A New Purpose for US Shale Oil
Frontispiece: Keep peddling to avoid crashing.
In the last week of 2019, I published a thought piece on the Future of Oil, and followed it up on LinkedIn with several posts of interesting, related articles. One of those described how the allegedly amazing decade for shale oil in the US was actually lousy for a number of reasons including lack of return to investors. Then on New Year’s Eve, Harold Hamm, Chairman and CEO of Continental Resources. published an OpEd in the Washington Examiner restating the claim that the 2010s were “the decade we won our energy independence” because of a number of defining moments associated with the shale oil industry. Mr Hamm is looking forward to the next decade with the US energy renaissance just beginning together with a new era of oil. I may be wrong but I am assuming what he has in mind for the 2020s is the similar to the last decade. In this blog I examine the facts behind these claims and further use Continental Resources (“America’s Oil Champion”) as a type example of shale oil company performance, including economic, societal and environmental. I conclude that US shale has been failing stakeholders with respect to both profit and purpose, America remains dependent on foreign oil, and the current trajectory is not currently sustainable in several meanings of the word. Instead I offer a different vision for the next decade and beyond with shale oil playing a different, purposeful role in the transition to a prosperous, low carbon economy.
Figure 1: US crude oil production and consumption since 1990. (Source: Data - EIA; Graphic - Capriole Energy)
Oil Dependence and Lifting the US Oil Export Ban
The first points to discuss are the notion of US energy independence and that export of US oil is a good thing for the country. Figure 1 displays the annual production and consumption of oil in the US. There are several points to note about this chart, starting with despite US production growth in the last decade, the nation remains dependent on more than 3 billion barrels of foreign oil to meet its need. That’s not independence. Worse, Mr Hamm may be right that shale oil changed the US public’s perception of oil from being scarce to being abundant. Oil demand peaked in 2005 and more or less declined for 7 years after that until in 2013 the trend reversed and demand is still growing. Americans are growing their position as highest energy users per capita in the world.
Figure 2: WTI-Brent spread and the 2015 lifting of the US export ban. (Source: StefanPohl, updated by Gretarsson - Own work, CC0)
Indeed the relative abundance of US (ultra-)light oil from shale, with US refineries more tooled to the heavier foreign foreign stuff, caused a bigger spread between WTI and Brent in the earlier part of the 2010s. The opportunity to make $10/bo or more on the international markets had oil producers lobby hard during 2014 and 2015 for a lifting of the export ban, in place for more than three decades. Ironically, lobbyists achieved their goal within a compromise with President Obama, with Republicans in Congress favoring lifting the ban in return to agreeing to not block a $500m payment to the UN Green Climate Fund and tax breaks for solar and wind power. The spread did indeed narrow, and WTI and Brent continued their plunge together to a bottom in early 2016.
Figure 3: Continental Resource’s production growth, revenue, net income and long term debt over the last decade (Source: Data - Yahoo Finance and DrillingInfo; Graphic - Capriole Energy)
Drilling ahead
In spite of oil price remaining relatively “lower for longer” in the latter part of the decade, shale oil producers continued to drill and increase production, with little real profit being made by the businesses. Indeed to borrow an analogy, shale oil has often looked like a cyclist, feet duck-taped to the pedals, furiously peddling ahead to avoid falling off. Figure 3 depicts Continental Resource’s version of this - tremendous year-on-year production growth with little commensurate growth in net income, and more an increase in Long Term Debt. In essence most shale oil companies have been outspending their cash flow on capex for new wells, and indeed borrowing more to drill more. Indeed Continental accumulated more debt than profit! The latest total industry estimate I’ve heard is $650 billion of debt on $71 billion annual income. There are several drivers of this behavior.
Institutional investors measuring performance and investment quality by EBITA growth. Until as recently as last year, Earnings Before Interest, Tax and Amortization was often used as key metric to assess current and future performance of shale companies. In the last 12 months this has worn off.
Leases having terms that incentivize rapid drilling and production. Short time frames and Pugh clauses cause drillers to drill and complete wells at fairly close spacing in order to secure the acreage. These terms benefit the lessor minerals owner so that they revenue more quickly than if a more measured (and responsible) approach to resource development is adopted.
Slackness in regulatory controls allowing lease terms and other factors to wasteful and unprofitable development. As well as spacing controls mentioned above, state regulators have also had lax controls on flaring and venting of associated gas.
Covenants on debt imposed by lenders that are designed to monitor the borrowing company’s ability to pay back its debts. One such leverage measure is Debt/EBITA where a ratio of 3 or more causes alarm. Continental, according to SEC returns, is apparently not bound by such a covenant but other peers are. This is another incentive to keep drilling new producing wells to offset decline in production and hence EBITA. Continental do indicate that they are bound by a covenant tied to Debt/(Debt + Equity) which incentivizes them to maintain certain stock pricing, and/or issue more equity.
The consequences of this behavior and the debt-based business model are indeed many and profound. Mr Hamm’s OpEd suggests that “a bit of back-of-the-envelope math suggests that our balance of trade is billions of dollars to the positive since the export ban was lifted, making us even an even greater economic superpower as well”. Maybe so, but the billions of dollars shows up elsewhere in the national balance sheet as Long Term Debt. This debt certainly presents a risk to the solvency and sustainability of the shale companies and could present a risk to the nation’s economy like sub-prime mortgages in 2008, particularly in one or two banks are too concentrated in bad oil company debt. It’s certainly not clear how this debt is ever going to get paid down.
Sustainability of US Shale oil production
Mr Hamm says he’s excited about the future, asserting that the shale-led energy renaissance has only just begun. He quotes Rystad Energy, the “independent” energy research firm, as reporting that the US now has 293 billion barrels of recoverable oil — 20 billion more than Saudi Arabia. Inspection of the Rystad press release (June 2019) shows that this recoverable oil number is a total of proven, probable and contingent including future discoveries. Looking at Proven (1P) reserves only presents a different picture. At 95 billion barrels Saudi Arabia has 3 times more Proven reserves than the US, according to Rystad. Moreover a different picture is presented by BP in their 2019 Statistical Review of World Energy: 297 billion barrels for Saudi Arabia, nearly five times that of the US. Despite the amazing production growth of shale oil, the US share of global production was only 13% in 2018. Proven reserves estimates, slower drilling as shale oil companies are having to live within cash flows, and continued concerns about company estimates of Estimated Ultimate Recoveries (EURs) of shale wells and plays, all mean that shale oil production is likely to decline and that 13% global share is not sustainable, neither economically nor technically.
Another challenge to shale’s sustainability is raised when Mr Hamm talks about shale’s contribution to US emissions reduction in the period 2010 to 2018. It’s true that “the U.S. is [was] leading the world in cutting carbon emissions, by 14% since 2006, largely as a result of fracking and cheap, clean natural gas”. Substituting coal-fired power generation for cheaper natural gas has indeed reduced emissions from the power generation sector. But claiming it as a success for the fracking industry is made to feel absurdly disingenuous when one considers that 2018 saw a return to GHG emissions growth in the US and energy policy is based on oil export and denial of Anthropogenic Global Warming. US shale oil companies, like Continental Resources, have higher GHG emission intensities that many other producers around the world as much of the emissions reflects wasteful flaring and venting of associated gas. This is a huge opportunity for the US oil & gas industry to do better. Instead it currently appears more likely to support various forms of climate change risk denial and sponsors policies and politicians that support that view. Emissions from oil and particularly gas production, refining/processing and transport further undermines the case for oil and gas to be “bridge” feedstocks and fuels as we transition to a lower carbon economy.
A new purpose of shale oil (and gas)
Our capitalist economy is driven on profits made from investments in products and services that a market needs, or desires, and can afford to pay for. Meeting market needs and desires is often part of a company’s purpose, but for an increasing proportion of consumers and other stakeholders that now reaches further into sustainability and future societal prosperity. With respect to financial performance and returns to investors, oil and gas E&P and services was the poorest performing sector in the US during the 2010s. Continental Resources looks like one of the better performers in the sector. $10,000 of shares (CLR) bought at the beginning of the decade are worth about $18,000 now, a 6% return. Buying CLR at the beginning of 2016, at the bottom of oil prices, would have yielded a return of 11%. But there were much better options in other sectors, and there’s very little of interest for the “impact investor” who is interested in sustainable societal benefit.
Here’s an alternative future for the American shale oil (and gas) industry for consideration. About 1/5 of oil consumed in the world today is used for making products, from lubricants to plastics. These products are use in manufacturing of most everything in our society, from basic staples like food, wind turbines and solar panels for energy, cell phones and laptops for communication, to cars and trains for transport. This demand is likely to grow and as I argued in the Future of Oil is fundamental to the energy transition. Imagine if the US oil & gas industry dedicated itself to the drastically destroying the nations’s demand for fossils for fuel. This could start with eliminating coal burning for power, but quickly moves to decarbonizing transport. As demand for oil as a fuel radically diminishes, so the dependency on foreign oil is relaxed. For this to happen US oil and gas production would need to radically reduce its own GHG intensity and embrace carbon pricing at borders so indigenous oil is preferred. And it would need to continue to drive down cost of supply to be resilient to lower prices in a world of perceived abundance. In this future USA, oil consumption is reduced from about 7.5 billion barrels today to about 3 billion barrels - 75% of the US oil production now and surely a sustainable trajectory of slow production decline as the economy becomes ever more efficient (circular) in the manufacture of more durable and recyclable products. The societal benefits in this imagined are huge: energy independence, low carbon manufacturing growth and jobs, vastly reduced emissions both GHG, and ozone/particulate pollution. There would be profit too for the lowest cost ($ and carbon) oil producers.
What must happen for this future to be realized. Leadership. A different kind of business leadership that is authentically promoting a sustainable energy future for the country. The US Oil & Gas Industry has an abundance of quality leaders and a big presence in the national psyche. All it needs is one or two big leaders to adapt, recognize alternatives, and puncture the group think. Maybe Mr Hamm means something different than I am assuming when he talks about “a new era for oil”. Maybe it’s much closer to the vision I articulated above. I hope so.
I have always been an optimist and a believer in the art of possibility. Extraordinary outcomes, beyond expectations informed by the past, can and have been delivered when someone makes a stand. As a potential advisor or non-executive I am available to energy companies who want to embrace the energy transition as an opportunity and need help with strategy, governance, capability and so on. Energy demand and particularly lower-carbon energy supply is also a huge risk to the rest of industry and commerce. Plan C Advisors is available to help the boards of companies of many different sectors consider and act on these and other climate-related risks.