What the oil sell-off means for the shale patch

Welcome back to Energy Source. This is Derek, live from New York.

It’s a big week in oil markets. It’s been volatile already, with Chinese protests against zero-Covid policies triggering a sell-off across markets yesterday that briefly took US crude to its lowest price of the year, at $73.60 a barrel, before settling marginally up on the day at $77.24/b.

The protests bring more bearish news to the deepening doubts about the health of the global economy. But for energy, there’s still much that could yet send prices up. On Sunday, Saudi Arabia, Russia and other Opec+ countries meet in Vienna just hours ahead of the December 5 start of the EU’s embargo on Russian crude.

These events don’t just matter for energy markets this week; they are part of a longer-term shift that is upending global geopolitics; one David Sheppard and I wrote about in yesterday’s Big Read about the new energy order. As Roger Diwan of S&P Global Commodity Insights said in our piece: “The potential dislocation in the near term is not controlled.”

In the newsletter today, we ask what the 15 per cent sell-off in US oil in the past month means for the country’s shale patch. Amanda Chu’s Data Drill looks at consumer confidence in the global energy industry. — Derek

Does the oil sell-off matter to the shale patch?

Brent and WTI futures contracts that expire in the upcoming months have been under heavy selling pressure in recent weeks — leaving benchmark crude prices more than $40 off their summer highs.

Crucially, the first few months of the US crude price curve has flipped into contango — as spot prices have slipped below futures prices several months out — an important signal of price weakness and near-term oversupply to US oil drillers.

What does the weaker price environment mean for the US shale patch? We asked around. Opinion is divided, but here are five things we learned:

1. Prices have entered a red zone . . . 

Operators are starting to feel the pinch — to the point where some argue they could start pulling back their already-modest output plans.

“This latest sell-off — just the past two to three weeks — is going to do some detrimental damage to production over what the industry thought was coming just a month ago,” Dennis Kissler, head of the trading division at BOK Financial told ES.

“A lot has changed in the last 14 days,” he added. “Over the next three months there’s a lot of wells to be spudded [drilled] and I think they’re going to be delayed — depending on price.”

Costs have risen substantially over the past year — as much as 30 per cent in many cases — driven up by supply chain problems and a tight market. Rising interest rates are also pushing up drillers’ debt costs. That means the oil prices needed to break even are much higher than they were a couple years ago.

And new investor demands for dividends and share buybacks, which eat up corporate capital, have pushed the price to drill even higher.

That, Kissler agues, means even prices in the mid-$70s (ie where WTI is now) are cause for a rethink on drilling plans two years out. “With the latest sell-off we’ve had, it no longer really works for them on the back end of the curve,” he said.

2 . . . . but many public companies are insulated

Others say a near-term reboot for production is unlikely — at least for publicly traded operators that were already planning for slow-to-no growth.

“In the near term, I’m just not expecting too much movement, honestly, one way or the other in terms of capital allocation from the industry — unless there’s a serious, serious blowout in the commodity price environment,” Matt Portillo, head of research at TPH&Co, told ES.

The industry’s capital discipline model means companies are setting more modest production plans — and actually sticking to them — as they pursue shareholder returns over ever greater growth.

“The business models for the upstream industry have just gotten to such a point where their capital allocation decisions are fairly immune to crude prices as it relates to downside risks,” Portillo said.

In short, there hasn’t been a huge uptick in drilling even with higher prices in the past year that might be undone at lower prices in future.

Devon Energy, one of the biggest drillers in the shale patch, said nothing had changed. The company told ES it planned “to maintain a consistent and steady programme for 2023”. The combination of a strong balance sheet and low costs, the Oklahoma City-based group said, allowed it “to mitigate risk as it pertains to potential swings in commodity prices”.

On top of all of this, the main shift in prices has been on the front end of the curve. Twelve months out, the slide is less significant. The January WTI contract settled around $77/b yesterday, off $10 this month. The December 2023 contract, by contrast, sat about $75/b, off just over $2 over the same period.

Any major shift in output among publicly traded groups, says Portillo, would require a bigger — and longer-term — reduction in prices.

“If we were to see a more sustainable drop towards $50 or so barrel, I think what you would see is companies that have growth plans in place — low-single-digit growth plans — coming back towards flat production and maintenance capital. But we’re still probably $20 to $25 higher than where the change in the budgets would occur.”

3. Investors might do (slightly) less well

Still, shareholders in those publicly traded groups are likely to see a dip in their returns — which have been enormous this year.

Lower prices mean lower cash flow. And lower cash flow means the variable dividends that make up a significant chunk of returns will also fall. Companies could also cut share buyback programmes, which have helped buoy share prices this year.

But even with the dip, investors are hardly going to be suffering. Yields will probably remain in the high single digits, according to TPH — still among the best on the S&P.

Pioneer Natural Resources, the Permian’s largest producer, told analysts last month that its dividend payout would shrink from $19 a share per year with oil prices at $80/b to about $10/share if prices fall to $60/b.

4. Lower prices are a bigger deal for private operators

While the price slide may not prompt a dramatic course correction from the big shale players, the smaller private drillers that have driven most of the US’s modest oil supply growth this year could feel the pain quicker.

Private operators, often backed by private equity firms, typically run their businesses with less of a cash cushion, making them faster to respond to fluctuations in crude prices.

As prices soared this year, they were quickest to add rigs and push new supply on to the market, accounting for more than half of US output growth this year. As prices weaken, they will also be fastest to pull back, slowing overall output growth.

On top of the weakening crude price, private drillers will also bear the brunt of the oilfield service inflation that is ripping through the sector. Bigger players, such as the supermajors or shale powerhouses, typically have more financial and market weight to negotiate with the service companies.

Private drillers also tend to operate in more marginal shale prospects, analysts noted, making their break-even costs higher than those disclosed by public companies.

5. Hedging is not a priority anymore

Another sign shale producers are little-concerned with price shifts: they are hedging less.

In the third quarter, operators pre-sold much less of their oil output than a year ago: just 24 per cent of next year’s future production was hedged, compared with 42 per cent in the third quarter of 2021, said consultancy Enverus, which analysed the derivatives position of 60 producers in North America.

The cash windfall companies have experienced over the past year has left bullish management teams much more willing to take risks in future.

Even if oil prices fell by another $20 a barrel and gas dropped below $4 per million British thermal units, big producers such as Pioneer, Devon, and EOG Resources would still be able to pay their base dividend and honour debt and other obligations to investors, argues Andy McConn, co-head of commercial intelligence at consultancy Enverus. “All the table stakes will still be safe,” he said.

(Myles McCormick, Justin Jacobs and Derek Brower)

Data Drill

Consumers are increasingly wary of their energy providers as they feel the pinch from higher prices, according to a new report from EY.

The consultancy surveyed 70,000 households in 18 countries about their confidence in their energy provider and the energy transition.

Affordability was a top concern for consumers, with 71 per cent of respondents more interested in cutting energy costs and consuming less than they were a year ago. The report found that a third of all consumers lived in energy poverty, meaning they spent 10 per cent or more of their income on electricity and gas.

Higher prices have also prompted greater scepticism toward energy providers and spurred the search for alternatives. Less than half of respondents said they were confident in the stability of their provider’s business in the next three years. (Amanda Chu)

Power Points

• The UK’s National Grid has called off a plan to pay British households and businesses to reduce their electricity usage.

• Prices for catastrophe reinsurance are set to soar after another year of extreme weather and rising costs to provide cover.

• Opinion: The push to regulate net zero commitments will prompt backlash among businesses, writes Pilita Clark.

• West Virginia senator Joe Manchin’s permitting reform deal hinges on his decision to run for re-election and Republican efforts to flip his seat. (The Hill)