When Will Tight Oil Make Money?
By Benjamin Shattuck
Despite its superstardom in the upstream industry, tight oil remains the subject of debate: Can it realize its potential as a profit engine, or will overinvestment drive supply up and prices down?
Tight oil profitability has been the focus of much debate since the oil price collapse of 2014. Its ability to scale down (and up) quickly and break-even at low price points has made the Permian Basin the star of the show for investors. But there are still plenty of skeptics.
Tight oil specialists failed to generate positive cash flow in 28 of the 29 quarters since 2010. We’ve found that tight oil requires as much up-front investment as conventional projects and, like most early-life operations, comes with its own learning curve and infrastructure development—as well as being highly sensitive to the downturn in price. It will take a while to generate returns. We believe tight oil producers may begin generating significant free cash flow in 2020.
All eyes seem focused on the Permian—and with good reason: in our analysis, it accounts for 60 percent of tight oil growth through 2025. Tight oil sceptics may view Permian fever as a reprise of the roles the Bakken Formation and Eagle Ford Shale played three years ago, but in fact, we’re watching a different mise-en-scène unfold.
Technological and production improvements have boosted our forecast, and the Permian is an outlier in its vast size and structurally lower cost. Its inventory of sub-US$50/bbl (barrel) break-even wells to be drilled is substantial.
One cautionary note is that Wall Street’s enthusiasm for tight oil investment might be inadvertently hampering its journey to positive cash flow. Because of tight oil’s marginal position, its greatest sensitivity is to changes in oil prices. The delicate interdependence of price, productivity, and available capital creates a three-legged stool on which profitability sits only when it’s balanced.
Should investors pump too much capital into tight oil—driving producers to make good on it—the industry could face an oversupply that threatens to drive down oil prices and take profits with it. By prioritizing production growth over profitability and margins, investors and producers are at risk of killing their goose before it lays a golden egg.
The road to returns
Tight oil’s road may not be completely smooth, but it’s the most attractive investment theme in the global industry because the potential resource is so huge, some of it low-cost. We believe that by 2020, production will climb to nearly 7 million barrels per day (b/d) from 4.2 million b/d today, based on our WTI (West Texas Intermediate) assumption of US$63/bbl. And the five leading tight oil specialists will likely start to deliver significant positive free cash flow from the same year.
But there are many risks. And if tight oil doesn’t deliver on bullish expectations, a lack of investment in conventional oil since 2014 means there would be a shortage of supply on the market. Prices would rise sharply.
Investor interest seems to be shifting away from growth and toward returns. The two goals are not always mutually exclusive, but the debate is often framed as such. In many cases, investors have had to learn the hard way that returns from tight oil investment do not materialize as quickly as advertised—especially after oil prices fall.
A recent move by a prominent U.S. E&P company suggests that industry is listening to shifting investor demands: Anadarko has announced plans to use part of its cash pile to buy back shares, rather than use it exclusively to grow production and de-leverage. Only a few months ago, this move would have seemed unlikely, given Anadarko’s wealth of development opportunities and large debt load. The shift underscores how quickly market sentiment can affect an industry’s strategy.