The accelerating recovery in tight oil: conventional investment at risk of stagnating
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Tight oil operators have raced out of the traps in 2017, breaking the shackles of the last two years and putting capital to work. We anticipated the US L48 would lead a recovery in upstream investment this year. What's surprised us is the speed things are unfolding.
The US horizontal oil rig count has soared to 469, up 90% from the low of May 2016. This is the sophisticated end of the market, rigs capable of drilling the 7,000 foot laterals that maximise productivity in the prime plays of the Permian, Mid-continent and Eagle Ford.
Eighty horizontal rigs have been added since November, operators emboldened by the firmer oil price after OPEC's deal to cut production. We have revised upwards our forecast for end 2017 by more than 50 rigs since the fall, which will be higher than any point since early 2015.
The 2016 Q4 results season is revealing the refreshed appetite. Continental Resources unveiled a 2017 budget +77% on 2016, planning to increase its rig count to 20, up from just one last year. All Continental's new drilling will be funded within cash flow. This is a pointed message to capital markets, bounding the euphoric upsurge in activity inside sober financial constraints.
Even so, momentum is building behind tight oil's recovery. The first 100 rigs to be added back after the Q1 2016 lows took 6 months, the second 100 just 3 months.
Just how flexible unconventional investment is to a rebound in oil prices and market sentiment has been underestimated.
Tight oil will drive a 4% increase in global upstream investment in 2017. Global spend will lift to US$413bn on our forecasts, up from US$398bn in 2016. All of the increase is in US unconventionals, with the world outside the US L48 stuck in the mud.
Investment in conventional projects will be flat at just under US$340bn, scraping along at the lows of the cycle. We don't envisage a material recovery in absolute spend for some years, though cost deflation has meant operators can do more with less. Investment in existing projects is tailing off; for total conventional spend to stay flat depends on green field projects coming through. If the 20 FIDs we assume for 2017 don't materialise, a decline is likely.
Despite diverging investment profiles, the players in both the unconventional and conventional sub-sectors have much in common. Capital discipline reigns - balance sheets across the entire industry have deteriorated, with financial leverage doubling through the downturn. Tight oil operators and conventional players are testing new investment against higher hurdle rates.
So what's driving tight oil players to invest?
First, production is in decline after the savage cuts of 2015/16 and companies need to get growth back on track. Volume growth, rightly or wrongly, is perceived as proxy for cash flow growth and value creation by investors.
Second, the opportunity set. Operators may have many wells capable of generating 20% plus returns above US$50/bbl. With capital limited, higher hurdles rates are being used to sort the wheat from the chaff and allocate capital only to the very best wells.
Third, new capital is flowing back into the sector. A total of US$29bn of equity was issued by the US sector last year, only just behind the US$30bn record in 2007; and US$1.6 bn has been raised already this year. At this early stage in the recovery, investors will back companies with the best drilling opportunities and growth prospects.
Fourth, tight oil's risk profile. The capital commitment to individual wells isn't huge, and short lead times means hedging can lock in revenues bolstering the economics. Drilling plans can be flexed up or down, depending on commodity prices - a scalability almost akin to a financial hedge.
Many conventional operators don't have the same urgent need to stem production declines, with volumes growing for a few years at least.
But at the same time the risk profile for investment in conventional projects is very different. The opportunities are fewer, larger and inherently riskier. Most green field projects are out-of-the money at sub-US$60/bbl; nearly all are capital intensive, with long lead times; and have returns that are highly sensitive to oil prices in the early years of peak production.
It's perhaps no surprise that equity investors have yet to embrace the conventional sub-sector in the same way.