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Morningstar | Higher-Than-Expected Shale Declines Shouldn't Worry Investors

In a recent study, The Wall Street Journal showed that most shale wells are failing to live up to company expectations, stoking fear that firms will have to spend more to sustain their production. The implied result: lower profitability and perhaps higher crude prices. In our own analysis, we found that decline rates are not typically decreasing to the 6%-10% range that the industry expects and are actually trending closer to 15%. Therefore, our models--which previously incorporated terminal declines at the high end of this range--were not as conservative as we thought. But there's no need to hit the panic button. The terminal decline rate only applies after a well has been on line for several years, when more than 80% of its resources have already been recovered. Typically, its output by then will be a small fraction of its initial production rate (under 10%). So, increasing our terminal decline forecast to 15% only has a moderate impact on well economics and the resulting valuation decreases for our exploration and production firms are mainly in the 5%-10% range. As a result, our top shale picks ( Continental Resources, Concho Resources, Diamondback Energy, and Pioneer Natural Resources) remain undervalued after this update.

Likewise, as our U.S. supply forecasts exhibit very low sensitivity to our terminal decline estimate, there is no material effect on marginal cost. Our midcycle forecast for West Texas Intermediate crude is unchanged at $55 a barrel.

We caution that further volatility is likely. OPEC’s remaining spare capacity is unknown, and it’s possible that steep declines are still on the way for Iran and Venezuela (not to mention Angola, Libya, and Nigeria). Likewise, on the demand side we note that the rebalancing of China’s economy is widely expected to dent crude imports in the next few years, even though consumption and investment actually have comparable elasticities of demand. On the other hand, we question whether the market has fully incorporated the impact on demand of higher product prices, the strength of the U.S. dollar, or the downside risk associated with U.S.-China tariffs. The bottom line is that undersupply and oversupply are both plausible outcomes next year and making a directional bet on short-term crude prices is extraordinarily risky.

Instead, we focus on the midcycle price and activity level that keeps U.S. output growing in lockstep with the "call on the U.S." For shale producers, collectively the global swing producer, the marginal cost is around $55/bbl. Though prices have now reached this level, the U.S. rig count still exceeds the Goldilocks level that balances the market in the next five years (by at least 150 rigs). Accordingly, we still see an upcycle playing out. Prices must fall further in the short run, or at least remain at the current level, to avoid excessive shale growth like what we saw in 2014. That limits our stock picks to the handful of undervalued producers listed above that can still thrive in a $55 environment.