The US oil production boom
It has profound implications on a macro level (impacting economic growth, inflation, FX and interest rates) and on a micro level (driving competitive advantages for the domestic oil & gas industry).
Disclaimer: The information contained in this article is not and should not be construed as investment advice. This is my investing journey and I simply share what I do and why I do that for educational and entertainment purposes.
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I am talking about the US field production of crude oil. It has surged from about 5 million barrel per day (mbd) to currently more than 13 mbd. It can’t be overstated how absolutely astonishing this achievement is.
And it has profound economic implications. Not just for the bull case of US oil & gas stocks. It’s a macro force with an impact on asset prices that is in my opinion underappreciated.
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It’s not a coincidence that the US stock market started outperforming on a global scale in the early 2010s when domestic oil production rebounded. The US oil production boom is a boon for the entire US economy. It drives economic growth and provides US companies with a competitive advantage by securing their access to cheap and reliable energy.
It improves the country’s trade balance by about $200bn annually which strengthens the Dollar and helps lowering interest rates and inflation. This facilitates innovation cycles in other industries, specifically in information technology, as it eases access to and cost of funding. The US benefits from a unique set of synergies between old and new economy.
The most fascinating aspect of this story is that it is entirely productivity driven. US companies are not throwing more resources at the problem. They are simply getting much better at it. It’s a profound innovation cycle, seemingly totally unnoticed by the investor community that is obsessed with chatbots and slim down shots. Domestic oil producers are capturing economic value big time from those productivity improvements. This lays the seeds for a much more sustainable bull market in US energy assets. One that is not just predicated on supply shortages driving windfall gains.
I see two key risks to this thesis, which relate to political headwinds from the current US administration and competitive threats from other countries potentially copying the US oil approach. Both risks seem low at the moment. The Biden administration has barked loudly, but ultimately has failed so far in delivering on their anti-fossil fuel mandate. This is presumably a mix of not being able to and not being willing to.
From a internationally competitive stand-point, the US has established seemingly unassailable technology leadership with respect to unconventional oil & gas production. Other countries are either far behind as development of this complex technology takes a long time. Or they are not interested in developing this expertise as humanity as a whole is currently phasing out fossil fuels. It’s a technology with an expiry date which makes it difficult to invest into it.
The Macro Angle
The production increase since 2010 is equivalent to about 8% of the entire global consumption today. The US is now the leading producer of crude oil, even ahead of Saudi Arabia. It has made them a primary energy exporter for the first time since the 1950s.
At a price of $75 per barrel, this 8 mbd production increase has an annual value of about $200bn, which is equivalent to about 1% of US GDP.
That does not sound like much. But think about the enormous economic implications. It provides access to cheap and reliable energy which fuels economic growth. It improves the trade balance of the US which strengthens the Dollar. This lowers inflationary pressures and consequently interest rates.
Access to cheap capital thereby becomes an enabler for the boom in the information technology sector. For many years, companies were able to experiment with novel business models without the necessity to become profitable immediately. Some failed, but some succeeded.
Of all leading oil producing countries, the US is the only country that is simultaneously at the forefront of another civilization changing innovation cycle. Information technology and fossil fuel technology are going hand in hand. A unique symbiosis.
Admittedly, interest rates don’t feel low right now in the US. But they have to be viewed in conjunction with nominal economic growth which is roaring at north of 6%. And given the fiscal spending binge, imagine where inflation and interest rates may be without this oil production boom? Also, the US tech sector has presumably reaped already most of the benefits of cheap funding in the 2010s. After all, companies like the FAANGs have become cash machines with little funding needs.
Look how the S&P performed against the MSCI World over the past two decades:
Both moved in lockstep until the early 2010s. And then the S&P marched ahead. As of today, its cumulative outperformance during this period stands at more than 100%. 2010 was about the time when oil production started picking up. Could it be coincidence? Sure. Is it likely coincidence? Absolutely not.
There is plausible qualitative causation underlying this quantitative correlation. Energy is the most important economic good. It is central to any economic process. It literally powers the economy. Economic and technological progress has always been and will always be a function of increasing the availability and thereby reducing the cost of energy. The entire history of humanity’s race to higher living standards is one big function of decreasing energy costs.
For energy to be a positive economic force, it needs to be two things: cheap and reliable. In spite of all of our efforts, crude oil still offers those features. Progress in battery technology has been impressive. But there is still no more economical way to store energy than in the form of hydrocarbons.
What’s driving this boom?
As a general principle, the output of a production process is typically a function of capacity and productivity. You can do more or you can do better.
To produce crude oil in particular, you need to drill a hole (called a well) and pump up the black gold. So, if you want to increase crude oil production, you have three choices:
You deploy more drilling rigs (drilling capacity)
You drill more wells per drilling rig (rig productivity or above-ground productivity)
You extract more oil per well (well productivity or below-ground productivity)
The interesting aspect about the recent boom in US oil production is that it’s solely a productivity story. The number of total rigs in operation (incl. both oil and gas) stands at about 600, merely a third of what it was a decade ago.
Likewise, the number of wells are also coming down.
US oil producers are using less rigs than in the past and they are drilling less wells than in the past. Yet their production is surging. This suggests that they have gotten much better at drilling wells. The Federal Reserve Bank of Kansas City carried out an interesting analysis on this matter. It’s from 2019, but I believe the underlying factors are probably still relevant today.
In their paper, they show that the number of wells drilled per rig remains at a low level, …
… while the productivity of those wells that are being drilled is surging.
They are digging deeper. But they are also targeting oil deposits with much higher precision.
Here is a quote from a Canadian industry executive that I consider quite telling:
"The ability to steer a drill bit with the accuracy to hit the target the size of a bathtub that is seven thousand metres below the surface of the earth, I mean that's what we did. We're drilling less but the wells are far more complex. They're longer, deeper and significantly more productive than the wells that we used to drill."
Mark Salkeld, the past president of the Petroleum Services Association of Canada
In an update to their analysis, Federal Reserve Bank of Kansas City found that this trend continued beyond 2019 and they found that combined drill/well productivity has increased about sixfold over the past two decades.
In their analysis, they also identified a close relationship between oil price declines and productivity surges, suggesting that these price declines incentivize drillers to focus only on the most productive rigs and crews in a process called “high grading”. You can see that in the productivity surge in 2020 in the chart above.
The Micro Angle
Unsurprisingly, the prices of oil and gas stocks are highly correlated with the price of oil.
Regressing XLE against WTI yields statistically fairly significant results.
It further allows us to come up with a hypothetical XLE*, i.e. the price level of oil and gas stocks if they always moved in line with the linear regression equation above. I have plotted XLE vs. XLE* in the chart below. The grey area illustrates how far ahead XLE is vs. XLE* in percentage terms. It’s a metric to measure how expensive oil stocks are vs. the price of oil.
As you can see, oil & gas stocks are currently outpacing the underlying commodity price. Historical correlation suggests that XLE should be at $65. Yet it is at $85, about 30% higher.
When I built my XLE bear case in 2022, I used this regression analysis to support my bearish view. Today, I must admit that this conclusion was likely misguided. I believe the superior performance of US oil & gas stocks is likely a function of the productivity gains in their domestic operations. It is fundamentally justified.
Oil & gas investors (and commodity investors in general) are often obsessed with identifying potential shortages because they expect those to inflate prices and create windfall profits for the industry. However, the problem with this approach is that it does not create lasting shareholder value. It’s in fact the opposite. The shortage creates a response that lays the seeds for the following production surplus which creates huge losses in the industry. It also creates undesirable income statement volatility which hurts cost of capital and limits valuation upside.
For oil & gas companies, the primary objective to create lasting shareholder value is the same one as for any company in any industry. It’s all about productivity. They cannot control macro forces. They cannot control swings in customer preferences. But what they can control is improving the way they create their products and services.
Right here in the early 2020s, US oil & gas companies are doing exactly that very well. And it largely happens unnoticed by the investor mainstream. I believe therein lies the opportunity. Whether spot oil moves up or down $10 does perhaps not even matter that much.
I see two threats for this success story:
Political risks from the US administration
Competitive risks from other jurisdictions copying the US approach
While most people are at least somewhat familiar with the 2010s US oil production boom, I can imagine that many were caught off guard by the rebound after 2021. I don’t know if you remember, but the prevailing narrative of 2021/22 was that US frackers were destroyed by a toxic cocktail consisting of the Covid oil price crash, the subsequent end of ZIRP and the hostility of the Biden administration.
Biden has blocked and paused drilling permits wherever he could. He introduced the Inflation Reduction Act which provides huge incentives to invest into renewable energy. And he returned to the Paris Accord leading to an intensification of emission standards.
For example, on December 2, 2023, the EPA announced a set of pollution reduction standards to address the largest sources of methane and other pollutants at oil & gas facilities. It requires to eliminate flaring, leak monitoring and emission reduction from high-emitting equipment. All of this is a significant earnings headwind for producers due to compliance costs and penalty fees.
So far, the US oil & gas industry has proven to be remarkably resilient against regulatory headwinds. I am not sure whether the Biden administration did not want to or was not able to pursue their mandate against fossil fuels with more verve. Perhaps it was a mix of both. For example, a (temporary) ban on drilling permits may sound intense. But the federal government can only do so on federal lands by definition. Most drilling happens outside of those.
I can also imagine that the Democrats were fairly grateful about the operating performance of their unloved stepchild industry. After all, much of Biden’s term was overshadowed by the most ferocious inflation surge in decades. The quick recovery of domestic oil production was certainly an alleviating factor.
The key question that lies ahead is whether there are risks for the US oil story beyond the presidential election in November. Donald Trump is currently leading with bookmakers. He would certainly support current trends to continue. If Biden was reelected, he could become a risk factor, especially if inflation remains a non issue and voters and renewable energy lobbyists demand policy change. I deem this risk low because Democrats are usually loud when they claim change, but very quiet when they are actually supposed to execute on it. But it is certainly a topic to keep an eye on. Not just as an investor with oil & gas exposure, but as an investor with an economic interest in the US as a whole.
There is one critical conclusion we can infer from the US fracking story. It lays rest to the supply-side peak oil fears. As a matter of fact, we won’t run out of oil. It’s everywhere in earth’s crust. We simply need to enhance our drilling capabilities which seems to work just fine. Oil production will therefore not end because there won’t be any of it. It will end when we decide to stop (or perhaps when we are being forced to stop for environmental reasons).
But this actually raises another question: If oil is so abundant, why is production growth seemingly only happening in the US? The chart below is fairly dated. It’s from 2013. But the message is clear: There are significant shale formations pretty much on all continents, including South America, North Africa, South Africa, China and Russia.
So far, the US is the only country that has commercialized shale oil and shale gas production at scale. China, Argentina and Canada are in early commercialization stages.
Here are a couple of reasons why this may be:
It’s a highly complex production process that requires very long development periods. For example, small scale operations started in the US as early as 1965. It took almost five decades from there for this technology to have its commercial breakthrough. For reference, the first shale gas fracking in China did not happen until 2010. They can probably leverage some of the knowledge already built in the US. But since they are still struggling to ramp this up, it seems plausible that there are considerable technological obstacles to overcome.
It’s a technology with geopolitical relevance. Therefore, it’s possible the US has put safeguards in place to avoid technology transfer to other countries.
Fracking is very controversial from a political and environment perspective. This makes it challenging to implement in areas with high population density and/or with strong environmentalism. This makes it virtually impossible to implement in Europe for example.
As we are now firmly heading into a political paradigm of ending the fossil fuel age, other jurisdictions may be hesitant to put development resources into fracking. It’s deemed to be a technology that’s on the way out. For example, China seems to be going all in on electrification. Why should the go hard on fracking then?
If you have additional reasons in mind, please let me know. My general perception is that the US will probably get some international competition eventually, but it will take time and they will likely further innovate to keep ahead. It seems unlikely to me that the US will lose this key competitive advantage anytime soon.
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