Investment pundits and oil analysts all have theories about why U.S. oil companies won’t drill, many of which we believe miss the underlying issues. Several complicated factors have come together to keep the industry from increasing activity. The result is that U.S. shale production growth — the only source of non-OPEC supply growth over the past decade — will likely remain muted for longer than most investors expect.

A tight relationship has historically existed between oil prices and drilling activity. Between 2008 and 2018, the oil price alone explained 70 percent of the variation in drilling activity. Since 2020, however, this relationship has broken down. The industry should be turning 1,000 rigs; instead, they are stuck at 533, nearly 40 percent below the 2018 levels, despite oil prices having nearly doubled.

Indeed, the oil price justifies new drilling. Prices have rallied steadily for the past 30 months and remain at the highest level in nearly a decade, while oil inventories continue to plummet. The market has shifted from structural surplus to structural deficit. We estimate that a company with high-quality Permian acreage can generate $38 million in undiscounted cash flow from a well given an $80 West Texas Intermediate crude price, compared with $8 million in drilling and completion costs. Given more than half of a well’s cash flow is generated in its first two years, the IRR at today’s oil prices is well over 200 percent.

Given these extremely attractive single-well economics, why are the companies not drilling more? Energy analysts throw around vague references to capital discipline or labor shortages. We don’t want to downplay these observations; however, we believe that other forces are at work. After studying the issue in depth, we believe oil companies are acting rationally, even if it seems counterintuitive. By keeping activity low, oil companies are responding to the signals sent from their three significant constituencies, all emphatically telling them not to drill. These constituencies are policymakers, investors and their internal strategy teams.

POLICYMAKERS

Despite calls for more production, policymakers remain hostile toward the fossil fuel industry. President Biden repeatedly floated the idea of a windfall profit tax that would severely impact exploration and production profitability. Every proposal by the Biden administration in response to high energy prices is either outright antagonistic toward the industry or, at best, neutral. They have suggested banning crude exports (bad for producers and refiners), reducing gasoline taxes (good for consumers, neutral for producers), implementing windfall profit taxes (bad for producers), banning drilling on federal lands (bad for producers), and increasing subsidies for renewable energy (bad for everyone).

At no point has the administration signaled to the energy industry that its stance might be moving from outright hostility to accommodation. In the first of two congressional hearings in the last 18 months, members of Congress criticized the sector for not cutting production faster; in the second, the same members blamed the companies for underinvestment, low production and high energy prices.

The situations in Canada and Europe are similar.

INVESTORS

Investors are also signaling oil companies to slow development. This claim might sound odd, given energy stocks have been one of the few bright spots in the market over the past two years. Since Jan. 1, 2021, energy exploration and production companies are up 182 percent compared with the S&P 500, which is up a mere 9 percent on a total return basis. However, investors are sending clear no-drill signals to oil companies.

Despite the rally, energy stocks trade at near-record low valuations. As recently as September, exploration and production companies traded for 5.6x earnings and 3.4x EBITDA — the weakest readings in more than a decade. On average, the stocks have traded for a median value of 22x earnings and 9x EBITDA over the past 10 years. Currently, the sector trades for 7x earnings and 4x EBITDA — 68 percent and 55 percent below the long-term average, respectively, and only slightly above the September lows.

We cannot recall a time when the entire industry traded for less than its NAV, and these extremely low valuations have tipped the scales away from drilling and toward dividends and share repurchases.

STRATEGY TEAMS

The last group signaling energy companies to keep development muted are their strategy teams: petroleum engineers, rig crews and project managers. The reason is resource depletion. We have long argued that Eagle Ford and Bakken producers have drilled out most of their best wells, so production would likely plateau and decline. Over the past years, several companies have gotten into serious trouble by running out of high-quality inventory. As recently as 2017, Oasis Petroleum, a sizeable Bakken driller, claimed it retained 20 years of top-quality drilling locations. However, only a few months later, the company tacitly acknowledged it was running out by closing a high-priced Permian acquisition to exit the Bakken and forestall future production declines. The strategy did not work, and Oasis declared bankruptcy in September 2020.

Similarly, Whiting Petroleum stated it had a decade of Tier 1 locations before declaring bankruptcy in mid-2020. The most dramatic example is Cabot Oil & Gas. Long a market darling that commanded a premium valuation due to its perceived asset quality, Cabot claimed to have had 20-plus years of top Tier 1 drilling inventory in the prized northeast corner of the Marcellus Formation. Our models, however, suggested that Cabot’s Tier 1 acreage was not as extensive as claimed, so we have not owned the stock for many years. Cabot began to suffer Tier 1 inventory depletion several years ago, and in 2021 Cabot unexpectedly announced it would merge with Cimarex, a mid-quality Permian company. Based on our research, this merger addressed Cabot’s quickly depleting Tier 1 inventory in the Marcellus.

Energy executives are acutely aware of the dangers surrounding Tier 1 inventory exhaustion. After being forced out of their Tier 1 cores, companies will suffer from ever-declining well productivity, production shortfalls, lower profitability and recurring earnings disappointments. Given such a scenario, even executives with the best remaining acreage are reluctant to increase drilling programs that speed the depletion of their inventory.

Is it any wonder energy companies are not drilling?

This column was excerpted from the Why Won’t Energy Companies Drill? report written by Leigh Goehring and Adam Rozencwajg, managing partners of Goehring & Rozencwajg. Download a complete copy of the document here.