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Why U.S. Shale Producers Aren't Riding To The Rescue Despite Tight Oil Supplies

The great U.S. shale machine has hit a wall.

Drilling and fracking activity has flatlined, and some shale executives are warning that U.S. production growth may come in below expectations - perhaps by a lot.

That's bad news for oil markets that are already supply constrained.

Spare capacity problems within the OPEC+ cartel are well-documented, an Iran nuclear deal that would unleash more Iranian oil onto global markets looks unlikely, and record crude oil releases from the U.S. Strategic Petroleum Reserve (SPR) are coming to an end in a couple of weeks, and a looming EU embargo is set to disrupt Russian oil exports further.

The oil market is set to suffer another big supply crunch, which means a spike in prices.

Despite intense market signals that more supply is needed, shale producers say a bailout is not in the cards. U.S. producers are doing everything they can under the circumstances. Indeed, shale executives are warning European policymakers that they can't rescue Europe from a supply crunch if Russian output is further constrained.

Shale producers will still enjoy substantial growth this year and next - it just may underwhelm market watchers compared to the high expectations and past performance.

U.S. oil production has stagnated at around 12.1 million barrels daily for the past few weeks. That's a considerable rebound after a decline to less than 10 million barrels a day when oil prices crashed during the pandemic. Still, it's far from the 13 million barrels a day America was producing before the pandemic.

More troubling, U.S. drilling and fracking activity has been flat since mid-June, with about 600 oil rigs operating over this span. The active oil rigs in the Permian Basin now number 316 - the lowest in four months. That suggests that the most prolific U.S. shale basin, the main driver of America's oil production growth, is going through a significant slowdown, which points to sluggish volumes in the future.

No one should be surprised if America fails to add the 1 million barrels per day this year that experts expected.

Scott Sheffield, CEO of Pioneer Natural Resources PXD -1.3%, expects U.S. production to rise by just 500,000 barrels a day this year - and next year's gains could fall well below the 800,000 barrels a day increase now foreseen by the U.S. Energy Information Administration.

What's going on here? Pre-pandemic, shale was single-handedly adding enough supply each year to meet global demand growth.

Now, the sector appears to be coming up short. Part of this is down to supply chain issues, inflation, and infrastructure constraints - the sorts of things that give producers less bang for their buck and cause them to think twice about new investments. These issues have been problematic across the global economy for some time.

What's unique for the energy industry is the extreme volatility in commodity markets that we've seen recently.

In the third quarter, so far, international benchmark Brent crude and U.S. marker West Texas Intermediate (WTI) are down about 20 percent for the worst quarterly percentage decline since the start of the pandemic in 2020. WTI was over $120 a barrel in June but dropped to $80 last month. It now trades at around $85 a barrel.

That kind of whipsawing of prices gives pause to any producer thinking about making new capital outlays.

Rising interest rates and fear of an economic recession are weighing on executives' minds, despite the incentive of supply tightness in energy markets.

Sheffield thinks oilfield inflation will remain steady at roughly 10 percent through 2023 but warns that diesel prices - required to power most drilling rigs and fracking equipment - are a potential driver of higher inflation. Diesel stockpiles have fallen on solid demand and exports, and U.S. supplies stand near five-year lows ahead of winter, a time of strong demand for this fuel type.

There are also investor and political pressures holding back shale production. Wall Street is not blessing significant production increases at this time, preferring instead a low-production, high-profit model that prioritizes dividends and share buybacks.

Compensation incentives for executives in the shale industry are now dominated by cash return targets rather than production growth targets. That means the low-growth model is baked into the sector.

The Biden administration's anti-fossil fuel policies and messaging have not helped the investment environment. The White House may ask producers for more supply today, but their policy priorities seek to eliminate the need for that additional supply within five years. This timeline is woefully short in an industry that often makes investments on timelines of 20 years or longer.

Even for shale plays with shorter investment cycles, there's little incentive to invest millions of dollars into new rigs and employees if companies don't see a long-term return.

It all adds up to something close to paralysis for the shale sector. With so many forces pushing and pulling at once, the prudent move in the minds of many executives is to do nothing - to wait and see how this crazy market pans out.

Indeed, a significant production increase is risky in uncertain times; it's better to sit back and take profits - particularly when this is what investors want from the sector.

The danger for oil markets is that things go wrong in the coming months with Russian supply. The International Energy Agency thinks oil sales from Russia, the world's biggest petroleum exporter, could fall by almost 20 percent when the EU embargo takes full effect on December 5.

If that prediction is correct, who will step in to fill the void? Don't count on shale this time - at least not under these circumstances.

[Source: By San Eberhart, Forbes, NY, 19Sep22]

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