Any investor with a financial stake in the oil & gas market is doing themselves a disservice if they don't listen to Schlumberger's (NYSE: SLB) management call every quarter. As the world's largest oil services company -- with clients ranging from micro-cap producers to Saudi Aramco -- it can take the pulse of the industry better than any other company out there.
This past quarter, CEO Paal Kibsgaard's comments on the direction of the oil market were like an Aaron Sorkin inspired soliloquy. Not only did he lay out a slightly worrisome trend that no one seems to be paying attention to, but he also took Wall Street to task for its support of what he sees is the irrational support of the U.S. shale industry.
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If you get a chance, go read the whole thing. If you are pressed for time, though, here are some of the firebombs Kibsgaard threw at the industry and what it could mean for the future of the oil markets.
Is U.S. shale production irrational?
U.S. oil & gas production has been nothing short of a miracle over the past decade and a half. Think back to 2005-2007. Oil production had slipped to 5 million barrels per day, we were importing more than two-thirds of our total demand, prices were at $100 a barrel and climbing every day, and gas production was on the decline such that we thought we would need LNG terminals to import the stuff.
By developing the technology to make shale a commercially viable production source -- thanks, horizontal drilling -- we now have an oil reservoir competing for the largest in the world, a natural gas supply that could last a century, and we can produce it at a reasonably cheap price.
As great as this all sounds, Kibsgaard wants to throw a little cold water on U.S. shale. He believes that the rapid decline in breakeven prices for shale has led to a wave of irrational exuberance from equity investors that has led to unsustainable growth.
Kibsgaard has a point here. It wasn't that long ago -- 2014 to be precise -- when independent U.S. oil & gas producers were taking on mountains of debt to fuel double digit production growth each quarter. The common phrase we heard was "we'll grow into our debt load." That ultimately proved disastrous as the price of oil fell from $110 a barrel to just $26 a barrel in January of 2016. We all know how that went over.
Since then, producers have become much better at drilling for shale, and many can generate operating cash returns at $50 a barrel. That doesn't change the fact that many are still spending more to grow than what is coming in the door in any given quarter. As it stands, it's an unsustainable and irrational trend to follow. Then again, Allan Greenspan coined the term irrational exuberance in 1996, and it took another four years for the dot-com bubble to pop. So there is no telling how long this irrational behavior can continue.
The biggest losers of the "shale vs. OPEC war"
Nothing sells newspapers or gets clicks more than pitting the U.S. against OPEC. Between the oil crises of the 1970s, the Persian Gulf War, or peak oil back in the 2000s; OPEC and its dominance of the global oil market is an easy target for vitriol. So when America's oil production started taking off thanks to shale, every journalist and their cousin lined up to write a piece on how shale production would impact OPEC and other American rivals such as Russia. Everything was a piece on draining Saudi Arabia's cash reserves or potential instability in the Middle East and how U.S. shale was causing it all.
What all of that jingoistic journalism overlooked, though, was more than half of the global oil supply. These sources are the ones have really suffered since oil prices started to crash. Unlike shale producers, the market held these companies to standards related to free cash flow and returns on invested capital. As a result, Kibbsgaard said these companies have drastically cut back on their exploration and development spending.
We haven't noticed the impact on these oil producers because their production rates haven't declined much, their longer-term investment projects have become operational, and U.S. shale has stepped in to pick up some of the slack in the market. What we don't see in those numbers is depletion rates. These are the rates at which a producer depletes any given reservoir. Many companies have looked to maintain production and juice returns by getting more out of existing sources. In doing so, they have shortened the window those reservoirs will produce, and future production will decline at a much faster rate.
What does this mean for the big picture?
I'll just leave it to Kibsgaard to lay it out.
This sounds scary to anyone other than oil & gas investors, who are likely salivating at the idea of a supply shortage in the next few years. This is a window of opportunity short enough that alternative energy won't have developed to a point where it is taking a big bite out of oil demand, and one far enough in the future that the short-term thinking on Wall Street could be undervaluing lots of stocks in this sector.
The one counter to Kibsgaard's comment here is that there is still a lot of those longer tail investments still waiting to come online. BP's management plans to grow production by an additional 1 million barrels per day between now and 2021. Similarly, Total and Chevron have plans to increase production more than 4% annually between now and 2020. Some of that will come from juicing production rates from existing fields and from shale, but it does go to show that there is still a rather large inventory of projects yet to become operational that could delay the sharp production decline trend Kibsgaard predicts.
What a Fool Believes
There is another variable that could throw Kibsgaard's predictions on its head: The ability for shale to take up even more slack in the global market. As he mentioned, shale producers today aren't growing with a sustainable model. However, it won't take a return to $100 a barrel -- or even $70 a barrel for that matter -- for shale wells to throw off fat stacks of cash and make the industry more economically viable. If shale becomes a more profitable endeavor with just a few dollars per barrel increase from today, how much more supply can Noth American shale deliver to the global market?
I don't have an answer to that question, but it will make following the oil industry over the next couple of years fascinating.
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