There is a fairly blithe assumption in government circles that shale production can be raised at will. That assumption is about to be put to the test as the American shale drilling and fracking industry attempts to respond to the entreaties and outright demands of legislators, members of the administrative branch’s leadership, and even the president himself to put more capital toward increasing production.
This is happening, but at a level and rate that will be insufficient to boost production significantly. In fact, data from the most recent publication of the Energy Information Agency’s Drilling Productivity Report-DPR indicates trouble could lie ahead. As the graph taken from EIA-DPR data reveals, the rig count is going steadily higher, but production from the eight major shale basins has leveled off and, as of Feb, 22, has actually slightly declined. If the May edition of the DPR confirms this trend then there is going to have to be a drastic reevaluation of what will be expected from shale in the future.
One obvious cause of the decline is not directly related to the rig count, but in the decline of Drilled but Uncompleted-DUCs, wells being turned to production. Over the last couple of years, operators have cut the DUC inventory from ~8,500 to ~4,200.
A year ago in an Oilprice article, I predicted this point would come. It has now arrived as operators have drastically curtailed the DUC withdrawal that was maintaining and increasing production over the past couple of years. There are multiple reasons for this situation and the primary ones will be discussed in the remainder of this article.
Forecasting the rig count
Physicist Niels Bohr once commented, “That prediction is difficult, especially about the future.” Anyone who has put a sales forecast together can relate to this wry witticism. Recently I attended an industry conference, The American Association of Drilling Engineers-AADE, where the Keynote speaker- Richard Spears, an industry analyst, and consultant, spoke about a key difficulty in forecasting in regard to estimating the likely year-end rig count. His point was that events occur and make prior forecasts seem ridiculous. His case in point was the invasion of Ukraine, which was on no one's radar...until it happened, and immediately made every forecast up to that point out of date. Almost ludicrously so.
He then took a poll of the room as to where we thought the land rig count would end up for 2022. He threw out numbers starting with 800, about a hundred higher than where we are now, and we responded when he hit the number that matched our personal belief. Virtually every hand rose with 800, about half dropped at 900, half again at 1,000, and just a few at 1,100. One or two hands stayed up at 1,200 and he stopped there. He then gave us his number, 800. This surprised me as I was one of the 1,100 hands. His justification for that number didn't surprise me, as it involved capital restraint, lack of financing, and logistics impacts that are causing inflation in the oilfield. All things I have discussed in prior Oilprice articles.
An article in the Wall Street Journal put a personal spin on this situation, as they quoted a small independent driller’s frustration with being able to secure needed materials.
“If somebody walked in and put a pile of money on the table and said, ‘Drill me a well next week,’ it isn’t going to happen,” said Jamie Small, president of private-equity-backed oil producer Element Petroleum III. “You just can’t get the stuff to do it.”
Take this operator’s frustration and multiply it by dozens of other small-time independent oil operators that drill about half the wells drilled annually, and you can see serious problems are brewing.
Oil companies revised their playbook after nearly going bankrupt post-March of 2020. As oil prices rose, these companies moved their capital allocation from growth to maintenance capex, which freed up huge sums for paring down debt, rewarding long-suffering stockholders with dividends, and buying back their stock - which was at ridiculous lows following the pandemic. This is all pretty well known by now. What isn't so well understood, is that despite some very public comments from the big players, ExxonMobil, (NYSE:XOM), and Chevron, (NYSE:CVX) to bump up production sharply, most companies are sticking closely to previously announced capex budgets. That could have profound implications for estimates of future production.
Access to financing
The big institution's repugnance for oil and gas investing is well known, at least as regards the big players operating the leases. What I hadn't realized is how severely service companies are affected by this mindset. Note this quote from the Schlumberger, (NYSE:SLB) press release-
“First-quarter cash from operations was $131 million, including a first-quarter build-up of working capital above the usual level, ahead of the anticipated growth for the year. We expect free cash flow generation to accelerate throughout the year, consistent with our historical trend, and still expect double-digit free cash flow margin on a full-year basis.”
SLB public filings
In Q-1 they burned half a billion in cash, likely supporting working capital builds for current project mobilization.
SLB public filings
SLB isn’t alone. Halliburton, (NYSE:HAL) burned nearly a billion in cash in Q-1, likely for the same reasons as their larger rival.
Halliburton public filings
If the big players like HAL and SLB are shut out of traditional financing, you can imagine the difficulty lower tier or private companies are having.
A final point here that Spears made is that service costs are still below the cost of replacement, and that is going to have to change in a hurry. He commented that based on his research talking to drilling contractors day rates for high spec rigs will be about $40K/per day at the end of 2022. Roughly twice current levels. Other service companies will be doing the same.
One of the points he made here is that oil companies may have to become the bank for service companies. Not a comfortable position for them, but as you can see the cash burn in the service providers can't go on. At this rate, cash balances will be used up before the impact of higher rates can hit the balance sheet. In one way, these are great problems to have. HAL and SLB are being tasked to do more which will impact cash flow and earnings. The problem is management has not squarely addressed profitability. All of the publicly held service companies have committed to raising prices to improve profitability and cash generation. Spears noted that this is on the horizon with the privately held companies and hopefully comes soon.
Logistics, supply chain, and inflation
The pandemic has upended the flow of goods from traditional points of manufacture. The war in Ukraine has exacerbated this profoundly in ways we are just now beginning to discover. As an example, Richard cited the bit company he serves as a board member. The body of the bit is cast, and cobalt is used to strengthen it. The widespread and growing manufacturing of EV batteries has caused disruptions in the supply and cost of cobalt.
His point was that the drill bit manufacturer is way down on the allocation curve for cobalt suppliers, and has no leverage when it comes to negotiating prices.
Take this factoid and expand it over the entire oilfield supply chain. Costs are going out of sight and will soon manifest themselves in restriction of service availability. He also cited an exponential increase in the costs for frac gear to redress worn fluid ends on pumps.
These are growing pains in my book. I am not quite ready to agree with Richard on the exit rate for U.S. Land drilling for 2022 at 800, but it is probably much lower than my guess of 1,100. The larger point is that 800 domestic rigs are nearing a very healthy market for services, and in this oil price regime, this growth should continue into next year.
The overall implication for service providers is a higher for longer oil price regime, leading to a robust market as Big Red and Big Blue have demonstrated with their Q-1 reports. To me, the cash burn will slow as prices adjust and working capital is supplemented with cash flow. They should be bought near current levels on any weakness.
For oil production from shale basins in general, the forecast is not as clear. As noted in the Oilprice article I referenced above, there are concerns about the quality of undrilled shale acreage remaining as to its ability to deliver the amount of production that Tier I acreage has delivered.
“One of the questions that often comes up is what will happen when Tier I acreage is drilled up. Some estimates have been put forward that this might occur within the next decade. Rystad has challenged those estimates showing an estimate of the longevity of Tier I shale in years at present rates of drilling.”
What is clear, is that the glib confidence the government has that shale production can easily be ramped higher is misplaced. A combination of natural limitations, logistics, inflation, and human impacts is taking its toll, and the effects will become more evident as the year goes on.
By David Messler for Oilprice.com
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