Imgorthand/E+ via Getty Images

Imgorthand/E+ via Getty Images

There are increasing signs that shale oil and gas production has plateaued, and may be on the decline. These facts are at odds with the EIA's own expectations of an 820K BOPD increase in production over the next year. An estimate that's already been shaved by 30K BOPD, and will be again. Soon, if this trend is sustained over the next few months.

EIA-914 oil production (EIA-914) EIA-914 gas production (EIA-914)

If you listen to people in government circles, you come away with the idea that shale production can be raised at will. All it takes is more money for drilling, and "Son of a gun," more crude will come bubbling up out of the ground. That "Jed Clampett" view of oil production is about to be put to the test as the American shale drilling and fracking industry attempts to respond to the entreaties and outright demands of legislators, members of the administrative branch's leadership, and even the President himself to put more capital toward increasing production. At the end of this report, you may find this assumption to be "balderdash."

In this article I will discuss the key over-riding reasons for this decline, and discuss some "verities" that may have ramifications for crude oil and natural gas prices. If you think they are high now....

As previously noted, the industry is attempting to respond to high prices by drilling more. But at a level and rate that will be insufficient to boost production significantly. In fact, data from the most recent publication of the Energy Information Agency's Drilling Productivity Report-DPR, indicates trouble could lie ahead. As the graph taken from EIA-DPR data reveals, the rig count is going steadily higher, but production from the eight major shale basins has leveled off and as of Feb, 22, has actually slightly declined. It is worth noting that some of this could be noise from wintertime shut-ins. If the May edition of the DPR confirms this trend then my expectation is that there is going to have been a drastic recalibration of what levels of shale production are sustainable.

Rigs, Shale Production, DUCs (EIA, Author's work)

Rigs, Shale Production, DUCs (EIA, Author's work)

One obvious cause of the decline is not directly related to slope of the rig count increase, but in the decline of Drilled but Uncompleted-DUCs, wells being turned to production. Over the last couple of years, operators have cut the DUC inventory from ~8,500 to ~4,200. This rate of DUC withdrawal was down by half in February, from just a few months prior.

In my public articles over the last couple of years, I've been predicting this point would come. It may now arrived as operators have drastically curtailed the DUC withdrawal that was maintaining and increasing production over the past couple of years. There are multiple reasons for this situation and the primary ones will be discussed in the remainder of this article.

I've seen many variants of this quotation, but physicist Niels Bohr once commented, "Prediction is difficult, especially about the future." Anyone who has put a sales forecast together can relate to this wry witticism. Recently I attended an industry conference, The American Association of Drilling Engineers Fluids Conference-AADE, where- Richard Spears, a well known industry analyst and consultant, was the Keynote speaker. He started off his talk about a key difficulty in forecasting. In this case he was speaking in regard to estimating the likely year-end rig count. His point was that events occur and render previously issued forecasts out of date. He cited the invasion of Ukraine, which was on no one's radar... until it happened, as a case in point. At that point every forecast that anyone had made, went out the window.

He then took a poll of the room as to where we thought the land rig count would end up for 2022. Hands were raised beginning at 800, about a hundred higher than where we are now, and we responded when he hit the number that matched our personal belief. Virtually every hand rose with 800, about half dropped at 900, half again at 1,000, and just a few at 1,100. One or two hands stayed up at 1,200 and he stopped there. He then revealed his number, 800. This surprised me as I was one of the 1,100 hands. His justification for that number didn't surprise me, as it involved capital restraint, lack of financing, and logistics impacts that are causing inflation in the oilfield.

An article carried in the Wall Street Journal, put a personal spin on this predicament, as they quoted a small independent driller's frustration with being able to secure needed materials.

"If somebody walked in and put a pile of money on the table and said, 'Drill me a well next week,' it isn't going to happen," said Jamie Small, president of private-equity-backed oil producer Element Petroleum III. "You just can't get the stuff to do it."

And, there-in lies the rub. Take this operator's frustration and multiply it by dozens of other small time independent oil operators that drill about half the shale wells drilled annually, and you can see serious problems are brewing in the frack patch.

After nearly going bankrupt post-March of 2020, oil companies revised their playbook. As oil prices rose, and the threat of bankruptcy receded, these companies moved their capital allocation from debt-fueled growth at any cost, to maintenance capex. All of a sudden they found huge sums available for paring down debt, rewarding long suffering stock holders with dividends, and buying back their stock-which was at ridiculously low multiples to increasing cash flow following the pandemic. This is all pretty well known by now. What isn't so well understood, is that despite some very public comments from the big players, Exxon Mobil, (XOM) and Chevron, (CVX) to bump up production sharply. According to Spears, most companies are sticking closely to previously announced capex budgets. This discipline could have, profound implications for estimates of future production. Indeed they could already be manifesting themselves as the referenced EIA reports note.

The repugnance of the big institutions for oil and gas investing, at least as regards the big players operating the leases, has been well established. What I hadn't realized is how severely service companies are affected by this mindset. Note this quote from the Schlumberger, (SLB) press release:

First-quarter cash from operations was $131 million, including a first-quarter build-up of working capital above the usual level, ahead of the anticipated growth for the year. We expect free cash flow generation to accelerate throughout the year, consistent with our historical trend and still expect double-digit free cash flow margin on a full-year basis.

In Q-1 they burned a half a billion in cash, likely supporting working capital builds for current project mobilization.

SLB cash balance, Q-1, 2022 (Seeking Alpha)

SLB cash balance, Q-1, 2022 (Seeking Alpha)

SLB isn't alone. Halliburton, (HAL) burned nearly a billion in cash in Q-1, likely for the same reasons as their larger rival.

Cash balance for HAL, Q-1, 2022 (Seeking Alpha)

Cash balance for HAL, Q-1, 2022 (Seeking Alpha)

If the big players like HAL and SLB are shut out of traditional financing, you can imagine the difficulty lower tier or private companies are having.

Spears made a final point, that services costs are still below the cost of replacement, and that is going to have to change in a hurry. He commented that based on his research talking to drilling contractors day rates for high spec rigs will be about $40K/per day at the end of 2022. Roughly twice current levels. Other service companies will be doing the same to bring margin back to their income statements.

Spears closed out his presentation with the comment that oil companies may have to become the "bank" for service companies. Not a comfortable position for them, but as you can see the cash burn in the service providers can't go on. At this rate cash balances will be used up before the impact of higher rates can hit the balance sheet.

In one way, these are great problems to have. HAL and SLB are being tasked to do more which will impact cash flow and earnings. The problem is management has not squarely addressed profitability. All of the publicly held service companies have committed to raising prices to improve profitability and cash generation. Spears noted that price adjustments are top of mind with the privately held companies, and hopefully comes soon in the public ones.

The pandemic has upended the flow of goods from traditional points of manufacture. The war in Ukraine has exacerbated this profoundly in ways we are just now beginning to discover. As an example Spears cited the bit company that he serves as a board member. The body of the bit is cast, and cobalt is used to strengthen it. The widespread and growing manufacture of EV batteries have caused disruptions in the supply and cost of cobalt.

Price curve for cobalt (MarketWatch.com)

Price curve for cobalt (MarketWatch.com)

His point was that the drill bit manufacturer is way down on the allocation curve for cobalt suppliers, and has no leverage when it comes to negotiating prices.

Take this factoid and expand it over the entire oilfield supply chain. Costs are going out of sight and will soon manifest themselves in restriction of service availability. He also cited an exponential increase in the costs for frac gear to redress worn fluid ends on pumps.

These are growing pains in my book. I am not quite ready to agree with Richard on the exit rate for U.S. Land drilling for 2022 at 800, but it is probably much lower than my guess of 1,100. The larger point is that 800 domestic rigs is nearing a very healthy market for services, and in this oil price regime, this growth should continue into next year.

The overall implication for service providers is a higher for longer oil price regime, leading to a robust market as Big Red, Halliburton and Big Blue, Schlumberger have demonstrated with their Q-1 reports. To me the cash burn will slow as prices adjust and working capital is supplemented with cash flow. They should be bought near current levels on any weakness. For big projects, like rig reactivations, or upgrades that involve millions of dollars, they may have to turn to the people holding the money, the operators.

For oil production from shale basins in general, the forecast is not as clear. As noted in past articles on Devon Energy and others, there are concerns about the quality of undrilled shale acreage remaining as to its ability to deliver the amount of production that Tier I acreage has delivered. In this article on Exxon Mobil, I quoted Scott Sheffield, CEO of Pioneer Natural Resource (PXD) from a Wall Street Journal article:

"You just can't keep growing 15% to 20% a year," he said. "You'll drill up your inventories. Even the good companies."

Pioneer bought two smaller drillers last year, Parsley Energy Inc. and DoublePoint Energy, in deals valued at almost $11 billion combined. Mr. Sheffield said that with those acquisitions, his company has about 15 to 20 years left of inventory. Pioneer's pool of potential drilling locations would last only about eight years at a 15% to 20% growth rate, he said.

I am also re-endorsing my past price estimates for DVN at $80, and Exxon Mobil at $137. I think they have substantial room for further appreciation in the year to come.

The prevailing opinion of investors and government officials has been that shale production can be easily ramped higher. All it takes is money. I think this glib confidence is misplaced. A combination of natural limitations, logistics, inflation, and human impacts are taking their toll. I view these as being early days in this new era.

On a macro scale, the era of higher oil prices and limits to supply is arriving, in fits and starts to some degree. One lesson that may well be soon learned in this era is, there is no such thing as a free lunch! The oil industry has been asked to step up output, at a time when it is vilified and over-regulated. It is unlikely that those two things can be simultaneously true. You have to pay for lunch. This is a verity.

This article was written by

I am an oilfield veteran of 38+ years. Retired from Schlumberger since 2015. My background is drilling and completion fluids. I have authored a number of technical papers on completion topics. I have worked around the world- Brazil, Russia, Scotland, and the Far East. I still maintain a training and consulting practice and am always willing to help people who want to learn.

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Disclosure: I/we have a beneficial long position in the shares of HAL, SLB, DVN, PXD, OXY either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This is not advice to buy or sell this stock or ETF in spite of the "BUY" rating I am forced to select in the SA template. I am not an accountant or CPA or CFA. This article is intended to provide information to interested parties and is in no way a recommendation to buy or sell the securities mentioned. As I have no knowledge of individual investor circumstances, goals, and/or portfolio concentration or diversification, readers are expected to do their own due diligence before investing their hard-earned cash