(Bloomberg) – Marathon Oil Corp. used to represent everything that was wrong with US slate: enormous debt burdens, lavish executive salaries, and an apparent willingness to spend anything to increase production. The company lost money and the stock plummeted 84% from a high in 2014 to late last year.
This year, CEO Lee Tillman took a different path. He cut his own wages by 25%, got rid of his company jets and, since oil production had dropped 20% after the pandemic, promised to keep it there. The result? The stock has doubled this year. His colleagues are also doing well. US wildcatters are the second best performing sector in the S&P 500 index.
After years of booms and bankruptcies that combined with a lot of oil caused astronomical losses, the fracking industry seems to have found a sweet spot. It is set to generate more than $ 30 billion in free cash this year, a record, according to Bloomberg Intelligence. While that’s just a slip up compared to the $ 300 billion Deloitte LLP estimates the sector burned in the last decade, it’s at least a temporary revival for an industry that was largely written off by investors a year ago .
Certainly, frackers have benefited from the 50 percent rise in global oil prices this year as demand roars again in places where the pandemic has receded. Equally important to their bottom line, however, was the ability to withhold new supply in order to avoid drilling the more marginal holes they would have had in previous years. You save money instead of spending money to increase production at any cost.
It’s a turning point since the dawn of the shale revolution a decade ago, when new horizontal drilling and hydraulic fracturing techniques released vast oceans of crude oil from rock previously considered impermeable, and eased the OPEC cartel’s influence on global production.
Back then, with oil trading over $ 100 a barrel and global scarcity concerns, lenders and stock investors rewarded companies for their high output. Profits would of course flow in later, so the thought. But the industry fell victim to its own success, pumping more oil than anyone needed.
The story goes on
“The shale boom has oversupplied the world and depressed prices,” said Dan Pickering, founder and portfolio manager of Pickering Energy Partners in Houston, in an interview. “Shale won’t do that in 2022 and 2023. It’s cautious optimism, feeling that ‘the worst is over’.”
READ: Saudis go ‘drill, baby, drill’ to push for more expensive oil
The key to transformation? Much less oil. The first era of shale from 2010 to 2014 was marked by explosive growth fueled by technological breakthrough, and in the second phase, from 2015 to 2020, prices fell but production rose amid high spending. Now, Shale 3.0, as some investment banks call it, is all about free cash flow.
The U.S. has been pumping about 1.9 million barrels less a day since Covid-19 caused prices to fall last year, a drop greater than Nigeria’s and Venezuela’s production combined. This is bad for consumers – creates higher prices at the pump – and is a boon for OPEC + producers as it gives the coalition led by Saudi Arabia and Russia more leeway to bring back their own production. But it has also put the domestic slate industry on a more sustainable path, directly to the benefit of stock and bond investors.
“From a financial perspective, shale is entering a new, better era with higher profitability,” said Elisabeth Murphy, upstream analyst for ESAI Energy LLC for North America.
For much of the last decade, shale producers spent every dollar they made and borrowed additional loans to drill new wells. According to Noah Barrett, a Denver-based energy analyst at Janus Henderson, manufacturers would typically invest 120% to 130% of their operating cash flow in new productions. Now that number is closer to 70% or less, leaving a lot of cash to pay out to shareholders.
Marathon, for example, expects to generate $ 1.6 billion in free cash flow from just $ 1 billion in capital expenditures, which will allow the company to increase its dividend and reduce debt, the culmination of a plan that began in 2017.
The optimism is also reflected in the bond market, where a junk-rated US independent oil producer index returned 10% this year – three times the average for high yield companies – as borrowing costs fell to a record high.
READ: Shale’s private army increases and supplies wildcards for OPEC
Consolidation is also helping the industry. Devon Energy Corp. merged with WPX Energy Inc. earlier this year to cut costs. The combined company will produce 8% less oil than a year earlier and has promised to pay a variable dividend on top of its regular payout. Pioneer Natural Resources Co. closed two transactions this year and says it will lower the growth rates of both acquired companies.
There is a risk that shale producers will lose discipline if oil prices stay above $ 70 a barrel, especially for companies that have used the past six months to pay off debt. According to Rystad Energy, the price it takes to break even in a Permian well is only $ 35 to $ 45 a barrel.
“Once internal price forecasts reach cost-breaking levels, those same executives have a fiduciary duty to allocate capital and resources to produce increasing amounts of oil and gas,” said Charles Kemp, vice president of Baker & O’Brien, a consulting firm. “If they don’t, someone else will.”
At current prices, drills can potentially invest more in 2022 while rewarding investors. The consulting company IHS Markit Ltd. estimates the U.S. shale industry is well on its way to increasing spending from $ 58 billion in 2021 to $ 80 billion in 2022.
“The first signs suggest that discipline is continuing, but we have yet to monitor this fairly closely,” said Jeff Wyll, senior analyst at Neuberger Berman, a fund manager with approximately $ 400 billion in assets. “There is a hypersensitivity to any company that shifts back into growth mode.”
An example of this was in February when EOG Resources Inc., the largest independent shale producer, announced plans to increase production by up to 12% in 2022. The retaliation was quick. Shares fell 8.5% the next day, wiping out a market value of $ 3.5 billion.
(Updates with analyst comment in the 16th paragraph)
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