30-10-2018

What next as Big Oil moves in on U.S. tight oil?

What does tight oil have in common with FAANG stocks? Answer: tight oil is arguably the upstream equivalent of these tech sector leaders. It’s the hot investment play in the oil and gas index, it’s outperformed like mad, and it’s been driving to distraction those that don’t own any.

Just like the tech disruptors, tight oil has risen from humble beginnings a few years ago, and continually proved the doubters wrong to emerge as the dominant growth theme in the sector. Production has leapt from zero six years ago to 5 million barrels per day (b/d) today and will double to 10 million-11 million b/d over the next 10 years on our forecasts, almost 10% of global supply.

Big Oil needs exposure to that growth, and the majors have progressively muscled their way in. BP’s US$10.5 billion acquisition of BHP’s assets in July is just the latest example of a portfolio re-weighting into tight oil that’s been underway for the last few years, with the Permian the primary target.

Tight oil is now an important driver of growth for most majors. ExxonMobil, Chevron, Shell and BP have all assembled material tight oil assets that include the Permian; Equinor has sizeable Bakken exposure. Roy Martin, a research analyst in Wood Mackenzie’s corporate team, expects the majors’ combined tight oil production to climb from 0.7 million b/d in 2018 to a peak of 2.2 million b/d in 2026. By then, tight oil will be 10% of the majors’ total production, and one-fifth of liquids. It’s quite a shift from reliance on conventional and deepwater fields.

Besides growth and scale, the short investment cycle has helped to diversify portfolios. Operators can ratchet their spend up or down, depending on price. Short-cycle has also fitted well into the industry’s present emphasis on capital discipline.

Last but not least, returns on new drilling look attractive. Full-cycle returns, including acquisition costs, are questioned with some justification. But going forward, returns from tight oil beat all but the very best conventional and deep-water alternatives. The majors’ inventory of yet-to-drill wells will generate an average IRR of 45% based on US$65/bbl Brent (real), well above the 16% weighted average for pre-FID conventional projects.

So what’s next? First, the majors will want still more tight oil. The industrialisation of extraction means tight oil is increasingly a scale game. Access to capital is key – the big will get bigger. Under bidders for BHP’s assets included Shell and Chevron, indicating unsated appetite for the right kind of assets. There’s certainly plenty of opportunity for more consolidation with over 120 operators of some scale operating in the prized Permian Wolfcamp play.

Second, what about the “have nots”? There’s been strategic polarisation among the majors with Total and Eni eschewing tight oil. Unlike ExxonMobil, Chevron, BP and Shell, which had legacy U.S. Lower 48 positions before the tight oil boom, both effectively had to start from scratch. It’s always been difficult to justify buying into tight oil. The outsider has none of the advantages of a legacy platform – the operational nous, leveraging contiguous acreage, the ability to high-grade inventory. Both of these European majors have made significant progress elsewhere to strengthen their conventional portfolios and may choose to stick to their knitting.

Third, investment in tight oil isn’t exactly risk free. Tech stocks are demonstrating in the current sell off that hot sectors have their downs as well as ups. As the world’s marginal barrels, tight oil’s value and cash flow are very sensitive to oil price. The plays are far better understood now after several years of development, and production growth for the next few years looks reasonably assured.

Yet the clue is in the name, “tight” oil. The geology should not be underestimated, and the challenges of extracting at a commercial cost will mount as operators begin to move out beyond the sweet spots into tougher rocks. For the Permian, that likely comes after 2020. It could go either way.

Source: Wood Mackenzie

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