Please ensure Javascript is enabled for purposes of website accessibility

Are Shale Drillers Making an $84 Billion Mistake?

By Matthew DiLallo - May 14, 2017 at 11:00AM

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More

Oil companies in the U.S. plan to spend 32% more than last year on new wells.

After two challenging years, shale drilling in the U.S. is bouncing back big time in 2017. According to an analysis by Barclays (BCS 1.73%), North American drillers plan to spend $84 billion on capital investment this year, up 32% over last year. That's well ahead of the rest of the world, where investment spending is expected to rise only 3%. Moreover, because the bulk of this investment is on short-cycle shale wells, which deliver production in a matter of months instead of years, it has unleashed a torrent of new production onto the market. That has kept a lid on oil prices despite OPEC's best efforts.

That spending spree could come back to bite the industry, because OPEC might decide not to extend its output cuts, which could cause crude prices to crumble. That would be bad news for weaker drillers, which are already drilling well past their financial capacity.

Drilling rig at sunset.

Image source: Getty Images.

Drilling down into the numbers

Leading the spending wave are independent oil and gas companies in the U.S., which, according to Barclays, will increase investment 51% this year to $53 billion. Two dramatic examples of budget-boosting shale players are Bakken Shale-focused drillers Continental Resources (CLR 2.80%) and Whiting Petroleum (WLL). In Continental Resources' case, it plans to spend $1.95 billion this year, that's up a whopping 77.3% from the $1.1 billion it spent last year, while Whiting Petroleum plans to double its capex budget to $1.1 billion. That capital will fuel a remarkable increase in output by year's end, with Continental Resources expecting to boost production 19%-24% by the fourth quarter of this year, while Whiting anticipates that its output will increase more than 23% over that same timeframe.

Meanwhile, another U.S. hot spot is the Permian Basin, where there has been a feeding frenzy over the past year to buy up as much acreage as possible because the drilling returns are so good at current crude prices. Concho Resources (CXO), for example, spent about $2.5 billion on acreage acquisitions last year, while Parsley Energy (PE) completed a slew of deals over the past year, the largest being a $2.7 billion transaction. With that increased scale, both companies have dramatically expanded their capex budgets for 2017. In Concho Resources' case, it plans to spend as much as $1.8 billion this year, up more than 60% from last year. Meanwhile, Parsley Energy intends to spend up to $1.15 billion this year after spending just $500 million last year. These stunning budget expansions will fuel an expected 25% increase in Concho's oil production this year, while Parsley Energy plans to deliver a gaudy 78% increase in output this year, though that's partially due to the incremental production from its acquisition binge.

When taken together, this combined push by shale drillers will add an incremental 800,000 barrels per day to North America's crude output by year's end, according to an analysis Wood Mackenzie. For perspective, Wood Mackenzie notes that this represents 44% of the combined output reduction by OPEC and its non-member partners. As a result, OPEC has less incentive to continue to prop up oil prices by reducing its production, since all it seems to be doing is encouraging shale drillers to increase their output.

Land rig drilling at sunset.

Image source: Getty Images.

Living dangerously

If OPEC decides to remove its support of the market, or, worse yet, increase output above where it was before last year's agreements, it could lead to breathless selling in the oil market. The companies at the most risk in such a scenario are those such as Continental Resources and Whiting Petroleum that not only based their budgets on higher oil prices but still have balance-sheet issues to work out. In both cases, these companies used $55 oil as the cash-flow breakeven point, which seemed reasonable earlier this year, when crude flirted with that level. However, with oil recently closer to the $45-per-barrel level, these companies are on pace to outspend cash flow this year. That is not something Whiting Petroleum can afford to do, because it has $1.5 billion of debt maturing in 2019 and 2020 that it might not be able to refinance if crude were to crash again. Meanwhile, Continental Resources has a debt-to-EBITDA ratio in the mid-3 range, which is well above its peer-group average of 2.4.

Drillers such as Whiting and Continental might therefore need to rethink their 2017 plans so they don't drill themselves any deeper into debt. They're not alone, either. Eagle Ford Shale-focused Sanchez Energy (NYSE: SN) recently joined forces with a leading private-equity fund to spend $2.3 billion on the acquisition of more land in the play. However, Sanchez Energy's plan was to use higher oil prices to boost production and cash flow so it could support the mountain of debt it took on to complete the deal, with its aim to get leverage to less than 3.0 next year. However, if crude oil doesn't remain above its forecast, Sanchez might need to cut back on drilling, so that its leverage ratio doesn't go the wrong way. It's just one of the dozens of shale drillers that appear to have gotten ahead of the market.  

Investor takeaway

When OPEC decided to step in to support the oil market, shale drillers saw that as the all-clear to boost spending. However, the velocity of the increase has brought more production on faster than expected, which has weighed on crude prices. The industry might therefore need to take its foot off the gas later this year if OPEC decides to stop subsidizing the market. 

Invest Smarter with The Motley Fool

Join Over 1 Million Premium Members Receiving…

  • New Stock Picks Each Month
  • Detailed Analysis of Companies
  • Model Portfolios
  • Live Streaming During Market Hours
  • And Much More
Get Started Now

Stocks Mentioned

Whiting Petroleum Corporation Stock Quote
Whiting Petroleum Corporation
WLL
Continental Resources, Inc. Stock Quote
Continental Resources, Inc.
CLR
$59.47 (2.80%) $1.62
Barclays PLC Stock Quote
Barclays PLC
BCS
$7.63 (1.73%) $0.13
Concho Resources Inc. Stock Quote
Concho Resources Inc.
CXO
Parsley Energy, Inc. Stock Quote
Parsley Energy, Inc.
PE

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

Related Articles

Motley Fool Returns

Motley Fool Stock Advisor

Market-beating stocks from our award-winning service.

Stock Advisor Returns
345%
 
S&P 500 Returns
119%

Calculated by average return of all stock recommendations since inception of the Stock Advisor service in February of 2002. Returns as of 05/17/2022.

Discounted offers are only available to new members. Stock Advisor list price is $199 per year.

Premium Investing Services

Invest better with The Motley Fool. Get stock recommendations, portfolio guidance, and more from The Motley Fool's premium services.