U.S. Shale Built Back Better in 2020
— December 17, 2020
By Paul Tice
After firing the first shot back in March, the OPEC+ cartel quickly surrendered after barely 30 days, pushing through drastic supply cuts to try to stabilize the world market that it had just upended. In recent months, the sovereign group has dealt with de rigueur issues of quota cheating and internal tensions, while repeatedly balking at adding back production due to demand uncertainty.
OPEC’s fractious nature was clearly on display at its most-recent semi-annual meeting earlier this month, when the group blinked for a second time around supply increases, further reinforcing its position as the production plug for oil prices when worldwide supply and demand get out of whack.
Over the course of 2020, OPEC+ lost world oil market share, while its member countries bled international reserves and ran up double-digit budgetary deficits. While precipitated by the pandemic, such macroeconomic pressures were made worse by collateral damage from this year’s ill-conceived oil price war.
U.S. shale, on the other hand, finally got religion about its business model in 2020—mainly on the back of the industry’s near-death experience with negative oil prices in late April. After largely giving lip service to shareholder activists since 2018, almost every U.S. energy company has now fully embraced the concept of capital discipline and the need for free cash flow generation rather than growth for growth’s sake.
When the world changed earlier this year, most U.S. energy companies immediately laid down drilling rigs, turned off capital spending and slashed operating costs and headcount. As a result, many leading shale operators have now lowered their all-in economic break-even WTI oil price to roughly $30 per barrel. This compares with an average 2020 fiscal break-even price of more than $75 per barrel for most OPEC members, based on IMF estimates.
More significantly, U.S. shale producers also opted to curtail current production by shutting in fracked wells during 2020. This was viewed as a step too far during the 2014-2016 industry downturn, due to the uncertain impact on well performance and structure integrity.
This year’s forced experiment revealed that unconventional wells do not experience any of the performance problems typically seen when conventional oil and gas wells are shut in and then turned back on. Rather, shutting in fracked wells would appear to recharge the underlying structures, resulting in flush (i.e., catch-up) production volumes once such wells are placed back on-line.
The flexibility to shut in fracked wells without adverse effect is a fundamental game changer for the shale industry.
Such an on-off switch provides an important pressure relief valve for the shale industry going forward—especially if the days are now numbered for the 60-year-old OPEC cartel in the wake of two failed price wars over the past six years, and persistently-lower oil prices (with increased downside volatility) become the new normal for global producers.
U.S. operators now have a just-in-time enhancement to dynamically manage their shale oil and gas manufacturing operations, which is a fundamental game changer.
Upstream M&A activity has also picked up since mid-2020 as shale players have started to combine to diversify operations, add scale and increase financial flexibility, thereby concentrating U.S. oil and gas reserves and production into fewer, stronger corporate hands. Large-cap integrated and independent players have scooped up competitors at attractive multiples, while smaller operators have opted to combine in de facto mergers-of-equals to help build critical mass. Most transactions have been all stock-financed, with minimal share price premiums attached. Over-leveraged companies need not apply.
Also feeding this consolidation trend has been another wave of bankruptcies across the shale industry, mostly at the lower end of the credit spectrum. Most Chapter 11 filers this year have been smaller high yield and private companies with pre-existing conditions (usually a combination of too much debt and too little liquidity).
It will take some time before the oil and gas sector works again for buy-and-hold equity accounts. In the post-shale period, energy equities have significantly underperformed the broader market indices. Since 2014, a short-term, commodity-driven trading strategy around the sector has made more sense than owning oil and gas company shares over a longer-term investment horizon.
However, the strategic steps taken by many shale companies during 2020 should eventually lead to an improved fundamental and technical argument to own energy company equities down the road.
Most importantly, running with less balance sheet debt and living within cash flow will also reduce the shale industry’s future dependence on external financing from the global banking system and institutional investors. While such attributes—along with increased commodity hedging—should lower the sector’s risk profile and make it more sustainable in the eyes of these capital providers, this reality gets lost in translation in the new environmental-social-governance (ESG) language now sweeping Wall Street.
The ability to self-fund from operations—upstream reinvestment rates are expected to drop to the 60-75% range in 2021, down from well over 100% historically—will help to immunize the U.S. energy sector from what is likely to be an increasingly hostile lending and capital markets environment over the next decade as the climate change movement and its ESG investment arm both come to a head between now and 2030.
The ability to self-fund from operations will help to immunize the U.S. energy sector from an increasingly hostile financing environment over the coming years.
Lastly, while the industry challenges of this past year will linger into the next, much of the coronavirus-related oil demand destruction seen in 2020 should not prove permanent and looks set to reverse by the end of 2021 once vaccines are rolled out globally and international travel patterns further normalize. Such a return to energy normalcy should prove a major disappointment to the anti-fossil fuels set.
Exiting the annus horribilis that was 2020, the U.S. oil and gas industry is on a stronger structural footing than it was at the pre-pandemic start of the year, and better equipped—both financially and operationally—to handle whatever a potential Biden administration may throw at it starting in 2021.
Paul Tice is an Adjunct Professor of Finance at NYU Stern.