Why tight oil specialists need to consider diversifying
Chairman, Chief Analyst and author of The Edge
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Vice President, Upstream Research
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Director, Americas Upstream
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Tight oil E&Ps, for the first time in the decade-plus focus on shale, would seem to have it all going for them. Capital discipline has strengthened balance sheets, with re-investment recalibrated for modest growth rather than the hell-for-leather strategies of the past. With WTI above US$70/bbl, there’s plenty of free cash flow to pay the dividends their shareholders now demand.
But listed companies find themselves unloved by investors as they appear, operationally at least, to be in blow-down mode – keeping production flat until inventory is exhausted, then shutting up shop. That’s reflected in equity multiples that are stubbornly half what they were when WTI last sat at around current levels and well below those of the US Majors.
The two peer groups present very different offerings to investors. Chevron and ExxonMobil have scale and diversified upstream portfolios ruthlessly honed by high-grading to core, lower-cost assets. These provide cash flow resilience and dividend protection.
Most Independents are the polar opposite – smaller in scale and exposed to the unique risks of US tight oil. Among the biggest risks are creeping unit costs as maturing plays track their creaming curves and increasingly assertive state and federal regulation. Both make life more challenging for smaller players.
Consolidation has been the chosen path for the Independents to revitalise investors’ perceptions. Bulking up in the same play carries modest integration risk, maximises the current skill set and delivers economies of scale. But the downsides are it’s expensive – acquiring truly top-tier inventory comes with a scarcity premium – and consolidation compounds the exposure to single-play risks. However, while it’s a valid strategy that some will follow, it doesn’t always bring cash flow protection and provides no meaningful catalyst for multiple uplift.
Now might be the time for a bolder strategy to get ahead of the game. The theme of balancing hyper-concentrated positions of maturing tight oil and starting to strengthen cash flow resilience is one we’ve advocated for some time. Robert Clarke and Ryan Duman, of our Lower 48 upstream team, identify two potential options.
First, reverse the trend of the last decade or two and diversify into high-impact opportunities, either through non-operated exploration or appraisal of existing discoveries. Hess is a prime example of an Independent that balanced conventional/unconventional and domestic/international through the last decade's shale boom. That has paid off handsomely with the high-value non-operated Guyana deepwater discoveries. Apache and Murphy have maintained similar strategies.
But a pivot to conventional, perhaps overseas, would be daunting for a US unconventional specialist. While opening up a Guyana or Namibia is an alluring prospect, many Independents simply lack the requisite upstream capabilities. We think such a move would spook shale investors.
Second, take the tried-and-tested US Lower 48 unconventional skill set elsewhere in the Americas. Tight oil is already commercial in Canada and some Latin American countries, including Argentina; other IOCs are already invested, and the plays have been de-risked.
There are sound arguments in favour, especially for those companies more interested in pursuing growth. Engineering, geoscience and operational expertise are eminently transferable north and south. A new ‘Americas’ shale asset would provide stimulating challenges for employees. Different markets would open up pricing diversification. And fresh acreage would counterbalance inventory exhaustion – there are thousands of attractive future locations in the Canadian Duvernay alone.
Against that, non-US shale plays will struggle to compete on traditional cost-of-supply metrics (though arguably not much different from acquiring or de-risking tier-two or tier-three maturing L48 inventory). Also, any US specialists would be trading relatively low US geological and governmental risks for higher Pan-American ones.
Finally, there’s the question of how much capital Independents should initially allocate to new ventures. Spend cannot increase to levels that sacrifice dividends. A rule of thumb for shale exploration in past cycles was 10% of capex. If WTI remains above US$70/bbl, several large independents can generate enough cash to potentially fund both new ventures at that proportion and distributions. Alternatively, a lower-risk non-op position could be a starting point to build through M&A. However, many mid-sized opportunities have already been taken over in target overseas shale basins.
Most of US shale’s largest players still have a decade of Lower 48 runway. Even so, now is the time to consider diversification, whether via toe-dipping, farm-ins, JVs or big-splash licensing. Returns will be higher for those who act before the crowd – better resources, better costs, better fiscals. Test today. Scale tomorrow. Current projections would have meaningful upside with new US players.