Supply Chain Woes, Inflation Crimp U.S. Producers’ Growth Potential

Investor concerns about returns are not the only thing keeping a cap on U.S. oil and gas production growth.

Producers are struggling with inflation, supply chain lags, and labor shortages – all things that make it difficult to ramp up quickly and cost-effectively.

There’s much confusion out there — in the media, political circles, and the general public — about how U.S. oil and gas producers plan their operations for the months ahead and the degree to which they could ratchet up their production to help alleviate the current global supply shortfall and help bring down high prices.

It’s not as immediate or straightforward as some might imagine.

There are many reasons why producers are either reluctant or unable to increase their oil and gas production quickly. Capital budgets are up in 2022 by an average of 23% over 2021. That increase seems substantial, but analysts estimate that about two-thirds (15%) results from oilfield service inflation.

That means the “real” increase in CAPEX – the dollars going toward actual production growth – is closer to 8%. And this increase is coming off a shallow base in 2021 when producers were still hesitant about investments due to the pandemic’s effects on energy demand. Most opted for “maintenance level” CAPEX levels, primarily designed to keep production flat.

Russia’s invasion of Ukraine, and the subsequent super-spike in oil and gas prices, have raised energy security alarms in Washington and Brussels. The Biden administration has called on U.S. producers to increase output to help alleviate the supply crunch and enhance energy security in Europe, which is finally getting serious about cutting its dependence on Russian oil and gas.

But publicly-listed U.S. producers have largely balked. They have finally won over investors with business models focused on cash returns – big dividends and share buybacks – rather than aggressive production growth. Investors got burnt badly by the growth model in past years when shale producers destroyed billions in capital, and shareholders don’t want a return to the “bad old days.”

But there is more to producers’ restraint. Undoubtedly, companies could continue to deliver attractive cash returns to investors and more growth at oil prices over $100 a barrel. After all, they proved they were free cash flow generating machines at prices closer to $65 to $70 in 2021.

But this ignores the structural headwinds facing the U.S. oil sector.

Supply chain and labor issues are real. How real? Pioneer Natural Resources CEO Scott Sheffield says it would take 18 months to grow production beyond current projections to deal with supply and labor shortages.

And by accelerating drilling activity and CAPEX in an inflationary environment, producers would be subverting their capital efficiency – which is precisely Wall Street’s concern for the U.S. oil sector in this high oil price environment. Leaning into a market defined by over-priced labor and materials is a bad look for any sector, not least one trying to stay in investors’ good graces after spending years in the doghouse.

As Sheffield notes, even if producers wanted to, rapidly increasing production would be a tall task.

The issues weighing on U.S. producers are similar to those plaguing the broader U.S. economy. The drivers are also the same: labor shortages, supply chain issues, and, ironically, soaring energy costs.

For example, the price of fracking sand used in completing wells has more than doubled as labor shortages at sand mines, a lack of truck drivers, and the soaring cost of diesel have constrained operational efficiency.

Permian oil producer Diamondback Energy recently noted that since the third quarter of 2020, its fuel costs are up 93%, cement costs up 43%, steel casings 42%, directional drilling costs 35%, and equipment rentals over 20%. While producers can get around some of these cost increases by entering into long-term contracts with oil services providers, E&P managements still guide to 10% to 15% inflation in their investment programs.

Another behind-the-headlines factor in rising budgets is a historic decline in the industry’s inventory of drilled but uncompleted wells, also known as DUCs in industry parlance. Completing wells that were drilled before or in the early days of the pandemic bust is the most cost-effective way to counter steep decline rates in shale production and maintain producers’ output. These wells have been drilled already and need to be fracked and hooked up to pipelines.

But this strategy is now essentially played out. According to the Energy Information Administration’s Drilling Productivity Report, DUCs have plunged from 8,828 in July 2020 to 4,372 in February 2022. During those 18 months, completed DUCs exceeded the number of new wells drilled in those same regions by 250 per month. So, the industry is facing a drilling inventory issue, too.

Still another issue impacting growth is the lack of takeaway capacity in some regions, notably the gas-rich Appalachian Basin, where there are not enough pipelines to demand hubs to allow production growth.

A focus on infrastructure could provide a short-term solution. More pipelines to get Canadian crude to refineries in the U.S. would help alleviate shortages of oil products like gasoline and diesel. Without putting it on ships, more pipelines are also needed to bring natural gas to the East Coast.

Of course, this would require the Biden administration to approve more oil and gas infrastructure, which looks like a bridge too far after its cancellation of the Keystone XL project last year.

The bottom line is that the industry faces severe shortfalls in the supply of labor, rigs, and other equipment and materials they would need to ramp up quickly. There are also still ESG concerns that limit the development of higher-carbon assets in company portfolios.

Politicians and other observers must stop merely looking at high oil and gas prices and robust industry profits and assume the sector can unleash a massive wave of investment that will quickly boost production.

The industry may have worked that way during past boom-bust cycles, but this market is much different in so many ways.