There are two big questions hanging over the oil price in 2017. The first is whether the supply truce between Opec and non-Opec producers at the end of 2016 will hold. The second is how fast US shale producers will gobble up market share now that Brent crude once again costs $55 (£45) a barrel. Between 2011 and 2015 tight oil production increased from 1m to 4.5m barrels a day, but that period of growth has essentially been put on hold for the past two years by Opec-orchestrated oversupply. With prices now stabilising, this flexible yet cash-intensive form of production is once again starting to increase. You need only look at the Baker Hughes rig count, which, since hitting a nadir in May 2016, has seen the number of producing oil wells in the main basins rise every week. By Christmas, the count was 66 per cent off the bottom.
Few global energy investors have failed to notice that tight oil - the once-trapped sandstone oil now accessible through horizontal well drilling and hydraulic fracturing - is a highly leveraged bet. Not only did tight oil producers take on considerable debt in the boom years in order to fund new wells, but the industry's relatively high per-barrel cost means that valuations can quickly upgrade with small movements in the oil price. Of course, the opposite is also a permanent threat, and may prove the case if the Opec agreement arrives stillborn. But providing Saudi Arabia, Russia et al hold their nerve and reduce production in the coming months, they will be cheered by well owners in Texas and North Dakota.
From an investor's perspective then, US shale certainly looks on the cusp of growth at the beginning of 2017. According to analysis by Nordic bank SEB, tight oil producers should add 30 rigs a month in the first half of the year, before plateauing in July. Pioneer Natural Resources (US:PXD), which with a market capitalisation of £30bn is one of the largest US shale producers, predicts that the major cost reductions seen at Permian basin wells have paved the way for 100 new rigs in the next year. EOG Resources (US:EOG) - which in addition to Permian has producing wells in the Bakken and Eagle Ford - thinks it can increase its output by 15 to 25 per cent until the end of the decade, so long as oil holds at $50 a barrel.
Room for doubt
Even with a lot of momentum behind it, there are reasons to doubt the longevity and force of the tight oil renaissance. First off, tight oil production volumes held up in the downturn partly because many operators focused on their best wells. The once unbounded improvements in production may soon be slowing; a study of the Bakken shale in North Dakota by Shell's former principal geoscientist, Jilles van den Beukel, estimates that the productivity and efficiency of tight oil drilling has plateaued. US Shale, Mr van den Beukel argues, has been a technological - rather than a reserves-based - revolution, and one that can't be repeated. Indeed, Rystad Energy estimates that efficiency improvements accounted for just a quarter of the drop in break-even prices in the past two years.
A fossil-fuel-friendly political climate may not be a great thing, either. Certainly, with the appointment of a pro-oil, climate change sceptic as energy secretary and a former ExxonMobil (US:XOM) president in the role of secretary of state, the shale industry is hardly short of supportive voices in Donald Trump's incoming administration. But the shale revolution managed to crash the global oil market even under Obama, so a flood of new legislative help or tax cuts could run the risk of another bubble. Whatever actions presumptive energy secretary Rick Perry takes, his ability to influence anaemic global demand is limited.
Neither will financing be quite so readily available this time. Potential lenders, many of which have been stung by the sector's ability to withstand low prices, are likely to be more demanding (or in shorter supply) now that supply has tightened. That dynamic could exacerbate the industry's cost-intensive profile which, despite technological innovations, has resulted in negative free cash flows ever since production started to grow at the beginning of the decade. That's an unsustainable trend, even if average break-even prices have come down from between $60 and $84 a barrel in 2014 to the $31 to $39 range this year. Operators may also find it hard to keep a cap on unit costs, which contributed to a large portion of the drop in expenditure in the downturn and will be harder to contain in a higher oil price environment.
Not an income play
The sector's recent volatility, and its historic struggles with free cash flow, mean US shale-focused companies are not known for their dividends. One exception is BHP Billiton (BLT), which as well as being the sixth-largest shale oil producer in 2015 is expected to yield 4 per cent this year. The commodities giant also has 6.33bn barrels of oil equivalent resources and reserves across its basins in the Permian, Haynesville, Fayetteville and Eagle Ford basins.
Another UK stock - albeit dividend-free - with assets in the Eagle Ford shale is Pantheon Resources (PANR), whose exploration programme in East Texas suffered a couple of disappointing drilling results in 2016. Management, apparently open to selling the company by the end of next year, expects production and cash flow from its Polk County acreage in the spring, although whether this will be enough to finance production remains to be seen.
IC VIEW:
Apart from the thousands of laid-off workers, and several lenders, the biggest victims of the crash in crude prices in the US shale industry were drillers in marginal basins, many of whose existing wells are now hitting the flatter part of their decline curve. That - according to analysts at RBN Energy - should make it easier for basins with high initial production rates to contribute to overall production growth, and explains why Diamondback Energy (US:FANG) was prepared to fork out $2.4bn for a large position in the highly coveted Permian basin last month. At $1.2m per well, that looks like a great deal, but more broadly we remain cautious of an oil sector that in the very recent past has been found wanting, after talking up its own book.
Favourites
For UK investors, it can be a little tricky getting direct exposure to US shale, as most tight oil players finance themselves in their home market. Consequently, readers may find it easier to buy into a US energy-focused exchange traded fund (ETF) or index such as the Ashburton Global Energy Fund I (LU1422756434), which invests in major shale stocks including Devon Energy (US:DVN), RSP Permian (US:RSPP) and Parsley Energy (US:PE). The sterling-denominated fund - up 64 per cent in the past year - both reduces individual company risk in a highly leveraged sector and offers exposure to several of the oil majors with tight oil production, such as Chevron (US:CVX).
Outsiders
Management at UK-listed John Wood (WG) recently warned that the "significant challenges" seen in the past year are likely to persist in 2017, but the oil services specialist sees rising rig counts in the US as a positive. And while refinery work has slowed, the company believes its "differentiated capability" across all of the major basins means it should benefit from any pick-up in investment and drilling activity. At 16 times forward earnings - and with the company's core North Sea market still looking rather subdued - the share price looks a little full for us.
