The Beginning of the “Great Moderation”
Global oil prices fell 60% in the second half of 2014 because rapidly rising shale production ran headlong into moderating demand. In response, oil and gas companies around the world slashed spending, leading to a “Great Moderation.” Between the majors and the largest US shale companies, capital expenditures fell from an average of $240 billion per year between 2011 and 2015 to less than $250 billion per year between 2016 to 2020—a 40% decline (Fig. 1).
The moderation in spend was driven in part by a new reality—revenues for some producers halved within a couple years. This was particularly true for shale producers. US shale cannot act strategically like swing producers in the Middle East who maintain excess capital; rather they must cut capital in response to lower revenues (McNally 2019).
However, the moderation was also driven by changing industry sentiment as the crude price outlook dropped substantially. For example, the World bank’s oil price forecast for 2020 was roughly $100 in 2014, $75 in 2015, and $60 in 2017. That view was widely held and the industry entered an era of “lower for longer” where cutting costs and generating profits took precedent over growing production. This new approach was dubbed “capital discipline.”
Is the Great Moderation Ending?
At one point, some of the largest energy companies planned for potentially permanently lower prices, but now optimism has returned to the industry. After 8 years, the end of the Great Moderation is in sight. It is driven by two factors: (1) The post COVID-19 resurgence of economic activity is boosting oil and gas prices, and (2) rising profits have led to a massive shift in the industry’s outlook. If prices and profits remain buoyant, the industry could be entering a new “higher for longer” era marked by higher spending and growing production.
1. US Oil and Natural Gas Prices Have Soared Since 2020
West Texas Intermediate (WTI)—the US oil price benchmark—shot past $90 in January after languishing mostly below $70 per barrel (bbl) since the 2014 crude crash. Similarly, Henry Hub natural gas prices have risen to almost $6/mmBtu, prices not seen since 2014 (Fig. 2).
The recent rise in energy prices, both in the US and internationally, has been driven in part by a “molecule crisis,” according to Jeff Curries head of commodities research at Goldman Sachs Group. This crisis has led to shortfalls in many commodities because short-term demand has rebounded strongly from the COVID-19 commodity crash but supply has not. “2008 was a financial crisis. This is a molecule crisis. We're out of everything. I don't care if it's oil, gas, coal, [or] copper. You name it. We're out of it. And the backwardation in this market is an indication of just how different this market structure is,” said Curries. It is hard to see that crisis ending soon based on recent economic data. The International Monetary Fund reported that the global economy grew by 5.9% in 2021 and is projected to grow by 4.4% and 3.8% in 2022 and 2023, respectively—much more rapidly than the 2.9% growth seen in 2019.
2. The Industry Is Generating Its Highest Profits Since 2008
The majors’ profits are at record levels. Fourth quarter earnings were $37 billion, the first time they approached $40 billion since first quarter 2008. Remarkably, 2021 full-year earnings were more than $116 billion, topping 2008’s $81 billion, and significantly higher than those of any of the intervening years.
Shale’s transformation is even more remarkable. After generating losses year after year for a decade, shale companies had record high—and more importantly positive—free cash flow in 2021. Industry consolidation, relentless cost cutting, and strategic investment in core regions meant that these companies were well-positioned to take advantage of rising commodity prices.
The next question is what they will do with their profits. While in the past few years excess cash might have been used to pay down debt and reward shareholders, at these prices many companies will likely restart drilling. That could mean the end of the Great Moderation.
An Industry on the Rebound
After several years of capital discipline, it is hard to imagine a sustained return to growth. Old habits die hard, and some argue that many companies have been hesitant to drill new wells despite high prices. That was not always true. In fact, the industry was historically associated with arguably profligate spending. As one hedge fund investor memorably put it, “If you give a driller a dollar, he’s going to drill a hole.” We might not quite be there yet, but rising prices have led to rising spirits, and companies’ hesitation seems poised to change. There are several signs that more money and production are on the way:
- First, industry analysts have said for years that underinvestment could lead to declining supply and rising prices (England et al. 2016). That day has come and the industry has responded by boosting production. The Permian has returned to record production levels.
- Second, US drilled-but-uncompleted well counts are at the lowest point since 2014. If companies want to sustain production, that will require drilling new wells rather than relying on existing inventory. It is not surprising that global and US rig counts have risen nine and seventeen months in a row, respectively (Baker Hughes 2022).
- Lastly, companies have started to announce larger budgets. For example, Chevron expects its project spend to grow by 20% in 2022. Industry analysts forecast similar growth in US shale spending as well. If oil and gas prices remain near current levels, we should see that growth revised upwards through the year as sentiment continues to improve.
After 8 years of lower prices and moderating spend, the oil and gas industry seems ready for a rebound. While rig counts remain below pre-COVID levels, the increase in prices—and perhaps more importantly sentiment—means that the 2022 might be an inflection point in the industry.
References
Baker Hughes, February 2022, Worldwide Rig Counts – Current & Historical Data
McNally, R., 2019. Crude Volatility: The History and the Future of Boom-Bust Oil Prices. Columbia University Press.
