JUST over a year ago Harold Hamm, billionaire boss of Continental Resources, one of the biggest shale-oil producers in America, issued a stern warning to his fellow frackers. Drill with restraint or we will “kill the market”, he said. This month the 72-year-old Mr Hamm, son of an Oklahoma cotton sharecropper who went on to become one of the founding fathers of the shale revolution, had a different message. Restraint is working.
The price of West Texas Intermediate (WTI), the light, “sweet” (or low-sulphur) crude that is a benchmark for American producers, rose to $71 a barrel on May 9th, its highest level since November 2014. OPEC, which Mr Hamm once called a “toothless tiger”, is successfully leading efforts to balance the market. Oil prices are partly rallying because President Donald Trump this week pulled America out of the nuclear deal with Iran and said he would reimpose sanctions on a big oil producer. Meanwhile a free fall in Venezuelan production may be further exacerbated by the move of ConocoPhillips, a large American producer, to freeze some Caribbean assets of PDVSA, Venezuela’s state oil company, as part of a long-running legal dispute.
But arguably the most remarkable development is that the rise in the oil price has not yet unleashed a flood of new shale-oil supply, as many market experts had predicted (and Mr Hamm had feared). The reasons for this are threefold: pressure from shareholders more interested in a steady stream of dividends than a gush of oil; production bottlenecks in pipelines and ports in America; and the fast depletion of shale wells after bountiful beginnings.
The question, as producers begin to savour higher profits and investors’ appetite for them increases, is whether the restraint will endure. Bobby Tudor of Tudor Pickering Holt, an oil-and-gas investment bank, says that as oil prices are rising, so are animal spirits. That could perpetuate the age-old pattern of overexpansion in commodities markets. If he is right, the impact of higher supply will be felt throughout global oil markets.
Bringing home the Bakken
Mr Hamm’s Continental is a decent place to start to understand the countervailing forces at play in the shale industry. Like many of its peers, the company has demonstrated the grit and discipline that has brought the shale industry back from the edge of disaster since 2014-16. Now the good times have returned, and with them the temptation to slip the leash.
Continental is a wildcatter’s dream. Started by Mr Hamm when he was 21, a decade ago it was still drilling just 7,000 barrels a day (b/d) in the Bakken, a 9,000 square-mile formation in North Dakota and Montana where it pioneered a combination of hydraulic fracturing (“fracking”) and horizontal drilling; last quarter production reached as much as 161,000 b/d. In 2014 Continental suffered a severe blow when Mr Hamm rashly unwound its oil hedges in the mistaken belief that falling oil prices would swiftly bottom out. Once again it is unhedged, but this time that means it is benefiting more from the current oil-price rally than conservative peers.
Unlike many rival shale producers, it has stuck with the Bakken and with shale deposits in Oklahoma, rather than chasing the more fashionable reserves of the Permian Basin in west Texas and New Mexico. For the past few years this has been a millstone, but now “the Bakken is back—and booming,” executives say. The firm’s production there grew by a whopping 48% in the first quarter of 2018, compared with the same period a year earlier, amid overall growth in its portfolio of 37%. Hess, a rival, is also doing well there. “The notion that you have to be in the Permian to be appreciated no longer holds up,” Mr Tudor says.
Reassuringly for shareholders and creditors, the growth is partly being used to shore up corporate finances. For years the shale-oil industry has been seen as a money pit. According to Bernstein, a research firm, ever since 2012 shale producers on average have spent more than they earned; by the first quarter of 2016 they were burning through more than three times as much cash as they produced. But since last year they have been living within their means, with profit margins rising to about 10% with oil at $55 a barrel—and going even higher now.
Some companies, such as Pioneer Natural Resources, Devon Energy and Anadarko, have used their rising returns to give more cash back to shareholders, through higher dividends, share buy-backs or both. Continental, which plans to generate $1bn of cash this year, is prioritising debt repayments, and is nearing its goal of net debt below $6bn.
Yet amid this Boy Scout good behaviour, the wildcatter spirit remains—all couched in typical industry hyperbole. Continental, for instance, says it plans to invest in a vast new 350-well project in Oklahoma, called Project SpringBoard, which will be drilled and developed so efficiently it will be like “mowing the lawn”. Devon Energy says it has recently drilled wells in the Permian’s Delaware Basin that have the best initial production rates in the basin’s 100-year history. Pioneer, the most successful producer in the Permian, talks of Permian 3.0, a new type of well technology that it says will produce a third more oil than previous wells. Parsley Energy, a small producer, said it started pumping oil from more wells in the Delaware Basin in the first quarter of 2018 than during the whole of 2017. Its average production was up by 57%.
To keep cautious shareholders happy, the industry insists that such drilling will only be focused on high-return projects; that spending discipline will be maintained; and that their goal is return of capital, as well as returns on it. Several exogenous factors are also helping to keep the flow of oil in check for now, notes Roy Martin of Wood Mackenzie, an energy consultancy. These include higher costs of fracking crews, a shortage of truck drivers and the steep price of inputs such as water in dry places like Midland, Texas, which strain even in-the-money shale producers.
In the Permian, pipeline constraints are making it harder to get oil to the main hubs such as Cushing or the refineries and export terminals on the Gulf coast (see map). This has caused a big discount for crude stranded in Midland, in the heart of the Permian, compared with that in Cushing. For those without firm transport contracts, that reduces the incentive to drill.
Moreover, the productivity of shale wells is becoming harder to improve. Already some of them extend two miles underground. Increasingly new ones are drilled close to prolific wells, which can quickly drain reservoirs. “Some of these companies couldn’t ramp up production if they wanted to. This is helping them tell their story of capital discipline to Wall Street,” Mr Martin says. But he notes that next year new pipelines will be completed to ship more oil out of the Permian, which will ease the bottlenecks. If oil prices rise further, Mr Hamm’s strictures on discipline may again be ignored.