ArtistGNDphotography/E+ via Getty Images

ArtistGNDphotography/E+ via Getty Images

Setting aside recent price action, the good times have been rolling in onshore shale over the past year. With commodity prices up, even the junkiest plays with poor acreage have seen share prices moonshot. The futures strip, while deep in backwardation, still remains incredibly supportive for most in the industry. Capital returns are the name of the game now in energy, whether it be direct via buybacks or dividends or indirect for companies that still need to engage in balance sheet repair.

Everyone continues to focus on the top line, but 2022 is likely to be more about differentiation on costs. The market has a nasty habit of extrapolating the current reality forward, and while I think some of the lamentations on shale cost structure is overdone in certain discussion spheres, 2022 is going to be a challenge for many. Inflation in diesel, steel, various chemicals, and cement is easily seen and, when combined with a tighter market for oilfield services, this will drive well drilling and completion costs higher. Those are discussion points for another day, but depletion of prior drilled but uncompleted wells are where I see challenges for several producers.

Drilled but uncompleted wells, or "DUCs", are incredibly important as investors start to think about maintenance spending levels for shale players over the intermediate term. As the name implies, DUCs are oil and gas wells where drilling has been done but the producer has not gone through the process of finishing the well to bring it online.

There are a lot of reasons that wells are not completed. DUCs have been used to hold onto the rights to acreage into the secondary term, as many drilling leases will not terminate so long as the lessee has commenced drilling during the primary term in good faith. Producers will also drill wells but not complete them to take advantage of their contracts with rig providers, as it can be cost advantageous to bear the cost in the current period rather than letting time on the contract go to waste. In other cases, a producer might have leased a rig for operations for a year, but not necessarily have commitments from completion crews to handle all the wells that have been drilled or even have the midstream infrastructure in place to bring that product to market. For well-capitalized providers, it could also just be a way of continuing to drill while deferring production to a later period; a DUC can be brought online quickly in response to higher prices. Plenty of valid reasons, and this means that there is always some sort of inventory of these wells out there, waiting to be fracked and production formally brought online.

In today's environment, DUCs have taken on a new purpose. As most producers have committed to keeping production levels flat and investors have begun to focus in on capital expenditure budgets and what kind of spending is necessary to offset natural decline within E&P portfolios, management teams have increasingly turned to tapping into their DUC inventories. Quite frankly, in a lot of cases it can be done to make themselves look better versus peers. The lower the capital spend costs, the more cash available to equity owners and the more efficient these companies look. After all, with contract drilling and casing costs running 25-35% of the typical well in most basins (call it $2.2-3.0mm per well on average), finishing wells that bore these costs in prior periods saves a lot of money.

But the good times cannot roll forever. During 2020 and 2021, many exploration and production companies significantly drew down on their DUC inventories. In some cases, there are not a lot of viable DUCs left for many. Timing could not have been worse in some cases, as labor shortages and long lead times in getting oilfield services providers into place means it will be both more difficult and more expensive to drill new wells in 2022 versus 2020 or 2021. The management of Apache was just one of a handful of E&Ps that talked about this dynamic a bit earlier on during Q3:

The extra rig we talked about, the incremental rig in the middle of 2022. I think it's important to point out, first of all ... it's harder to stand up a rig quickly, it's a couple of quarters to from the time you make that decision until the time you're [done] just because of long-lead items, supply chain issues, and to make sure that we have everything we need to keep that rig running.

This will leave some producers in a pretty poor spot as they get into the 2022 capital budgeting and spending process. As most firms give their initial outlook in Q4, some investors could be in for an unfortunate surprise. But based on operational data, who have been the worst offenders?

In February of 2020 prior to the pandemic, there were roughly 9,000 DUCs across the United States. However, a portion of these are so-called "dead" DUCs, or wells drilled more than two years prior. Data has shown that once these wells reach this age, there is very little chance (5.0%) that these wells will eventually get completed. An example for those that have followed my energy research would be Unit Corporation (OTCPK:UNTC). The company has 46 DUCs out there according to state regulators, and despite exiting bankruptcy with a relatively clean balance sheet and incredibly high incentives to resume well completions because of its midstream agreements, management currently has no plans to complete any of these wells.

Excluding dead DUCs, available inventory was 6,943 in February of 2020. What I've done below is show how the top twenty public companies by inventories pre-pandemic have drawn down on their reserves over the past two years roughly. In total, these twenty firms had more than 4,000 DUCs that they could tap into or 57.9% of available pre-drilled inventory. As of most recent reporting, E&Ps have drawn this balance down by more than 2,000 (or the wells have shifted into dead status), bringing overall DUC inventory back to 2012 levels. While there is perhaps some availability to continue to draw down on DUCs in 2022, it's muted for several E&Ps.

*Source: ShaleProfile.com. Includes Hess Corporation (HES), Enerplus (ERF), BP (BP), SM Energy (SM), Pioneer Natural Resources (PXD), Continental Resources (CLR), Apache (APA), Occidental Petroleum (OXY), EOG Resources (EOG), ConocoPhillips (COP), Devon Energy (DVN), Civitas Resources (CIVI), Diamondback Energy (FANG), Range Resources (RRC), PDC Energy (PDCE), Chevron (CVX), EQT Resources (EQT), Exxon Mobil (XOM), Marathon Oil (MRO), Chesapeake Energy (CHK).

Nearly all of these firms have not provided much in the way of a 2022 outlook quite yet. That generally comes in Q4, but there are some signs to latch onto. Hess Corporation is adding a rig in the Bakken for obvious reasons, and as guided on the conference call, that will bump capital spending by $200mm versus 2021 as a "rule of thumb". Enerplus sees $500mm in spending in 2022, up from the $380mm it has guided in 2021, so material inflation there (albeit bringing some liquids production growth). Occidental Petroleum, while not yet sharing a firm plan, explicitly called out their use of DUCs as a challenge when thinking about 2022 budgeting:

And the only thing that I could really point to, in terms of what we've said before about this is in 2022, we won't have as many DUCs to complete as we did in 2021. So, there is a difference there. We completed about 100 DUCs in this year.

Long story short, with most producers running very light hedge books into 2022, expect focus to shift to all the debits below the revenue line. Differentials, breakeven costs, decline rates, capital expenditures - these are going to be the focus points from the market next year. The big move in commodities has been the proverbial tide that has lifted all boats. An investor did not have to pick great companies early in 2020 to knock it out of the park; they just had to make a counter-consensus macro call. For investors that want to make serious money in the energy sector from here, it's going to take a bit more nuance to get right.

Are you an investor looking for quality research within the oil and gas industry?  Energy Income Authority is the source. Many missed out on the rally in these companies last year. Even now, several companies are still trading below intrinsic value. 

Deep dive analysis and monthly reporting forms the cornerstone of the platform. Many companies fall under the coverage universe, from pipelines to renewables to producers. Receive actionable research to keep your portfolio outperforming benchmarks - the EIA portfolio has done so four out of the past five years. 

Sign up for a NO OBLIGATION FREE TRIAL today!

This article was written by

Author of Energy Investing Authority

Top 1% Analyst According to TipRanks

I have a decade of experience in both the investment advisory and investment banking spaces, with stints in portfolio management, residential mortgage-backed securities, derivatives, and internal audit at various firms. Today, I am a full-time investor and "independent analyst for hire" here on Seeking Alpha.

Disclosure: I/we have a beneficial short position in the shares of APA either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.