Shale Drilling Could Accelerate Soon

WATFORD CITY, ND – JULY 28: North Dakota has been experiencing an oil boom in recent years, due … [+] in part to new drilling techniques including hydraulic fracturing and horizontal drilling. . (Photo by Andrew Burton/Getty Images)

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Much has been made of the fact that oil and gas prices have recovered to the point that U.S. shale is very profitable, and yet drilling has not picked up yet. The rigs active in the Marcellus and the Permian are still about half pre-pandemic levels. As the two primary sources of incremental gas and oil supply from U.S. shale, the direction of investment in those areas will be important in determining world oil and U.S. gas prices in the next year and beyond.

Generally, the upstream sector has seen a significant decrease in investment after both the price drop in 2015 and the pandemic with its associated weak prices in 2020. This has caused serious concern about tight supplies in the medium-term future, rather as happened after the 1998 oil price collapse, which was partly responsible for the high prices in the 2000s. (The second Gulf War and Venezuelan political turmoil were also major factors.) Also, as Bloomberg’s Will Hares said, ““Oil companies are finding it increasingly difficult to raise financing amid rising ESG and sustainability concerns, while banks are under pressure from their own investors to reduce or eliminate fossil-fuel financing.” Cost of Capital Widens for Fossil-Fuel Producers: Green Insight – Bloomberg

But U.S. shale is a somewhat different animal, partly because much of the operation is carried out by small, independent oil producers and partly because shale is higher cost than much of the world’s oil supply, but also because it has a short lead time. Production could ramp up much more quickly in U.S. shale fields than almost anywhere else in the world.

So why hasn’t it? Most argue that the shale industry has been burned before by overinvesting, only to see prices collapse, and that always remains a possibility. But additionally, the financial sector has become much more wary about investing in shale after the collapse in prices for oil and natural gas, albeit at different times. This, combined with pressure for investors to focus on ESG targets, translates into less money for fossil fuels and more for renewables, which means companies don’t want to invest in petroleum development.

Until they do. Capital discipline tends to be cyclical, as does spending and while companies (and investors) might be more focused on return to investment for their capital, it also seems likely that the current high prices will encourage more drilling. The first objection, from Pioneer Natural Resources

CEO Scott Sheffield, that companies should avoid investments that would flood the market and collapse prices, tends to fall down in the face of the lack of control over producers, who will tend to seek profits—if they perceive them. This is one reason commodity prices tend to be volatile:

The argument that ESG pressure will stymie oil investment could hold true, but recent media has suggested ‘green’ investments might be proving less attractive than advocates claimed, and the energy crisis [sic] has seen the public clamor for more fossil fuels, not more ESG. President Biden at Glasgow calling for more oil from OPEC+ is the perfect symbol of a backlash against restrictions on fossil fuels. (Presumably, online dictionaries will now have his picture under the phrase ‘cognitive dissonance.’)

The next, and possibly more interesting objection to higher investment, revolves around the returns on capital. Until recently, the returns on oil were anemic, while stocks provided stellar returns, as the figure below shows. (Annual change on the S&P 500 year on year from November 11th.) In six of the last ten years, the S&P 500 grew by more than 10%, making it a very attractive investment indeed.

Annual change in S&P 500 (from 11/11)

The author from St Louis Fed data.

But. A big part of the surge in equities (and some other assets) stems from the enormous fiscal stimulus coming from governments around the world, and very definitely in the U.S. More money was pumped into the economy than could be absorbed and much of it went into the stock market. The precise amount is not certain but the effect is perfectly clear—and unlikely to continue. Whether inflation will cause the Fed to raise interest rates, slowing the economy, or just a move towards Quantitative Easing (under whatever name) accelerates, the fiscal stimulus should soon be negative (fiscal dampening? Fiscal disheartening? Fiscal disincentive?) and the stock market should cool. Given that, returning cash flow to shareholders to invest somewhere else would be much less appealing.

Because while it is possible that the price of oil will come down (likely, I would say), oil prices are much less correlated with the global economy than equities, primarily because of the efforts of OPEC and OPEC+, but also because the income elasticity of oil demand is asymmetrical—more GDP translates into more oil demand much more reliably than lower GDP reduces oil demand.

Some might argue that while investor sentiment can change quickly, the upstream sector is like an ocean liner that cannot change course abruptly. While that is true of much of the international industry, in the shale basin, rig activity can change fairly quickly. As the figure below shows, gas drilling in the Marcellus and oil drilling in the Permian has fluctuated wildly in the past, but both basins could hit pre-pandemic levels of rig activity within six months—if drillers decide to do so.

Rigs Active in the 2 Major Shale Basins

The author from Baker-Hughes data

The global financial market is a complex one and there are any number of paths that finance for oil development could proceed along over the next twelve months. But the current problems of high oil and gas prices seems likely to reduce political pressure against investment in fossil fuels, and the likelihood that the near-term stock market will underperform, perhaps sharply, could lead investors to ask companies to invest more in production rather than return cash to shareholders, who have no good place to put it.

EPRINC\With Global Oil Demand on the Rebound, What About Supply?\ By Rafael Sandrea – EPRINC