U.S. oil has weathered cheap crude better than expected. Yet, the consensus view overestimates the sector's capacity to ramp up production while containing costs. U.S. production growth won't come until $80 a barrel.
The U.S. exploration and production sector has been surprisingly resilient in the face of collapsing oil prices, so far avoiding the wave of bankruptcies some investors had been bracing for. So resilient, in fact, that the prevailing view on Wall Street is that $60-per-barrel oil is the new $90, or the price needed to trigger the same level of growth that marked the previous upcycle.
In fact, the price point for getting U.S. oil production back on track will likely be higher. “We believe the long-term oil price required to deliver U.S. production growth is at $80, not $60, per barrel, and growth will take longer to return than the market expects," says Evan Calio, head of U.S. integrated oil, exploration & production and refining research at Morgan Stanley, in a recent report, “Global Insight: $80, Not $60 Is the New $90."
At the same time U.S. producers are taking cues from oil prices, their actions also influence global oil prices, now more than ever. “In November 2014, OPEC abandoned its market balancing role, leaving market forces to balance global supply and demand," says Calio. Whereas changes in conventional oil production can take at least three to five years to play out, U.S. shale can respond relatively quickly to price signals. Consequently, he adds, “the U.S. is the new swing oil producer."
Once Bitten, Twice Shy
Though long-term fundamentals of oil look attractive, the near term will likely be marked by volatility as the market weighs trough-period valuations against trough-period stress. E&P companies, meanwhile, are taking a wait-and-see approach. They are unlikely to add rigs or finish drilled, but uncompleted, wells until oil is sitting safely at $50 a barrel.
Before they start spending in a meaningful way, moreover, they'll need to shore up their balance sheets and gain access to capital. Energy lending is down 8% since the first quarter of 2015, and banks continue to trim their borrowing bases and tighten underwriting standards. “Even with the recent increase in the price of oil, it could take several more quarters for credit availability to improve," says Ole Slorer, head of global oil services research.
When it does, producers will likely be more conservative about outspending. Morgan Stanley estimates that E&Ps will spend 115% of cash flow in 2016, down from a trailing four-year average of 140%. “More than half of E&Ps have their intention to spend near organic cash flow, while the other half plans asset sales to fund the gap," Calio says.
Efficiency Hard to Scale
When oil prices fell, the industry responded by reducing costs and gaining efficiencies. A combination of smarter drilling and a significant drop in service costs helped to drive down break-even points to less than $40 a barrel, versus $45 at the end of 2014.
But this isn’t the new norm. For one thing, E&Ps are focusing current production on superior rock in the choicest locations. “These are not large enough to support a mid-cycling level of activity for a prolonged period without running out," Calio says. For another, reactivating idled equipment will drive up service costs, currently 20% to 40% off their peak. Finally, higher labor costs could further erode these efficiencies. “Labor has left the industry and will be reluctant to return, at least until deeper into a recovery," says Calio. “We believe this is the No. 1 operational concern of E&P management teams."
Morgan Stanley agrees with the consensus projection for U.S. production to grow to around two million barrels a day by 2020, roughly 90% of non-OPEC growth. As volume increases, expect the average break-even to swing back to $50, in line with the prior upcycle.
For more Morgan Stanley Research on the outlook for oil, ask your Morgan Stanley representative or Financial Advisor for the full report, “Global Insight: $80, Not $60, Is the New $90" (April 18, 2016). Plus, more Ideas.