October 2021
History shows that those who underestimate the US shale sector do so at their peril. That hasn’t stopped many experts from writing off shale, believing that low prices, high well-decline rates, and investor demand for capital efficiency have effectively neutered shale’s growth potential.

These fundamentals existed before COVID-19, and the pandemic has only increased the pressure. Shale could have the last laugh, though, outperforming expectations on the back of lower breakeven costs. Producers are consolidating after a tough 2020 but recent higher oil prices are already testing their discipline.


Smaller, Slower and More Profitable

When the worst oil crash in decades struck in 2020, shale project operators were forced to slash capital expenditure, sack tens of thousands of workers, idle rigs and cut production. Scores of Chapter 11 bankruptcy filings ensued. Now a more resilient industry is emerging from the ashes and aims to entice investors. The new industry will be smaller – some believe the sector will be reduced to just 50 dominant shale producers. AME expects production increases will be modest, and financed from cash flow, and activity will focus on fewer prolific shale fields, mainly in Texas.


Early Warning Signs

After years of growth, shale’s cash-intensive business model was running on fumes even before Saudi Arabia’s price war with Russia and COVID-19 crashed the oil market last year. The sector’s defining feature is the fast decline of each shale well’s production, where output can drop by 80% after just a year. To offset the loss, another must be drilled. Then another, to offset that well’s loss.

In 2019, operators drilled more than 14,000 shale wells according to the US Energy Information Administration (EIA). It helped the US hit record-high oil output at near 13 million barrels per day (Mbpd), a level unmatched even by Saudi Arabia and Russia, the world’s next largest producers. That was a rise from 5Mbpd just eight years earlier, a surge that sparked booms from Texas to North Dakota. The output helped drag the US economy out of the global financial crisis, adding 1% to GDP between 2010 and 2015, according to the US Federal Reserve Bank. But it required huge infusions of cash offered at basement interest rates.

The sector spent around US$400bn capital in those years, but by 2019 free cash flow had arrived only once, in 2016. Investors that rushed to finance shale’s recovery from the 2014-15 price crash (an earlier Saudi price war to capture market share) were fleeing the sector by 2019. As capital markets began to close for shale companies, operators were forced to trim spending plans, reducing new drilling activity. With profits still absent and growth prospects diminishing, the shale patch entered 2020 in distress.

Then came last year’s price crash, including the symbolic moment in April when West Texas Intermediate traded below zero for the first time. COVID-19 effectively reset the entire shale sector. Just a few shale companies showed they could survive the collapse in relative health. However, for majors such as Chesapeake and scores of smaller producers, the distress was acute, with more than 100 operators and service providers, with US$102bn in debt, going under.


M&A Rush

One tenet of the emerging new shale sector is that scale is critical to survival, but of operators, not the overall sector. AME expects the mergers and acquisitions to achieve adequate size, coupled with the consolidation of weakened companies, will continue to shrink the number of producers. From around 500 exploration and production companies in the US before the crash, it is expected 50 may survive to run the best plays. M&A activity is brisk, with about US$52bn worth of deals done in the US oil sector in 2020. 

Chevron moved first, buying Noble Energy in July. ConocoPhillips bought Concho Resources. Devon Energy merged with WPX Energy. Heavy debt, battered balance sheets and weak equity valuations meant that stocks, not cash, were the currency in each deal. The consolidation wave has continued in 2021 with the involvement of bigger, stronger players, more disciplined management teams with stronger balance sheets.  Companies with market capitalisation above US$10bn will remain attractive to a value-focused investor base.

ExxonMobil and Chevron, US majors which have built up commanding shale positions, intend to produce about 2Mbpd from the Permian Basin later this decade, almost a fifth of total current US crude production. Most of the M&A activity has occurred in that shale oilfield, the world’s most prolific, where operators will concentrate on the rich layers of oil-bearing rocks in the Delaware and Midland Basins of New Mexico and Texas. Gas-focused players, such as the revamped Chesapeake, are likely to stick to their best assets. Other shale fields, even the Bakken of North Dakota that sparked the shale oil rush a decade ago, will lose out.


Capping Output

But the main feature of the post-crash shale patch will be an era of tepid growth, if the sector expands at all. Some major companies, such as Devon, can now break even at US$30/bbl or less, well below the US$75/bbl-plus for WTI oil in recent weeks. Yet Devon will hold its rig count flat this year, only drilling a few wells to meet the lease terms of some acreage. AME expects US total oil production to fall by 200-300kbpd in 2021 as a result, remaining at around 11Mbpd, well below the record highs set before last year’s crash. The sector is not anticipating a big ramp up in drilling, and companies will not return to past levels of activity even if oil prices hit US$100/bbl. Activity will be driven and enforced by the market, which has punished excessive supply growth, even before COVID-19 hit last year. Until the world has fully recovered, it will not need shale producers to increase oil supply. So far, operators are holding the line. If the discipline sticks, dividend- and value-focused investors could be lured back.


High Prices Testing Producer Discipline

Despite the wave of consolidation, AME notes that some industry observers and investors remain unconvinced by shale’s new mantra and more mature outlook, saying operators will be unable to resist another supply surge if the recent price rally continues. Higher prices in recent weeks are already testing operators’ resolve. The monthly rig count hit 449 in August 2021, more than 102% above its low in August 2020. Private operators, which account for about 15% of onshore US oil production, have led the resurgence, taking advantage of falling costs caused by the drop in demand for oilfield services from publicly listed companies.

Brent and WTI prices are currently at highs of US$80/bbl and US$75/bbl, respectively, and Henry Hub natural gas prices have exceeded US$6/MBtu. AME predicts that 2021 will become the best year for the shale sector from the perspective of free cash flow generation. It may even allow for profitability, and new production growth, testing operators’ promises to investors. Shale sector operators are in a dilemma. They always have difficulty maintaining discipline as a group, because they’re all competing with each other.

All of this suggests that, with the higher oil and gas prices now prevailing, there is a possibility that shale drilling and production will resume its growth of about 1Mbpd from the start of 2022. Combined with shut-in capacity in OPEC+ producers, this seems easily capable of balancing the market and keeping a lid on prices.  How Saudi Arabia in particular will react to a resumption of shale oil production growth will determine prices over the next few years.