Edge of Disinvestment: US Shale Oil Sector Under Pressure Amid Prices Slide

2017-06-19

US oil drillers are facing the creeping threat of disinvestment for the second time in the past three years, as the recent decline in global oil prices, despite OPEC output cuts, made some investors pull out of the US energy sector.

Kristian Rouz – The recent drop in global oil prices has contributed to renewed fears of disinvestment in US shale oil, as crude overproduction in North America has resulted in a massive build up in oil inventories. Once again, for the first time since the 2014 oil bust, the robust activity in US shale extraction might divert investors from allocating their capital in drilling. This might impair the profitability of US oil production and affect the entire US energy sector.

US oil prices have declined from $51.47/bbl on 23rd May to $44.46/bbl on 16th June as a result of the recent increase in drilling that produced an accumulation in US oil inventories. Whilst the demand for energy in the US, mainly from the manufacturing sector, oil processing and individual consumers, is lagging amidst fair overall economic expansion, investors are starting to consider once again pulling out of the US energy sector in order to prevent possible losses stemming from the decline in oil prices.

The largest US oil field, the Permian oil field in Texas, has become extremely attractive to businesses in the past 12 months amidst the rebound in oil prices that drove the recovery in the US oil sector. However, the sudden decline in oil prices in the past three weeks is becoming a concern for some investors, as it might undermine the profitability of some shale drillers. The boom-bust cycle in US shale, observed in the past three years, has contributed to increased volatility in this sector of the economy, rendering investors rather nervous every time oil prices drop.

“We’ll have to see if these US producers have the discipline to not go crazy and keep prices where they keep making money,” said Gary Bradshaw of Dallas-based Hodges Capital Management.

US hedge funds have decreased their participation in Permian shale drilling by $400 million in recent months, as they are concerned that the robust activity of US drillers might erase the positive effects to the global oil market observed after OPEC cut crude output in November 2016 and extended the deal in May 2017.

Should the international oil prices extend their losses, the profitability of the indebted US shale drillers will be yet again put into question, affecting their investment appeal and possibly causing a repeat of the capital flight from US oil production seen in 2014-2015.

The hedge funds currently pulling out of the Permian have a total $286 billion worth of assets. These funds are not, however, reducing their exposure to other North American oilfields, and the reason might be the relatively higher costs of oil production in the Permian – the region will be first in line to suffer if oil prices extend losses.

Whilst OPEC and other oil producing nations have coordinated cuts to their oil output, US private sector shale drillers have no intent to decrease their output. The breakeven oil production price at the Permian Midland oil field was $38/bbl in 2016 compared to $98/bbl in 2013, whilst the breakeven price at the Bakken oil field in North Dakota is $29/bbl, according to data from Rystad Energy. Meanwhile, for most OPEC oil producers, crude fiscal breakeven prices are even higher, at $49/bbl (Kuwait), $55.50/bbl (Qatar), $87.20 (Iran), $105.60 (Saudi Arabia), and $117.50 (Venezuela), according to IMF calculations.

“Right now, OPEC understands we’re in a push-and-pull experiment with the United States,” Michael Tran of New York-based RBC Capital Markets said. “Two years ago, we thought prices hovering around $50 to $60 meant that non-OPEC production growth would end. But US production came back stronger.”

The success and massive expansion of US shale oil production, however, has produced a buildup in oil inventories amidst a lack of demand. In the Permian basin, service costs are on the rise, and the recent decline in oil prices has started to affect the producers’ margins. The average price-to-earnings ratio of Permian drillers is currently about 35 compared to the broader energy sector price-to-earnings ratio of 17.8.

Modest returns on investment, therefore, might further divert capital from US oil production. The first signs of such a possibility are already here: the stocks of 10 Permian oil producers have dropped by an average 18 percent this year, whilst the broader S&P 500 energy sector only declined by 13 percent.

Most US drillers are willing to increase output as long as the price is above breakeven, meaning that only a sustainable decline in oil prices to below $30/bbl would convince them otherwise. Investment capital flight, however, comes quicker, and unless US oil consumption and exports post significant increases in the near term, or other global factors drive oil prices higher, fears of disinvestment in the US shale oil segment have a solid chance to materialize.

Source: Sputnik

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