This time was supposed to be different. This year was supposed to be the year in which the U.S. shale industry proved that, after years of frustrating investors, they would finally start dishing out hefty returns after earning stacks of cash.

The International Energy Agency said a few weeks ago that 2018 was shaping up to be a turning point. “Higher prices and operational improvements are putting the US shale sector on track to achieve positive free cash flow in 2018 for the first time ever,” the IEA said.

The industry had succeeded in lower costs so much that they could turn a profit – the thinking goes – even with oil prices trading at around $50 per barrel. The rise in oil prices over the last year was supposed to be an unexpected bonus, definitively pushing drillers into profitable territory.

But a new report from the Wall Street Journal finds that the shale industry is once again coming up short. Using data from FactSet, WSJ found that roughly 50 major U.S. oil producers burned through $2 billion more than they generated in the second quarter. While shale drillers succeeded in lowering costs during the oil market downturn that began in 2014, those efficiency gains have largely been tapped out.

Moreover, beginning last year, a renewed drilling frenzy, particularly in the Permian, has led to a rebound in costs. Many shale executives had promised that the cost efficiencies were structural, locked in, and would not reverse. But that is now looking to be overly optimistic.

The financials “have improved, but they’re not there yet in terms of making money,” Todd Heltman, a senior energy analyst at investment firm Neuberger Berman Group LLC, told the WSJ. “The realization is setting in that it’s going to take longer than investors thought for them to generate free cash flow and deliver more powerful earnings.” Related: Oil Prices Jump As Saudis Cap Oil Supply

Pioneer Natural Resources, a top driller in Texas, conceded that costs are rising faster than expected. “We've had a more significant increase in cost issue than we would have assumed,” Timothy Dove, Pioneer’s CEO, told investors on an earnings call. The company had higher costs for electricity because of hot weather in Texas in May and June. Labor costs also continued to climb higher.

The problem grows worse for Permian producers that have not secured hedges for their oil sales. Higher costs are running up against pipeline constraints, which has led to discounts for oil in Midland in excess of $10 per barrel relative to WTI in Houston.

Costs for sand, water, drilling crews, equipment and other services have all been rising. The WSJ reports that more than a dozen shale companies announced in their second quarter earnings reports that they either would have to spend more to produce the same amount of oil and gas, lowered this year’s production guidance, or they missed second quarter production figures. The WSJ singled out Noble Energy, which revised up its expected spending levels for this year, while conceding that its production would come in at the lower end of its expected range. (On an unrelated note, Noble is also uniquely vulnerable to potential drilling restrictions in Colorado’s DJ Basin that will be put up to a public referendum in November).

The flip side of that is that slower activity could keep cost inflation in check, something that Pioneer’s Timothy Dove tried to tell shareholders. A slowdown in well completions “does not bode well for increases in costs when activity levels are coming down,” Dove said on an earnings call. “And you see some of the big service companies now saying we're not bringing additional, for example, frac fleets into the basin while margins are not improving any more than they are.” Related: Why Is Big Oil So Excited About Alaskan Crude?

The slowdown in drilling could ease the pressure, he argues. “And so I think we could have a situation where if we can stagnate oil prices where they are today, we might be able to put more of a lid on service cost increases and cost increases in general in 2019 as compared to this year, just a product of a slowdown in relative completion activity.

But that isn’t a saving grace for companies are that are also cutting back on expansion plans. And when pipelines do come online over the next few years, drilling activity will pick up all over again. Shale companies will rush to work through the backlog of drilled but uncompleted wells (DUCs), which has exploded over the past 18 months, potentially all at the same time. “[T]hat could be another period of inflationary activity to the point where everyone is trying to get their DUC count reduced,” Dove said. “And so I would say the bigger risk inflation-wise is really past 2019. It's really 2020 and 2021.”

In short, the cost inflation that many in the shale industry had hoped to keep at bay is only getting started.

By Nick Cunningham of Oilprice.com

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