What to Expect from Shale This Year
The shale oil and gas industry enters 2022 in fine health but with some firm resolutions for the new year. As usual, the challenge will be sticking to those goals. The oil shock of 2020 forced companies to cut costs and restrain spending. The industry kept this capital discipline last year as oil prices rose, generating enormous free cash flow for shale companies. Now the question is how the industry can raise spending from unsustainably low levels over the past 18 months while keeping its focus on profitability.
The first decade of the shale boom created jobs, delivered tax revenue to states and the federal government, and helped reduce the trade deficit—but destroyed investor capital on an unprecedented scale. Quarter after quarter, many shale companies reinvested all their cash flow as management teams were incentivized to seek growth rather than returns. The result was a lost decade for investors. According to one estimate, free cash flow for the entire U.S. shale sector for 2010–2019 was a stunning -$300 billion.
The oil price crash in 2020 was a turning point. Exploration and production companies were forced to cut their capital programs and lay down rigs, which decimated the oilfield services industry and left many workers out of a job. Crude oil production in the United States fell from a peak of nearly 13 million barrels per day (b/d) in November 2019 to average 11.3 million b/d in 2020 and 11 million b/d in the first 10 months of 2021. This contraction, painful as it was, created a more disciplined and resilient industry.
Last year, shale companies focused on paying down debt and returning cash to shareholders through increased dividends and share buybacks. Companies such as Devon Energy and ConocoPhillips began offering variable dividends, boosting cash payouts during periods of high profitability. Capital discipline helped the sector to generate enormous cash flow. Twenty of the top shale producers in the United States generated nearly $36 billion in free cash flow in the first three quarters of 2021 (see table). Investors responded, and the energy sector outperformed the rest of the S&P 500 last year, posting a 46 percent return compared with 28 percent for the broader index.
Underpinning this profitability, however, is an unsustainable level of investment. Last year most shale companies reinvested less than 50 percent of their cash flow in new drilling, as the industry downshifted into “maintenance capex” mode. But initial production rates at wells usually drop off quickly, so companies need to drill continuously to sustain output. They can only pull back on investment for so long without sacrificing future production levels and cash generation.
Management teams are determined to stay disciplined this year. Most companies will prioritize payouts to shareholders and debt reductions. Companies insist they will take a more disciplined approach to new capital expenditures, for example running an additional rig or two in their highest-margin areas to generate more cash flow. Consolidation in the shale patch also means that more conservative management teams control a larger share of output.
Still, with higher oil prices (West Texas Intermediate—the key U.S. benchmark crude—has mostly remained above $70 per barrel since early fall) companies can meet multiple goals simultaneously. They can grow production, protect their margins, and deliver higher returns to shareholders. Privately held companies that are not subject to investor pressure will have especially strong incentives to increase output. But a higher oil price environment will create some new challenges.
Key Factors for Shale Growth in 2022
Broad market conditions, the need to replenish well inventories, and higher costs will determine how companies adjust their production plans. But there is little doubt that companies will dial up spending this year.
Market trends support a rationale for shale companies to increase spending. The dramatic increase in gas and electricity prices in Europe in recent months, as well as rising gasoline prices in the United States last fall, raised long-dormant concerns about energy security. There are strong signals that new investment is needed after years of capital constraint. With the Organization of the Petroleum Exporting Countries and allied producers (OPEC+) winding down their production cuts and spare capacity, there is an opportunity for the shale sector to grow again and meet strong global demand.
Another reason to expect higher spending is the falling inventory of drilled but uncompleted wells (DUCs). As companies sought cheaper options to sustain output over the past 18 months, they turned to well completions rather than new drilling, and the number of DUCs began to fall sharply. In a sense, the fall in DUCs has artificially boosted production numbers and well productivity data for the major shale basins, especially the Permian Basin. The drop in DUCs means that the industry will have to drill many more wells in 2022, reducing capital efficiency. The production rebound of recent months will run out of steam unless the industry ratchets up spending.
Most companies also expect higher service sector costs. In a recent survey of energy executives, the majority of oilfield services representatives expected to increase their rates by at least 10 percent this year. Cost inflation reflects broader trends in the economy, but the service sector is also pushing for higher margins after years of depressed demand for its services. Companies will have to spend more on well completions and drilling, and higher spending will not translate as easily to increased volumes.
As Shale Matures, Its Role in the Global Oil Sector Is Changing
Companies want to extend the policies that created bumper profits last year, and shale players are wary of an investor backlash if they ramp up spending too quickly. But the concept of capital discipline is evolving. It is safer—and perhaps even necessary—for companies to grow again, albeit at a slower rate.
Shale oil and gas production in the United States is already rising. The U.S. Energy Information Administration (EIA) estimates that crude oil production was 11.7 million b/d in November, and crude production could increase from 700,000 b/d to 900,000 b/d in 2022, according to various estimates. These are big numbers but fall well short of the breakneck pace of 2018 and 2019, when oil production rose by 1.9 million b/d and 1 million b/d, respectively. Most companies and investors would agree that this is a good thing. There will be no return to debt-fueled peak production levels, and slower growth is more sustainable.
As the shale sector matures, the role of the U.S. oil and gas industry in the global oil system is evolving. The United States is still the principal source of short-cycle oil, creating a dynamism and responsiveness that is unparalleled elsewhere. But the wild production increases of years past could be gone for good. If global oil demand continues to grow, the U.S. shale sector will be an important source of incremental supply, but other countries will have to step up investment as well. Higher prices and a tighter market would enable more output from countries that are higher on the cost curve—but only if capital is available.
Ben Cahill is a senior fellow in the Energy Security and Climate Change Program at the Center for Strategic and International Studies in Washington, D.C.
Commentary is produced by the Center for Strategic and International Studies (CSIS), a private, tax-exempt institution focusing on international public policy issues. Its research is nonpartisan and nonproprietary. CSIS does not take specific policy positions. Accordingly, all views, positions, and conclusions expressed in this publication should be understood to be solely those of the author(s).
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