Biden Plays Long Game With Short-Term Fracking Freeze

(Bloomberg Opinion) -- There are two basic routes to an energy transition: encouraging new forms and discouraging old ones. President Joe Biden’s legislative agenda, centered on stimulus spending, will focus on the former. His executive agenda has moved swiftly on the latter already. But in targeting the oil and gas business, Biden’s eyes appear fixed on the horizon.

Exploration and production stocks took fright at Biden’s 60-day freeze of new federal leases and permits for drilling. The fear is that this tees up a bigger move as soon as this week: a “fracking ban,” or outright end to new leasing and permitting for federal areas, which account for about a quarter of current U.S. oil production and roughly a tenth of its natural gas.

The freeze certainly raises that possibility. And it should be set alongside Biden’s other energy-related orders from last week targeting the Keystone XL pipeline and the revival of social-cost calculations for greenhouse gases in permitting. 

A growing segment of climate activism has coalesced around a strategy of choking off funding for oil and gas. One method is pressuring money managers to divest from the sector. Two others are delay and doubt. The first erodes an investment’s value via the magic of the time value of money. The second does it by raising the cost of capital going in; if something looks riskier, it must clear a higher hurdle before anyone cuts a check to finance it. 

Biden’s actions effectively cast a pall over the longer-term cash flows from oil and gas investments. To quantify the impact of this, I turned to Bob Brackett, who analyzes the E&P sector at Sanford C. Bernstein. Using a simple model for a generic large-scale Permian shale operation holding production flat — “arguably a consensus view of the sector outlook” — he calculates only about 33-40% of free cash flow spits out in the first five years. So much of the potential value lies over that horizon. For a company growing production at 10% or more, the spending required pushes all net present value beyond the five-year window.

For investors, Biden’s orders raise numerous potential complications. Drilling permits for federal lands expire after two years but have typically been granted two-year extensions by the Bureau of Land Management. That may not remain typical under Biden. Meanwhile, Keystone XL’s latest (and likely final) demise is a reminder that you can have all the oil and gas in the world (or, say, in Alberta) and it’s worthless if you can’t get it to market at a reasonable cost. Similarly, revived social-cost calculations of greenhouse gases represent another cost input and source of uncertainty for oil and gas models. This is as much about what may happen as what has happened.

None of this helps if you’re relying on the back half of the 2020s and beyond to realize the majority of your return. It’s not like many oil and gas investors felt they had a bead on the back half of the decade anyway. Climate change, and the expectation of tightening policy worldwide, was forcing capital costs up long before Biden was even the Democratic candidate (and forcing them down for clean energy stocks).

Meanwhile, the E&P industry’s self-inflicted wounds of excessive spending and weak governance during the shale boom provided another excuse for investors to stay away. Indeed, the strategic center of gravity in the business was shifting already away from growth at all costs — with very back-end loaded (or outright non-existent) cash flows — to emphasizing dividends, with ConocoPhillips’ “embrace the FUD” approach being the clearest example. Biden’s moves should reinforce this shift toward prioritizing near-term cash over terminal values.

Companies with a big federal-land footprint, such as EOG Resources Inc. and Devon Energy Corp., have sold off since Biden’s freeze was announced. But others face less-obvious risks. Exxon Mobil Corp. is very diversified both within North America and globally. But its Permian operations are central to its growth strategy. And within those, its acreage in the northern Delaware sub-basin on federal land in New Mexico — much of it acquired in 2017 — is particularly attractive. That’s why it has kept rigs running there even as it has dropped them elsewhere. Enverus, a data and analytics firm focused on oil and gas, estimates that, assuming Exxon’s roster of uncompleted wells and permits were grandfathered into any long-term Biden freeze on federal-land fracking, its inventory there would last a little over two years. There are many caveats around such assumptions, and Exxon can clearly both fight in the courts and deploy capital elsewhere if needed. But this is another risk factor at a time when the company really doesn’t need any more.

On the other side, Biden is taking big risks of his own. Curbing drilling and pipeline construction limits oil and gas supply, putting upward pressure on prices (especially if Biden gets his big stimulus package approved). Indeed, any oil company without exposure to federal lands (or Alberta) may benefit in the near term . This raises the risk of alienating American drivers and leaves Biden open to criticism that he’s helping the likes of Saudi Arabia and Russia. Moreover, no state has more to lose from a federal fracking ban than New Mexico, which provided Biden with only five electoral college votes but also, crucially, sent two blue senators. 

Oil’s advocates may hope a political backlash, along with arguing their case in front of a roster of judges appointed under Biden’s predecessor, blunts any deep freeze on federal fracking. That’s a lot of wildcards to wager on, though. After a decade defined by easy financing and the safe assumption of continued growth, the past week’s politics reaffirm the 2020s present a far murkier prospect for oil and gas. Capital markets will price accordingly — and thereby shape the outcome.

Fear, uncertainty and doubt, folks.

This assumes Exxon maintained itspace of drilling and completing wells as observed in 2019 and 2020.

This could effectively turn Brackett's calculation on its head, with more of the available free cash flow from an oil project being generated upfront. Brackett calculates that if the oil priceincreasedfrom about $50 a barrel to $85, then roughly 67-80% of his theoretical Permian operation's free cash flow would be generated in the near term. Still, a 70% increase in oil prices would be a huge move. As he says: "That’s roughly the scale of how ‘bad’ Biden impacts would have to be for investors to be, say, indifferent to difficult policy."

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Liam Denning is a Bloomberg Opinion columnist covering energy, mining and commodities. He previously was editor of the Wall Street Journal's Heard on the Street column and wrote for the Financial Times' Lex column. He was also an investment banker.

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