Oil and gas capital spending has been slashed but U.S. production is going up. How can that be? The answer is that the industry is just now completing projects that were started in prior years. The production increases we are seeing now when capital spending has fallen below sustaining levels is because of this lag effect. The data indicates that this inventory of uncompleted projects is falling fast and when it’s gone the industry will have to explain to shareholders, policy makers and all other stakeholders that more spending is needed, or production will decline.
We have shown the graph in Exhibit 1 before, that shows the organic (i.e. non-merger and acquisition related) growth rate to the petroleum industry’s capital base.
Exhibit 1 – Capital Growth Rate for the Large Publicly Traded Petroleum Companies
Source: FactSet, Bloomberg, EIP Estimates.
We are simply dividing net capital spending (capital spending minus depreciation, depletion and amortization) by the asset base. The high levels of capital growth between 2007-2014 built up an inventory of uncompleted projects that are now being brought to production.
The industry reports to the Department of Energy, the wells that are drilled and the wells that are completed and brought on-line. Wells that have been drilled but are uncompleted are referred to as “DUCs.” Think of these as unfinished widgets for a manufacturing company. In normal times, wells drilled roughly equals wells completed, but since the summer of 2020, the industry is completing 1.6x more wells than it is drilling, meaning the industry is de-stocking its inventory of half-finished widgets.
Exhibit 2 shows how the inventory of DUCs grew when oil prices fell, and capital spending declined beginning in 2014. In part, this is because in most shale areas the cost of completing a well is 2-3 times the cost of drilling the hole[1] and so that was the spending that was deferred. It’s the completion part that involves fracturing the rock and installing all the equipment at the surface so production can flow.
Exhibit 2 – Oil Wells Drilled But Uncompleted in U.S. Oil Basins
Source: EIA
But the decline in capital spending and the need to meet stronger global demand post Covid is now resulting in a rapid decline in DUCs as the lag effect of not drilling new wells takes hold.
After the available DUC inventory is gone, we believe the industry will have to increase its level of capital spending just to offset natural depletion (the decline in production that occurs as the well is drained). That will require convincing skeptical shareholders that the companies can reinvest profitably – something they haven’t done for decades. They will also have to convince ESG shareholders – the ones that believe in engagement over divestment – that it is the socially responsible thing to do because high prices hit low-income folks disproportionately. Even if they get the green light from shareholders, they will then need to rehire over a hundred thousand workers who have likely moved on to other industries and restart equipment that is now covered in rust or has been repurposed. If this labor and supply chain narrative has a familiar ring, it should.
What does this all mean for investors in non-cyclical energy infrastructure? Well, for one, it might have a positive impact on sentiment towards pipelines that investors have written off as stranded assets with a very short remaining life expectancy. Recent price spikes in both fossil fuels and electricity and the reliability problems experienced in the California and Texas electric grids remind everyone that we cannot run an energy system entirely on renewables and batteries as seasonal swings in supply and demand require a huge surplus of readily dispatchable supplies. Carbon capture and sequestration – which got a huge boost from the bipartisan infrastructure bill – has the potential of dramatically extending the life of natural gas fired power generation.
Okay but without production growth which feeds pipeline volumes what would drive pipeline earnings higher? Since production growth over the last ten years led to overbuilding of competitive (non-monopoly) pipelines and related infrastructure, which resulted in per share earnings declines for many pipeline companies, we would say less of that is good. We are seeing a collapse in pipeline spending as well, which is good for margins, free cash flow, share repurchase, etc. There are always small projects with high returns that will continue to get built which along with yields of 7-8%, inflation escalators in many pipeline tariffs, debt paydowns and some share repurchase, investors might come to embrace this “no growth” environment.
[1] EIA report: Trends in U.S. Oil and Natural Gas Upstream Costs, March 2016.
The above is Energy Income Partner LLC’s (EIP) opinion and such opinions may change without notice or duty to update. The information is based on data obtained from third party publicly available sources that EIP believes to be reliable, but EIP has not independently verified and cannot warrant the accuracy of such information. References to a particular company or funds are for informational purposes only and are not an offer to purchase or sell or a solicitation to purchase or sell a particular security, company or fund.