WTI prices showed remarkable stability in July, as prices closed between $39.64 and $41.88/barrel. This data is consistent with what we’ve written before: crude prices face a hard ceiling, a soft(er) floor, and a narrowing range. There’s a hard cap on prices until a vaccine unlocks demand, downside risks could send demand lower, and supply/demand balances are stabilizing, albeit not at the level many in the industry would prefer.

Let’s assume this dynamic continues to play out and prices trade within a range of $35-45, at least until a vaccine is deployed. Will U.S. oil production come back online at those levels? We think that few oil producers will risk drilling new wells at such low prices, although some shut-ins may come back online and offshore assets are relatively well-positioned. Additionally, Wall Street does not want to see producers boosting output that is not supported by free cash flow, and access to capital will likely limit output. U.S. crude production will remain highly constrained at $40/barrel.

Offshore holds steady at $40/barrel, but Permian?

The Dallas Federal Reserve Bank collects information on reported break-even prices by shale basin. We’ve summarized results below, but before we jump in let’s note some qualifications. First, the simple average (black line) isn’t weighted by production, and the Dallas Federal Reserve Bank doesn’t provide the volume-weighted break-even price. Second, this data was collected in mid-March, and a LOT has changed since then. Anecdotally, we’ve heard that some costs have fallen due to greater labor availability, but also that many investors are requiring higher rates of return for U.S. oil companies.

Break-even prices vary by basin. To the surprise of no one, the Permian enjoys superior break-even costs. What may be more surprising to some is that some “other U.S. (Non-shale)” assets are profitable below $20/barrel. We think some of these assets are found in the offshore, in the Gulf of Mexico (GoM). While greenfield offshore projects require billions of dollars and years to complete, brownfield projects enjoy superior economics since most of their costs are already sunk. Since breakevens for offshore brownfield projects can fall below $30/barrel, we think this segment of the industry is well-positioned even if prices remain at $40/barrel for a year or longer. There will be little impetus to cancel planned offshore brownfield projects. Some offshore brownfield projects could conceivably take FID at current price levels.

The Permian’s story is more complicated than the offshore. Some new Permian wells are theoretically competitive even in this price environment. In practice, however, we see little evidence that Permian producers will seek to drill new wells due to capital constraints and managing investor expectations. Indeed, Permian rig counts and production have fallen sharply since COVID began. Even supermajors like Chevron and Exxon may only have 14 producing rigs between them by January, off 80% from a year ago. Occidental is down to a single rig in the Permian, although last week’s data shows a rebound in Permian oil drilling.

It’s more likely that the supermajors and majors will re-open previously shut-in wells than start a new drilling program. Permian production could tick up if prices firm, but we see little evidence of a return to pre-COVID production levels anytime soon.

Will $40/barrel slow Permian consolidation?

We’ve talked for over a year about how the Permian faces and in fact needs consolidation to become more efficient in a Darwinian competition with overseas oil producers. If U.S. producers are able to leverage economies of scale and contiguous acreage, they could shave several dollars off those all-important break-evens and become even more competitive. So why aren’t we seeing more signs of consolidation?

Even completed acquisitions seem to signal trigger-shy companies. Chevron’s acquisition of Noble could signal that it lacks the appetite for other, larger targets. Oxy, the $40 billion debt-burdened elephant in the room, is an obvious acquisition target for any supermajor, but perhaps especially for Chevron. During their price war over Anadarko last year, many analysts noted that Anadarko’s assets complemented Chevron better than Oxy. If that remains true, why doesn’t Chevron concentrate its resources on gobbling up Anadarko’s old assets?

Oxy and other struggling producers may not find buyers because $40/barrel may be the “anti-goldilocks” level of prices. At $40/barrel, prices may be too low for supermajors to generate the free cash flow needed to acquire smaller competitors, who can, in turn continue to limp on. At the same time, $40/barrel prices may be too high for private equity funds to see value in acquisitions.

Offshore producers appear well-positioned for the current environment, but the Permian is facing some challenges. Oil prices at $40/barrel may be too low to generate free cash flow, but just high enough to deter private equity players from entering the market. In the short-term, crude production could be locked in a narrow range, while an unconsolidated sector could become less competitive in the medium-term.