US oil producers live up to their promises on spending restraint
As crude prices have rebounded over the past year, E&Ps have stepped up activity only gradually. They still face fundamental strategic choices.
Mr Micawber’s well-known principle of financial management is set out in Charles Dickens’ David Copperfield: “Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness.” US independent oil producers are holding to a much more demanding standard of frugal conduct. Listed US E&P companies reinvested just 48% of their cash flow on average in the first quarter of 2021, and the rate is likely to have been even lower in the second quarter.
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Their cautious approach to spending, largely sticking to budgets and drilling programmes set last year when prices were much weaker, will make it possible for E&P companies to pay down debt rapidly. It raises questions about the US industry’s longer-term strategy, at a time when many governments around the world are setting goals for greenhouse gas emissions that imply a significant decline in oil demand over the coming decades.
As oil prices have rebounded over the past year, with WTI holding above $70 a barrel since June, the cash flows coming in to US E&Ps have soared. At current prices, all the Tier 1 and Tier 2 acreage in the tight oil basins of the US Lower 48 is profitable to develop. But the industry’s response to these price signals, in terms of increased activity and production, has so far been restrained, and much more cautious than has been typical over the past decade.
The four most expensive words in the English language are famously “this time it’s different”. But so far in this upturn there really does seem to be something different about the capital allocation decisions of the publicly traded US E&P companies. Management teams have for years been telling investors about their commitment to strengthening balance sheets and rewarding shareholders, rather than going for growth at the first opportunity. Now they are backing those words with action, or rather inaction.
Privately-held companies have been more ambitious with their drilling programmes than their listed peers. In the Lower 48 states there are now more horizontal rigs running for privately-held operators than for listed companies. In the Permian Basin, private companies accounted for about 70% of all new wells in the first quarter. Endeavor and Mewbourne, both privately owned, are currently operating about as many rigs in the Permian as EOG and Devon, two of the largest listed independents. But the total effect across the industry has still been a relatively slow rebound in activity.
“A look back at history shows us how unique this moment is,” writes Linda Htein, Wood Mackenzie’s senior research manager for Lower 48 oil and gas supply in a new note. “Never before has tight oil investment been so low with prices so high.” Last week there were 339 oil-focused horizontal rigs active in the US, according to Baker Hughes, well below the numbers in past periods when crude prices were at similar levels.
That number of horizontal wells is below the number of 400 or so required to keep US tight oil production flat, barring a change in the numbers of drilled but uncompleted wells. Production from the Lower 48 has remained broadly unchanged at about 9 million barrels per day for the past year, as companies have worked through their inventories of DUCs.
The steep backwardation in crude futures is part of the explanation for the industry’s cautious response. August 2021 WTI is trading at about $72 a barrel, while the December 2022 contract is about $63. Next year’s production cannot be hedged at current front-month prices. The most significant factor, though, is that the listed companies are standing by their commitments to investors on capital discipline, at least for now. The E&Ps’ presentations of their first quarter earnings in April and May were full of discussions of debt reduction and distributions to shareholders, including EOG Resources’ special dividend and Continental Resources’ reinstatement of its quarterly payout, which was suspended last year.
The combination of these policies with the rebound in oil prices has paid off for investors. The S&P select index of E&Ps has risen by 50% year-to-date, comfortably eclipsing the 18% rise in the broad S&P 500. The rebound has not come close to undoing the weakness of the past seven years — the E&P index is still down 73% from its peak in July 2014 — but has been a welcome reversal of a long downward trend.
Spending restraint means that the listed companies’ debts are falling fast. The average gearing for the leading E&Ps was about 43% at the end of 2020, and about 40% at the end of the first quarter of 2021. If WTI stays at around $70 a barrel, most of those companies will reach 25% gearing next year.
The big strategic questions for those companies will come if they are still generating strong cash flows once their balance sheets are in a much stronger position. They cannot go on paying down debt forever. As Robert Clarke, Wood Mackenzie’s vice-president of upstream research, says: “What is the right level of debt for an E&P? It isn’t zero.”
US oil companies face a range of strategic options for capital allocation. They could follow the European Majors into diversification into alternative energies including renewables and EV charging. They could follow companies such as Occidental Petroleum that are staying focused on hydrocarbons, but aiming for zero emissions through carbon capture. They could aim for stable or declining production and maximise distributions to shareholders. Or they could return to growth.
All of these approaches have their pros and cons. With many governments around the world committed to steep reductions in emissions over the coming decades, and incentivising or mandating the electrification of transport to support those goals, the outlook for oil demand is clouded. But the capabilities and culture of E&Ps are likely to make a return to growth the most appealing strategy for many, as soon as they are able.
Mr Micawber finds it impossible to adhere to his own principle of frugality, and gets sent to a debtors’ prison after “some temporary embarrassments of a pecuniary nature”, although ultimately (spoiler alert) everything ends happily for him. For US E&Ps, too, asking them to maintain their current spending discipline for the long term is an instruction that goes against their nature. READ FULL article here.
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