U.S. drilling activity has recovered meaningfully since the depths of COVID, driving a resumption of growth in oil production. However, upstream producers are demonstrating more restrained behavior in response to higher commodity prices than was observed in the years leading up to COVID. The resulting lower reinvestment rates are leading to expectations for more modest growth in U.S. oil production than in the past. This increased capital discipline has coincided with the rise of environmental, social and governance (ESG) investing as a factor in financial markets and a heightened focus on the impacts from a transition to a low-carbon economy.
We view the increased capital discipline by upstream producers as a function of improved governance rather than pressure to mitigate their impact on the environment. The emergence of U.S. shale over the last decade was transformative for energy markets: U.S. oil production more than doubled, turning the country from a net importer to a net exporter of crude oil, while natural gas production increased by more than 70% with the U.S. becoming a leading exporter of LNG. This yielded enormous benefits for many, but not the investors in U.S. oil and natural gas producers. Over this same period, the shale industry as a whole failed to generate positive returns for public equity investors and represented a key source of defaults in the U.S. high yield market. This capital destruction was enabled by the symptoms of poor governance: misaligned executive incentive structures that prioritized volume growth over free cash flow, limited management accountability and insufficient realism in capital budgeting.
While the adjustment period was protracted and challenging, capital markets have responded to the industry’s poor historical financial performance. Investors have driven changes to governance structures and demonstrated a strong preference for producers that maximize near-term cash generation. This has resulted in increased capital discipline across the industry and a lower elasticity of U.S. hydrocarbon supply that we expect will be sustained. Management teams are actively focused on reducing emission intensity and, looking forward, we do anticipate that continued focus on the secular challenges posed by the energy transition will put upward pressure on the cost of capital for producers of oil and natural gas. This will have implications for investment towards incremental supply of hydrocarbons, particularly long-cycle projects; however, environmental concerns are not the driving force behind the current trend of more restrained drilling activity by U.S. producers.