On Thursday, the price of the global oil benchmark, Brent, briefly touched $70 a barrel, which marked the first time oil was in the $70s since 2014. That pushed Brent's price up nearly 30% from where it was at this time last year and more than 50% above where it was this past June. As such, the current price point is well above the mid-$50-a-barrel range that most analysts expected oil would average this year.
On the one hand, that's great news for producers because most have pushed their costs down to the point where they could prosper at $50 a barrel. They should produce a gusher of cash flow this year if oil sticks at this level. The concern, however, is what they plan to do with that windfall. If they use it to drill more wells that then unleash a torrent of oil, it could cause crude to crash again.
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All eyes are on U.S. shale
While the price of Brent crude touched $70 a barrel, it's worth noting that the U.S. oil price benchmark, WTI, was recently in the low $60s. So drillers in the U.S. aren't receiving as much money per barrel as their global counterparts. That said, the current oil price is plenty for most shale drillers, since many can generate the cash they need to grow at a healthy pace with oil in the mid-$50s.
For example, when Bakken Shale kingpin Continental Resources (CLR) provided an initial glimpse at its 2018 plan in early November, the company modeled its strategy based on oil averaging between $50 and $55 a barrel. In that range, Continental could increase production 15% to 20% this year. Meanwhile, Permian Basin-focused driller Concho Resources' (CXO) current three-year plan is to increase output at a 20% compound annual rate, which it can deliver as long as oil is in the $50s.
Because these and other drillers had been banking on oil being around $55 a barrel, that means their current plans will generate excess cash given where crude is at the moment. They have several options for that money, including paying down debt, buying back stock, initiating or increasing dividends, and drilling more wells. It's that last option that could upset the apple cart, because if too many drillers decide to reinvest all their excess cash into more wells, that incremental oil could weigh on crude prices.
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Drilling down into the industry's current thinking
As things stand right now, most shale drillers haven't yet accelerated their drilling plans due to the recent rebound in oil. One of the few to bolster their budgets in the past few months was Pioneer Natural Resources (PXD 0.07%), which added back $50 million to its spending plan in the third quarter of last year. That partially reversed a $100 million budget reduction in the second quarter due in part to lower oil prices at the time. That said, Pioneer's plan for this incremental money is to use it in drilling but not completing wells, which means it won't immediately result in higher production.
Meanwhile, Continental Resources' stated goal is to use excess cash flow generated in 2018 to pay down debt. The company, which ended last quarter with $6.6 billion in debt, wanted to get that number down to $6 billion in the near term and $5 billion in the long term. Concho Resources, likewise, has been using its excess cash to pay down debt, with it paying off $580 million over the last year, which has helped reduce its annual interest expense by $90 million.
Others have started returning their excess cash to investors. Hess (HES 0.65%), for example, was one of several oil producers to announce a stock repurchase program. In Hess' case, it expects to buy back $500 million in stock this year, while also paying off $500 million in debt and pre-funding a large offshore development. The hope is that more drillers will choose to follow these game plans and use any excess cash to firm up their financial situations or return the money to investors.
Waiting for more clarity on the plan for 2018
While many shale drillers have unveiled preliminary drilling budgets for 2018 calling for moderate growth fueled by a mid-$50 oil price, those plans could change given that crude is now much higher than it was a few months ago. If drillers decide to use the bulk of their newfound windfall on drilling more wells, the incremental production would likely push supply well past demand and could cause crude prices to tumble -- and take oil stocks with them. Investors should focus on top-tier low-cost producers that haven't participated in the recent rally, since they appear to offer the best reward for the risk given the continued uncertainty in the oil market.
