US Shale: Evolving Trends May Make 2018 Different
Anwar Altaqi – Esam Aziz
Though US shale producers are set to produce record amounts of shale oil and gas this year, there are certain underlying trends that could make this year little more than a quantitative bump to what shale achieved last year.
The main area where those factors play out is financing.
We should first mention that companies, which played the main role in the US production boom, have spent $265 billion more than they generated from operations since 2010, according to a Wall Street Journal analysis of FactSet data. This was reflected in the stock market, of course. In themselves, producers’ stock outperformed other companies.
Yet, those stocks gained 17 percent in the last three months. But the increase in oil prices was well over this limit. One imagines that when proven assets increase, say 20 percent, in value, stocks increase a little more. Crude prices increased almost 30 percent during that period. The impact was a meager 17 percent in the case of shale stocks.
Why is that? This phenomenon can only be explained by saying that investors are growing cautious. But why would an investor hesitate to rush into buying shale stocks? Quite simply, because for three long years these companies have been spending more than they earn. They continued to spend, despite alarming signals from the market and wise advice from executives.
Now, what we see is a classic picture from an active market. While many companies, Chevron for example, are cutting investment in shale this year, we will see two developments that may appear to some as difficult to explain:
First, we will see an increase in shale production.
Second, we will see smaller companies still rushing to borrow and invest more, hoping that the market somehow will not let them down.
The first development should be clear if it is considered within the context of the investments of the past three years. During these years, significant amounts of money have poured into shale while the sector was unable to show real profits, even when it was able to show real barrels. All this investment will be partially paid back by the relatively high production of 2018.
When a dollar is invested in drilling in 2017, it pays back in 2018. Shale companies have a backlog of almost 7,000 wells that have been drilled but not fracked — 30 percent more than in January 2017. Having already spent money to drill last year, operators can save money and boost production by fracking the backlog. Yet, the slow investment in 2018 will, in turn, be reflected in 2019 production levels, even when the United States is expected to break its 1970 record level of 10 million barrels a day during the current year.
Moreover, some shale companies reported that they produce higher than expected gas from their wells, sending a chilling message to investors who saw this as sign that wells are aging quicker than expected and will soon decline.
The second development is due to smaller companies having shorter sight. Big producers are usually more capable of seeing beyond making an instant buck. But even among smaller producers there is a degree of caution. They will increase spending by about 8 percent in 2018, compared with a 55 percent increase in 2017. Investors are demanding that shale companies sell off weaker holdings, pare spending, and pay down their debt.
Yet, the central question here is: What made shale producers run wild and increase output even at the expense of sound financial management? The answer lies, at least partially, in the policies adopted by the Exploration and Production (E&P) corporate boards. Executive pay incentives for exploration and production companies are under scrutiny from investors, too. The compensation plans laid out by E&P corporate boards encourage these companies to grow production at almost any cost. For example, pay may be tied to sales volumes or additions to reserves, rather than measures of cash flow. The strategy builds the personal net worth of the CEOs but does nothing for the shareholders, for whom they are legally fiduciaries.
Another possible reason is heavy public support to fracking. The US Energy Information Administration (EIA) was spreading exaggerated numbers about US production. States were giving tax incentives to producers. “Private” research institutions were portraying shale in an excessively positive light. And financial companies were deliberately easing their lending policies in the case of shale with expectation to reap the profits in other sectors if energy prices remain low and global markets remain glutted.
Saudi Energy Minister Khalid al-Falih said recently that the International Energy Agency (IEA) is overhyping the impact of US shale growth on the oil market. “I am not disputing the amazing revolution of shale. But in the overall global supply demand picture it’s not going to wreck the train. That’s the core job of the IEA, not to take it out of context,” he added. Yet, this was only one way to hype the sector and help it get the money it needs and a bit more to expand.
In short, what could be said about shale at this juncture is that its future is still a question mark. We have to wait and see, keeping an eye on its finances.