By Charles Ruff, CFA

Manners are a constant battle, especially with a 5 and 3 year old. The other day I found my 3 year old knuckle-deep in her nostril. Before I could correct her or ask her if she needed a tissue she pulls out a big one. “Daddy what do I do with this?” I guess that got me thinking about extraction industries.

A different format than usual but I wanted to spend some time and touch on this topic.

In a former life, I was an energy analyst covering oil and gas companies. During COVID-19, US onshore oil production took a hit but held up pretty well. From its pre-COVID peak, production dropped about 12%. This was particularly notable that land-based oil-focused rigs fell from 657 in February 2020 to 470 today (a 29% decline). Time and time again, US shale has surprised to the upside. Can the US shale repeat this past success?

Weekly U.S. Field Production of Crude Oil

Weekly US Field Production of Crude Oil

When it first came onto the scene, shale reversed a multi-decade decline in US oil production. After 2014, oil prices crashed from about $100 to $50-$60 and eventually hit about $30/bbl in early 2016. Shale appeared to be barely profitable at ~$90 WTI… surely the industry couldn’t survive this environment.

But by the end of 2016, with WTI trading below $50/bbl, US production came back! Shale producers learned how to get more with less. Plenty of industries go through periods with improving efficiencies but I cannot think of another example where an entire industry lowered the cost curve as much or quickly as US shale. Maybe Space X with space travel but the datapoints are few.

In the shale patch, drillers got much more efficient- wells that took a month to drill were now getting drilled in a week. The industry also got better at drilling longer wells which added efficiencies. Depending on the geology, a well can go about 10,000 feet down and miles out. The longest horizontal well in the US was drilled by Eclipse Natural Resources (now Blue Ridge Mountain Resources) in the Utica shale and reached over 3.5 miles long! Drillers also got more accurate hitting their targets. Directional drilling allowed multiple wells to be drilled from a single pad, saving significant time and money.

Pad drilling and rig mobility lead to more efficient drilling

Pad drilling and rig mobility lead to more efficient drilling

Taking the above graphic one step further, drillers began drilling at different depths offset from the previous horizontals. Appropriately known as wine-rack spacing, this type of drilling allowed a single well-pad to touch a large percentage of the rock below.

The efficiencies didn’t stop with just the drillers. After a well is drilled, it is capped until a completion crew arrives with a fleet of trucks and pumps to frack the well. The frackers got more efficient with better pumps, cheaper proppant, and leaner processes.

Also, geologists better understood what was below their feet and were able to tweak different variables (which are way above my pay grade) to get a higher yield from the shale. Across the industry, the efficiencies were enormous and allowed shale producers to continue pumping oil in a $50/bbl environment. US geopolitical concerns about reliance on energy imports (remember those?) completely disappeared. The below chart is old (efficiencies have climbed much further since 2016!) but it does a good job of illustrating the improving trend. By 2019, the US was a net exporter.

New Study: US Shale Productivity Will Offset Rising Service Costs

US Shale Productivity

At every stage, shale seems to surprise to the upside. Can shale grow strongly again? I think the efficiencies are in the rear-view mirror. Continued growth depends on a few things including decline curves, DUC inventory, and Wall Street.

1. Decline Curves

The geology of shale is different than conventional oil wells. One of the important pieces of data that petroleum engineers monitor is the decline curve of how a well production decays over time. A typical well might be very prolific initially but will decline over time to a more steady-state where it will produce for a longer period of time. A conventional oil well might decline at 15% annually until reaching this level. With unconventional shale wells, this effect is magnified! Shale declines steeply around 40-50%!

Back to the decline-curve chart. In addition to showing improved efficiencies, this chart shows the steep decline in unconventional shale wells. Improved efficiency is nice but it can’t change the fact that a shale well will produce far less after it’s first year.

December 2016 by Trent Jacobs

US shale producers operate on a treadmill. Each year, more is required to offset declines. But onshore oil producers were able to lay down almost 1/3 of rigs but only see a 12% production decline… how does this make sense? There are a couple reasons. First, when the going gets tough, any business shuts down its least profitable lines. With COVID-19, the worst rigs drilling the worst land were the first to get laid down. This boosted productivity temporarily but I worry that the reduction in drilling activity leaves a bit of an air pocket in US shale production. The second reason why production hasn’t fully ‘caught up’ with the impact of COVID is because of DUCs.

Picture of a duck

2. DUCs (Drilled Uncompleted Wells)

When a drilling rig runs, it will outpace a completion crew. The rig will drill as many holes as possible. The completion crew comes second. Fracking can take more time and also involves significant logistics given the number of trucks, infrastructure, pipelines, etc. that are required. It’s easier to just wait to complete the well.

The result of this process is that the industry tends to have a significant amount of DUCs or Drilled- Uncompleted Wells. These are unfinished but can be brought online pretty quickly with less capex. During lean times, E&P companies will lean on their inventory of DUCs to help make up any difference. During COVID- this is exactly what happened. Completing these previously drilled wells allowed the onshore oil industry to outperform the rig count.

Excess DUCs

But with the excess inventory gone, what comes next? Oil companies MUST step up activity to fill this gap. We are now starting to see this trickle through suppliers. For US onshore production, Halliburton (HAL) is a strong proxy for US onshore spending. From HAL’s 4Q21 Earnings Call.

Quote 1 of 2 from Jeffrey Allen Miller of Halliburton

Quote 2 of 2 from Jeffrey Allen Miller of Halliburton

3. Wall Street

Oil extraction is a very capital-intensive business. During the early days of the Shale Revolution, Wall Street was more than happy to finance this tremendous growth. The most important metric for management teams and analysts was production growth. You wanted to own the stock that had the fastest production growth.

As the industry endured volatility and matured, Wall Street’s tone began to shift. Growth at all costs was no longer in vogue. Cash flow and the sustainability of that cash flow became the primary metrics.

Pedal-to-the-metal growth for US shale companies is in the past. Companies must show discipline. I believe this means that Shale’s supply response to higher prices will be more muted than many are expecting.

Today, a barrel of WTI sells for about $87 on the NYMEX. The futures curve shows oil prices declining through 2022 and 2023 to end ’23 at about $71/bbl. The below chart (blue line) is the median forecast by Wall Street strategists for what oil prices will be over the coming quarters. These strategists are assuming about a 20% decline in oil prices. The market AND Wall Street are both expecting prices to moderate from here.

Projected Oil Prices

Anyone want to take the over? I know I do.

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