Supply shortage fears are pushing oil prices near $90 a barrel, and the return of $100 oil only seems like a matter of time now.
Weak investment in new oil and gas projects is the main culprit for the higher prices as markets fear there will not be enough incremental oil supply to keep up with growing demand as economies around the world recover from the pandemic.
With oil prices closing in on $100, why aren’t oil companies investing in new production?
The main culprit is ESG – environmental, social and governance – pressure from investors, who anticipate a rapid transition to low-carbon alternatives within the energy sector, a process that will take decades to play out.
In the meantime, they appear hellbent on milking publicly traded oil companies for cash and punishing those they believe are investing too much in growth.
This has forced many companies in the sector to adopt a low-growth or no-growth business model that is starting to cap supply and create tightness in oil markets, driving prices toward triple-digits.
The push for a rapid energy transition and its economic consequences can already be seen in Europe, which is experiencing a full-blown energy crisis with unprecedented spikes in natural gas and electricity prices. Investor ESG pressure is so intense in Europe that the Netherlands is still dithering about reversing a decision to shut down one of the continent’s largest natural gas fields, Groningen, despite the continent’s worsening energy crisis.
The same scenario is slowly playing out across global oil markets, and American consumers won’t be spared the pain despite our country’s vast oil resources.
The ESG problem has already manifested itself in the shale business.
Shale was supposed to act as the world’s swing producer outside the OPEC cartel, capable of ramping up production when prices were high and lowering it when prices fell. Shale’s short investment cycle — in which new wells can be brought onstream in a matter of weeks or months after a company decides to invest — are key to the sector’s flexibility.
But ESG pressure has thrown a wrench into this critical oil market mechanism. The clearest sign of this is the difference in how public shale companies are responding to current high oil prices compared to their privately owned peers.
A new report by investment bank Evercore ISI shows that private U.S. exploration and production (E&P) firms plan to increase their capital expenditures this year by 42 percent. In contrast, publicly owned shale companies are expected to increase investment by about 20 percent – a good portion of which will be swallowed by inflation in prices for labor, materials and services.
Private E&P companies are not hampered by the same ESG pressures as their public peers. They have more freedom to run their businesses based on changing market conditions. And over the past year, as oil prices surged, they have seized on the opportunity to aggressively grow their production, reaping healthy profits in the process. Meanwhile, public E&Ps face the wrath of angry shareholders if they anything more than 5 percent growth.
Private E&Ps have largely been responsible for increases in the rig count and domestic production over the past year. Today they account for about 60 percent of the U.S. land rig count, but only account for 13 percent to 15 percent of Evercore’s 2021-2022 domestic capex estimates.
Private firms account for about one-third of U.S. oil production, which averaged 11.2 million barrels a day in 2021, according to the Energy Information Administration. Those privately held companies will deliver the majority of the expected 600,000 barrels-a-day increase in domestic output to 11.8 million barrels a day this year, and a further 600,000 barrels a day in 2023.
Now imagine if public producers, which account for two-thirds of U.S. output, were free to operate in the same way. The United States would be on its way to producing more than its pre-pandemic peak of 13 million barrels a day, creating a far more comfortable global oil market with more affordable prices for crude and refined products like gasoline, diesel and jet fuel. Inflation would also not be so problematic because unavoidable energy costs are a prime driver throughout the supply chain.
Of course, investors have the right to manage climate risk in their portfolios. And given the E&P sector’s track record for capital destruction before the pandemic, they are justifiably wary of companies with overly aggressive growth plans.
But the sector has proven over the past two years that it can be disciplined and efficient with capital. It has also shown a willingness to be an active participant in decarbonization by reducing natural gas flaring, methane emissions, electrifying operations using renewables and replacing gas-driven equipment with air-driven devices.
In short, public E&Ps are delivering fat cash returns to investors, decarbonizing operations and growing their production modestly.
Wells Fargo estimates they will deliver a 13.9 percent free cash flow yield in 2022 – well above other sectors. With returns like that, it’s time for investors to establish a new grand bargain with shale producers to allow more growth before a full-blown energy crisis that threatens the global economy.
Even the most bearish oil market analysts now concede that demand for petroleum will continue to grow until late this decade and will have a long tail after it peaks. It’s time for investors to loosen the reins on shale and allow the sector to help the world avoid another oil crisis.
