Shale 2022 Analyst Perspective: US Tight Oil’s Uncharacteristic Response to Rising Prices

Editor's note: This article first appeared in Hart Energy's Shale 2022 report. For more information and insights, view the Shale 2022 report here. 

Many doubted tight oil’s ability to show restraint. But after a hard reset in 2020, the sector continues to resist the temptation to grow, even with oil prices above $80/bbl. A look back at history shows how unique this moment is—never before has tight oil investment been so low with prices so high.

So what are the macro trends shaping the near-term trajectory of U.S. tight oil?

Several issues are worth noting. First, year-to-date, there has been no meaningful supply response to rising prices, and Wood Mackenzie does not expect to see material growth until 2022. Additionally, the rig recovery is sluggish compared to the previous downturn and uneven across the major oil plays.

Meanwhile, capex restraint from publicly listed producers is driving the lack of supply response and slow drilling rebound. Annual budgets are low and inelastic to prices. Spending must increase in 2022 if supply is to grow. Private operators, on the other hand, do not face the same pressure to limit spending and are playing an outsized role in the ongoing activity recovery.

When oil prices crashed in 2020, so did shale production. But despite 2021’s surge in prices, there has been very limited supply response at the macro level. Lower 48 oil production has been remarkably flat, hovering around 9 MMbbl/d for the last 12 months, except for weather-related outages in February 2021.

In Wood Mackenzie’s October Macro Oils short-term outlook, the company forecast a flat trajectory for the remainder of 2021 and a decline of about 360,000 bbl/d on an annualized basis. By 2022, drilling should return to levels that support supply growth again.

Wood Mackenzie expects a material increase in capital investment in 2022 and corresponding growth of 165,000 bbl/d year-on-year. Wood Mackenzie’s best leading indicator for supply is drilling activity, and today’s rig trends indicate the industry should not expect significant production growth any time soon. While rig count has been on a steady rise since October 2020, the recovery rate has been tepid at best. Thus, in the context of historical drilling relative to price, 2021 is a clear outlier.

Oil drilling has increased nearly 170% from its low point in August 2020, but it is still about 35% below pre-price crash levels. The majority of returning horizontal oil rigs—53%—have been in the Permian Basin. Drilling is particularly slow to bounce back in Rockies oil plays. The rig count in the Bakken is at about 23 to 24 horizontal rigs—a mere fraction of the 50-plus rigs that were operating there in early 2020.

Smaller rig additions more recently have been a clear signal of deceleration in the drilling recovery. By contrast, the previous downturn saw an accelerated rig build six months after reaching the trough. History would have indicated a faster rig recovery this time since drilling fell lower and prices have bounced higher, yet the opposite is true.

Why has shale been so unresponsive to higher prices? Firmly anchored capex budgets are at the heart of it. At the start of 2021, U.S. producers set annual capital guidance 7% lower than 2020 and roughly half that of 2019. The reduced budgets came as little surprise given the financial suffering brought on by 2020 and continued investor pressure to reduce debt and generate free cash flow.

But their stickiness at today’s prices underscores the sector’s resolve. ConocoPhillips, Marathon and Matador were among the many tight oil producers that explicitly committed to fixed capex targets, regardless of price. Indeed, budgets have not crept up despite rising prices.

Hedges have somewhat dampened the upside from higher prices. But despite this, first-quarter 2021 was one of the best in the history of U.S. shale by many measures. For example, the aggregate reinvestment rate was below 50%, and the peer group reduced net debt by $2.6 billion during the quarter, an astonishing transformation for a sector once notorious for piling on debt to fund new drilling.

After servicing debt, investors were the next priority. About a dozen companies either initiated, reinstated or increased a quarterly dividend. Many more outlined plans for dividends or share buybacks once they reach target leverage. Devon and Pioneer each paid out a variable dividend in addition to the base dividend, and EOG issued a substantial special dividend of $1/share after generating a record $1.1 billion of free cash flow in the quarter. In aggregate, the group paid out $1.6 billion in dividends, and these payments will continue to serve as the outlet valve for any surplus cash in 2021.

The current model is working, and there’s little incentive for producers to spend more for the time being. Investors have responded favorably to capex restraint and no production growth; U.S. oil and gas indices are up nearly 40% since the start of 2021. Debt reduction and shareholder distributions will remain the top priority for the next several quarters, at minimum.

Uncertainty around global dynamics is part of the calculus too. Devon, for instance, intends to avoid all growth projects until demand has recovered.

Richard Muncrief, Devon’s president and CEO, told analysts on the company’s third-quarter earnings call “OPEC+’s spare capacity is effectively absorbed by the world markets.”

Tight oil producers and investors have learned the hard way not to grow production while OPEC+ is curtailing its own.

Any changes to the model will have to originate from investors. Improved balance sheets and more predictable macro conditions in 2022 could be enough to trigger a shift. The share of proceeds going to debt reduction will shrink, opening the door for more investment in high-return projects.

Not all U.S. producers are beholden to the same capex pressure though. While publicly traded companies must answer to shareholders, the same is not true of private producers that operate about one-third of all U.S. Lower 48 oil production.

Private equity-backed companies have long followed a buy-and-flip model. Little value is ascribed to undrilled potential in most asset sales today, so private equity companies may very well be increasing activity to build up a valuation based on flowing barrels. Founder- and family-owned producers will also have different drivers and criteria for making investment decisions. The absence of rigid annual targets and quarterly reporting requirements allow these companies to be nimbler and retain flexibility to respond to fast-changing conditions.

Wood Mackenzie is seeing this demonstrated as private companies are playing an outsized role in the ongoing activity recovery.

In addition to the advantage of higher prices, private companies are benefiting from service availability and continued low costs without the usual competition from large public companies. In the Permian, private operators typically account for less than half of new wells, but that share grew to two-thirds in first-quarter 2021. They’ve also been the driving force behind 2021’s rig build. Endeavor and Mewbourne, both privately owned, are operating about as many rigs in the Permian as EOG and Devon, two of the largest public independents.

Will this trend hold up? Wood Mackenzie believes public companies will play catch up in 2022. It is quite possible that private companies become the true “swing producers” of tight oil, uniquely responsive to short-term price volatility. But Wood Mackenzie’s outlook for future growth depends heavily on continued investment from public E&Ps given their top-tier assets and potential for much larger capex programs.

With WTI sitting above $80/bbl, the lack of response from U.S. tight oil is highly uncharacteristic yet not surprising. Talk of limiting reinvestment rates dates back to 2019—well before the price crash—and the premise of fixed capital was clearly stated. Caution is further dialed up given the unique circumstances of this moment. The oil market is still precariously balanced with uncertainty on both the demand and supply side.

After years of abysmal returns, tight oil investors are finally starting to get what they asked for. Producers are benefiting too—raking in cash, lowering debt and reestablishing shareholder trust. The 2021 run-up in oil price is an important test for the sector, and so far, it’s passing with flying colors.

Linda Htein, director of the Americas region consulting group at Wood Mackenzie, is a senior research manager focused on forecasting and analysing Lower 48 oil and gas supply. Prior to joining Wood Mackenzie in 2016, she was a reservoir engineer with BP, supporting onshore U.S. tight gas fields as well as deepwater assets in the Gulf of Mexico. She has experience working with multidisciplinary teams to advance field development, plan new wells and optimize production from existing wells.