Until recently, U.S. shale producers across the board have exercised production restraint due to market uncertainty and pressure from investors to practice capital discipline, but now a production surge in the prolific Permian Basin is leading recovery in the country’s shale patch.
As the energy crunch continues, the price of oil continues to rise, with both Brent crude and West Texas Intermediate approaching $85 per barrel this week. The Organization of Petroleum Exporting Countries is not straying from its plan to gradually reduce production cuts, meaning the organization did not decide to ramp up production in order to supply the deficit market.
Rising natural gas prices, trading at their highest levels since 2014, are also affecting crude oil as demand begins to switch to oil from natural gas (“gas to oil switching”) – an about-face from the long-standing shift to cleaner natural gas for power generation. Analysts across the board are speculating the demand increase on oil; Citigroup estimates growth may be as high as 1 million barrels per day, while the International Energy Agency has a more conservative estimate of 150-200,00 barrels per day.
In the United States, the return of shale production thus far has been slower than what we have experienced in past recovery cycles. This lag in return to production can be attributed to several factors, including pressure from investors to display capital restraint and protect free cash flow, the increasing velocity of energy transition efforts, and overall uncertainty around the duration of demand recovery as the pandemic continues.
However, while total U.S. production is still behind compared to prior years and below current demand needs, the Permian Basin is making a comeback. The Permian is responsible for almost 40% of all U.S. oil production and 15% of U.S. gas production, according to the Federal Reserve Bank of Dallas, and has increased output to nearly 5 million barrels per day in October, which is very close to pre-pandemic levels.
The Permian is generally the lowest-cost shale basin, meaning drilling there is profitable at lower prices, comparatively. The low break-even costs are due to several factors including location (a large part of the basin is in Texas where there is a favorable market), its massive size, and most importantly, the fact that it is made up of stacked formations allowing for more efficient extraction.
For these reasons, it is not a surprise that the Permian is leading the way in return of production, but it’s important to note that the boom is led by private operators (instead of public companies that historically have led the way) taking advantage of the high-price environment without the restraint pressure from investors.
Broader sector implications
While the increase in output in the Permian is a clear signal to the market that production restraint is not forever, total output is still behind, so the ramp up of production is unlikely to significantly affect the high-price environment in the near future.
In the face of a worldwide demand surge, the increase in production domestically will help replenish inventory shortages and keep the deficit to moderate levels within the United States. As we look ahead to 2022 and beyond, it is our viewpoint that this supply trend will continue and further temper prices. While high prices may impact middle market companies in the short term, leaders should consider the potential duration of the price surge as a part of their long-term strategy.
