Re: Oil-Will Shale Ruin The Party Again?

Capital reallocation risk is the reason why I express my long-term bet through PE.

At the risk of saying “this time is different”, I’m going to say that this time is indeed a bit different from the past from a number of angles.

First, US public E&P’s are much more focused on capital discipline and shareholder return than years before. I’ve said often that one of the biggest risks in investing in the public E&P space is capital reallocation risk.

You can have a favorable commodity backdrop and still lose $ from poor capital reallocation.

Great wellhead returns mean nothing for shareholders if all of the free cashflow keeps getting diverted back into the ground and likely into less favorable geology (if you assume that companies will go after low-hanging fruit first).

Since 2019, public shareholders have begun clamoring for capital discipline and shareholder return, and public E&Ps began to listen – even before COVID. I believe COVID further bolstered that attitude.

Private E&Ps don’t have public shareholders to answer to and have more flexibility in pursuing “full cycle returns” by fully harvesting inventory without having to redeploy that cashflow. They can afford to be more aggressive in their response to higher oil prices than publics.

According to a recent BMO analysis, private E&P activity “has driven an outsized share of the recovery” despite accounting for only 17% of lower-48 volumes vs. 32% back in 2014. To me, this corroborates the tepid supply response so far.

The chart below shows that the recovery in both rig counts and frac spreads has been somewhat tepid despite the recovery in spot WTI. I attribute this to 1) steep backwardation, and 2) the aforementioned capital discipline among public E&Ps.

At the pre-COVID rig/frac spread counts, US production peaked at 13 mmbpd. It is now struggling to get back to 11 mmbpd, although the EIA is projecting 11.4 mmbpd by Q4’21 and cresting 12 mmbpd by Q4’22.

And that brings me to my second point: how much did the 1-2 month curtailments/production disruptions during Q2’20 damage reserves and/or accelerate decline?

My smart CEO friend says: “I believe we are about through the DUC inventory, and I think we have too few rigs relative to fleets to stay balanced. So...what gives? Capital coming up or production falling?”

He is skeptical of a quick return of capital especially among publics: “Most are signaling 5% growth max -- at any price. Above $70 that probably changes. Below $70, we will probably see slow growth..."

..."The majors may shift to higher growth in the US, but at the expense of declining international bbls.”

These sentiments to be what is driving a more aggressive response from OPEC+. Saudi oil minister AbS reportedly stated last month that “Drill, baby, drill is gone forever.”

Forever is a long time, but many pros I talk to in the industry believe it would take a minimum of strip pricing firmly north of $60 in WTI for a more serious shale response.

Bottom line: Absent a complete about-face in OPEC+ resolve, it is unlikely that US shale will be able to ruin the party – especially when the missing long-cycle “production wedge” from global capital starvation over the last 6-7 years is coming home to roost.