The great disconnect

Mfon Usoro, Jean Charles Combe, Pablo Prudencio and Mark Oberstoetter, Wood Mackenzie,

USA, consider why US oil production growth and investment is disconnected from surging oil prices.

Oil prices have surged this year as a result of the war in Ukraine but drilling activity in the US, particularly in the Permian Basin, does not fully reflect this. The disconnect between oil prices and activity levels is more pronounced than ever. And while 2021 was clearly an outlier year, activity so far this year is even further removed from historical trends. Well spuds today reflect something more akin to a US$50/bbl price environment.

The reason for the disconnect is continued capital discipline, which has impacted reinvestment rates. Two US basins – the Permian and US Gulf of Mexico (US GoM) – are worthy of a deeper dive and highlight examples of how corporate factors are limiting growth in activity levels despite the rising oil price. The Permian and the US GoM accounted for over half of US oil production in 2021 (Figure 1).

Key reasons why tight oil growth is not surging more this year

A combination of lingering balance sheet concerns, field development patterns, cost inflation, tight labour and the strong need to not deviate from 2021’s successful playbook all compound on one another. Energy transition pressures play a role in the restraint, but are muted compared to their impact on global upstream spending elsewhere.

Some developments might suggest that companies are well positioned to advantageously increase budgets and accelerate rig additions. Leverage is lower, equity valuations are up and companies are embedding cost synergies. Yet, despite this, the capital discipline put in place in 2021 has proved iron-clad.

The Permian remains the bellwether for production growth. Wood Mackenzie’s latest Lower 48 supply outlook calls for nearly 0.5 million bpd of crude and condensate year-on-year growth in 2022. This represents tight oil production growth levels close to what we saw back in 2017 – but with an average oil price that is US$30/bbl higher.

The Permian is highlighted in Figure 2, as it contributes the most to monthly rig additions and 85% of all Lower 48 liquids supply growth over the next 5 years.

Company peer groups heavily influence supply growth this year

Understanding the nuances in the operator landscape is more important than ever to calibrate supply expectations. Each Permian operator peer group is following a different path and some E&Ps will push harder than others. Wood Mackenzie has analysed how the majors, largest privates and independents are responding to 2022 price signals as future supply trends are analysed.

The majors in the Permian are set to see year-on-year gains of circa 170 000 boe/d via significant spending hikes. However, that growth includes associated gas and NGLs. For perspective, the 2022 activity level will be at most one-third of their combined 100 rig peak in early 2020.

Permian private E&Ps are more of a wildcard, as they have been growing aggressively and bring upside risk if their strong momentum remains uninterrupted. The largest ones, led by Mewbourne and Endeavor, control over 60 rigs and could add over 100 000 bpd this year if they continue the same growth trajectory as last year. But downside supply risk – albeit smaller – also persists if any of the large privates are purchased in a market that is still consolidating.

While public independents control the lion’s share of Permian production, they are so far only guiding towards flat or single-digit growth in 2022. Therefore, their production trajectories can counterbalance growth from the other groups. For example, ConocoPhillips has messaged it intends to only add four rigs across the entire Lower 48 this year. Devon averaged 16 rigs in 4Q21 and is guiding towards an average of 14 rigs this year. Looking at 2022 and beyond, public independents are showing no signs of deviating from the current playbook of strict capital discipline, improving leverage and maximising investor returns. Rising oil prices have made little difference to date. That leaves future supply growth largely in the hands of the majors and private operators, who only control a fraction of Lower 48 supply. Despite all of that, oil production in the Permian is at an all-time high (Figure 3), and Wood Mackenzie expects the play to continue leading Lower 48 growth for the foreseeable future.

Figure 1. US liquids production growth indexed to 2015. Source: Wood Mackenzie oil supply tool (US$50/bbl long-term).

Figure 2. Permian horizontal rig count to WTI price relationship. Source: Wood Mackenzie, Baker Hughes, EIA. WTI = nominal.

Is the US offshore showing similar growth trend seen in the Lower 48?

US offshore production is set to grow to record levels, but most operators in the region are also exhibiting similar capital restraint as seen in the Lower 48. Wood Mackenzie estimates US GoM 2022 production to reach 2.4 million boe/d. But the growth is not driven by the uptick in oil prices, as offshore operations are long-cycle in nature and lack the flexibility to ramp up activity quickly. The production growth is a result of an investment cycle that began in 2016.

Three new semi-submersible production facilities are expected to begin production this year, including the BP-operated Argos, Shell-operated Vito and Murphy-operated King’s Quay. The three projects were sanctioned between 2016 and 2019 and discovered as far back as 2009.

Evidence of continued capital discipline can be seen in project sanctions in the US GoM. Wood Mackenzie expected five major projects to be sanctioned in 2022, but one will likely be delayed or fall off the queue of pre-final investment decision (FID) projects entirely. 2022 had been pegged by Wood Mackenzie for the sanction of the ultra-high-pressure North Platte project. But the operator – TotalEnergies – recently pulled out of the project, citing better capital allocation opportunities in their portfolio. Although North Platte’s economics are attractive, it missed TotalEnergies’ new hurdle rate for oil investments of CAPEX plus OPEX of US$20/bbl and breakeven of US$30/bbl. Wood Mackenzie estimates CAPEX plus OPEX of US$22/bbl and breakeven of US$36/bbl (NPV10), which is not far from but outside the bar TotalEnergies set. This highlights the strict adherence to capital allocation criteria set by public companies, especially amidst execution of energy transition strategies.

Wood Mackenzie still foresees projects like the LLOG-operated Leon/Castile, Shell-operated Rydberg and Chevron-operated Ballymore getting sanctioned in the near-term. These operators remain committed to the US GoM and their respective projects rank favourably in their global portfolio. But the shift in sanction and first oil date for North Platte will have an impact on the long-term pace of production growth in the US GoM (Figure 4).

Early indicators of a price-induced ramp-up in activity would be increased exploration activity and pursuit of short-cycle tie-back opportunities. But operators in the region are not signalling a major increase in 2022. Wood Mackenzie revised its exploration well forecast to 25 wells, which represents a 25% increase from 2021. But 25 wells is a far cry from the 40 wells drilled in 2012 when the oil price was around US$100/bbl. Operators continue to maintain structural cost improvements made since 2014, like minimised appraisal drilling, dual use of wells and phased developments. Aside from companies keeping their purses tightened, supply chain log jams limit the ability of operators to ramp up drilling activity. Rig supply in the GoM area is tight and the lead time for subsea production system kit orders has risen. Figure 3. Permian Basin oil supply by operator type. Source: Wood Mackenzie Lens.

Will the capital restraint trend be reversed?

Most trends eventually turn, which begs the question: is there an oil price at which companies will ramp up drilling in the US? So far, recent comments from Lower 48-focused companies like Pioneer suggest that even seeing prices well above US$100/bbl will not spur much more activity. But even if a theoretical price trigger is hit, any growth will be checked against financial performance – and oil prices are not guaranteed to stay at the current high levels.

There is no denying the massive impact US tight oil growth had on global oil and gas markets over the past decade. Future Permian growth will still be closely watched. But Wood Mackenzie expects the volumes to be much more modest. Volume growth in the next decade will come more from OPEC countries, Brazil and Guyana.

Instead of sheer volume additions, the next decade could instead see North American innovation leading the sector on energy transition topics. Companies are addressing methane emissions, planning small and large carbon capture and sequestration projects, and making increasingly ambitious carbon pledges. Funding these efforts while still addressing shareholder returns will be another factor moderating volume growth from the region. But the US will continue to play a critical role in supplying energy to the globe.

Figure 4. US Gulf of Mexico oil and gas production. Excludes yet-to-find volumes. Source: Wood Mackenzie Lens.