping-up drilling activity to capitalize on higher oil prices. Hopefully, U.S. operators will continue to self-regulate and we can salvage what’s left of our industry for everyone’s benefit, while minimizing the damaging boom-bust cycle.

About the Authors
Craig Fleming
World Oil
Craig Fleming
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