Smaller, slower and more profitable. These are the watchwords for Chesapeake Energy Corp. as it emerges from bankruptcy. Free of the colossal liabilities that sank it as the pandemic slashed global energy demand last year, the company has also abandoned the growth-at-all-costs strategy that made it a pioneer of the shale revolution—and poster child of the sector’s debt-fueled excess.

Chesapeake’s market value will be a fraction of the $35 billion it boasted more than a decade ago, back when its controversial founder, the late Aubrey McClendon, was America’s best-paid CEI and his company poured money into everything from Oklahoma real estate to an NBA arena. The new Chesapeake pledges to spend less than it brings in and return the excess to shareholders.

Outside the U.S. oil and gas industry, this wouldn’t sound radical. Within the business, it is a departure. The only feature that matched shale’s disruptive rise in the past 15 years—more than doubling US oil and gas production and sharply reducing dependence on foreign oil supplies—was the industry’s unmatched knack for destroying investors’ money, as hundreds of billions of dollars were spent with little return. Wall Street reacted by dumping its stocks, making the sector one of the S&P 500’s smallest. When the worst oil crash in decades struck last year, operators were forced to slash capital expenditure, sack tens of thousands of workers, idle rigs and cut production. Chesapeake’s Chapter 11 filing was just the most high-profile of scores of bankruptcies.

Now, promise shale executives, a more resilient industry is emerging from the ashes that aims to woo investors. Like the reincarnated Chesapeake, it will be smaller—some analysts believe the sector will be reduced to just 10 dominant shale producers. Production increases will be modest, and financed from cash flow. And activity will focus on fewer prolific shale fields, mainly in Texas. Oil operators that feared new U.S. president Joe Biden’s ambition to launch a green energy revolution would stymie the industry’s drilling and slow production growth, now promise to do both themselves.

“I do believe we have a lot of proving to do to get investors back,” said Vicki Hollub, CEO of Occidental Petroleum Corp., which 18 months ago racked up $50 billion in debt buying a rival producer in a deal now considered one of the most reckless gambles in the shale patch’s short history.

Cash flow and earnings growth must be the new priorities, Hollub said. “I believe that the watershed moment is here and our industry will, I don’t think, ever be the way we have been in the past.”

Can the industry’s new pitch be trusted? Some investors remain skeptical, remembering how past promises of capital discipline crumbled when oil prices rose. “Give an oilman a dollar and he’ll drill a well,” runs the old industry adage. In an era when environmental concerns are already deterring investment in fossil fuels, and long-term growth in oil demand is no longer assured, shale executives know they cannot risk breaking more promises.

“Why should investors trust it?” asks Matt Gallagher, who headed Parsley Energy, a shale producer acquired by larger operator Pioneer Natural Resources Co. last year. “They shouldn’t.”

Early warning signs

After years of growth, shale’s cash-intensive business model was running on fumes even before Saudi Arabia’s price war with Russia and the coronavirus pandemic crashed the oil market last year. The sector’s defining feature is the fast decline of each shale well’s production, where output can drop by 80 per cent after just a year. To offset the loss, another must be drilled. Then another, to offset that well’s loss.

“In a shale play if you stop running, you will fly off the back of the treadmill,” said Raoul LeBlanc, vice-president of energy at consultancy IHS Markit and former head of strategic planning at Anadarko Petroleum, the company bought by Occidental in 2019. “Just to stay still, you’ve got to do a lot of drilling.”

Operators drilled more than 14,000 shale wells in 2019, according to Rystad, an energy research company. It helped the U.S. hit record-high oil output near 13 million bbl/d, a level unmatched even by Saudi Arabia and Russia, the world’s next biggest producers.

That was a rise from 5 million bbl/d just eight years earlier—a surge that sparked booms from Texas to North Dakota and helped drag the U.S. economy out of the mire of the global financial crisis, adding one percentage point to GDP between 2010 and 2015, according to the Federal Reserve Bank of Dallas. But it required huge infusions of cash offered at basement interest rates. Rystad says the sector spent around $400 billion capital in those years, but by 2019 free cash flow arrived only once, in 2016.

“The fundamental problem with the shale model over the past decade has been the pursuit of growth over return on capital employed or returning capital to shareholders,” said Ben Dell, managing partner at Kimmeridge, a private equity firm that has built up an activist position in the sector.

Investors that rushed to finance shale’s recovery from the 2014-15 price crash—an earlier Saudi price war to capture market share—were fleeing by 2019. As capital markets began to close for shale companies, operators were forced to trim spending plans, reducing new drilling activity. With profits still absent and growth prospects diminishing, the shale patch entered 2020 in distress.

A reputation for flagrant corporate misgovernance and excess—from colossal executive bonuses earned by hitting oil output growth targets, not profits, to flashy office developments and rumours of company-funded hunting trips—didn’t help.

Then came last year’s price crash, including the symbolic moment in April when WTI, the U.S. benchmark crude contract, traded below zero for the first time. “COVID hits, oil prices collapse, everyone has to cut their capex, valuations crash,” said Aaron DeCoste, an equity analyst at Boston Partners, an institutional investor. “And it’s effectively reset the entire industry.”

Just a few shale companies showed they could survive the collapse last year in relative health, Gallagher said. From Chesapeake to scores of smaller producers, the distress was acute, with more than 100 operators and service providers, with $102 billion in debt, going under, according to a Rystad analysis from law firm Haynes and Boone.

“The ones that went wrong went way wrong,” Gallagher said. “What’s going on now is people are finding religion about the models that work.”

M&A rush

One tenet of the new shale “religion” is that scale is critical to survival—but of operators, not the overall sector. The mergers and acquisitions to achieve adequate size, coupled with the consolidation of weakened companies, will continue to shrink the number of producers.

Lee Maginniss, managing director at Alvarez & Marsal, an advisory firm involved in oil industry restructuring, says subscale producers will face “intense” pressure. From around 500 exploration and production companies in the U.S. before the crash, 50 may survive, he says. Other analysts say just 10 or so dominant public shale companies will be left to run the best plays.

M&A activity is brisk, with $52 billion worth of deals done in the US oil sector last year, according to Enverus, a data provider. Chevron Corp. moved first, buying Noble Energy in July. ConocoPhillips Co. bought Concho Resources. Devon Energy Corp. merged with WPX Energy. Heavy debt, battered balance sheets and weak equity valuations meant that stocks, not cash, were the currency in each deal.

Pierre Breber, Chevron’s CFO, expects the consolidation wave to continue. “You need to have bigger players, stronger players, more disciplined management teams, stronger balances sheets,” he said. Scott Sheffield, Pioneer’s CEO, said only companies with market caps above $10 billion will remain attractive to a value-focused investor base.

Scale will also allow them to compete with Exxon Mobil and Chevron, U.S. majors which have built up commanding shale positions. Between them they intend to produce about 2 million bbl/d from the Permian Basin later this decade—almost a fifth of total current U.S. crude production.

Most of the M&A activity has occurred in that shale oil field, the world’s most prolific, where operators will concentrate on the rich layers of oil-bearing rocks in the Delaware and Midland basins of New Mexico and Texas. Gas-focused players, such as the revamped Chesapeake, are likely to stick to their best assets. Other shale fields, even the Bakken of North Dakota that sparked the shale oil rush a decade ago, will lose out.

“The heydays of the Bakken, [Texas’s] Eagle Ford, [Nebraska’s] Niobrara, the SCOOP/STACK play in Oklahoma, are all over,” said Sheffield, referring to other shale fields in the U.S.

Capping output

But the main feature of the post-crash shale patch will be an era of tepid growth—if it expands at all. Rick Muncrief, CEO of Devon, said his company can now break even at $30/bbl or less, well below the $50-plus for oil in recent weeks. Yet Devon will hold its rig count flat this year, only drilling a few wells to meet the lease terms of some acreage.

“From publicly traded companies you’ll see a very measured response,” Muncrief said. U.S. oil production is likely to fall by 200,000-300,000 bbl/d as a result, he believes, remaining around 11 million bbl/d—well below the record highs set before last year’s crash.

“Are people going to return to growth? Is US shale going to grow? The answer is no,” Sheffield said. “Don’t anticipate a big ramp up in drilling, people are not going to go back to the old ways.”

Even if oil prices hit $100, Sheffield said his company would only increase output by 5% a year—less than half the rate of average annual growth in total shale production between 2008 and the beginning of last year.

Analysts say this will be enforced by the market, which has punished excessive supply growth—even before the pandemic hit last year—reducing oil and gas’s share of the S&P 500 almost to a footnote.

“The reason why energy is down to 2% of the S&P 500 is because of that behavior,” Breber said. Until the world has fully recovered, it will not need shale producers to increase oil supply, he said.

So far, operators are holding the line. Rystad says third-quarter capital spending by the 39 main shale operators it covers was $3.6 billion beneath cash flows from operations, allowing a record 89% of operators to balance their budgets. If the discipline sticks, dividend- and value-focused investors could be lured back.

“I see attractive fundamentals that I haven’t seen for 20 years,” said DeCoste, referring to the cheap valuations of some operators, juxtaposed with expectations for higher oil prices. But he is cautious about the new capital discipline pledges: “It takes years to build your reputation and moments to destroy it.”

Prisoner’s dilemma

Despite the wave of consolidation, other analysts and investors remain unconvinced by shale’s new mantra and more mature outlook, saying operators will be unable to resist another supply surge if the recent price rally continues. “Gordon Gekko once said ‘greed is good’,” says one adviser to shale operators. “In the oil patch that means ‘growth is good.’”

CEOs are just “giving the audience what it wants to hear,” said Art Berman, a consultant and shale skeptic. Forgoing growth is “absolutely antithetical to the DNA of oil companies in general, but shale companies in particular.”

Investors will be hesitant to take operators’ pledges on faith alone, Hollub said. “It’s going to be a ‘show me’ situation with them.”

Higher prices in recent weeks are already testing operators’ resolve. The weekly horizontal rig count hit 338 in mid-January, more than 60% above its low in August. Private operators, which account for about 15% of onshore US oil production, have led the resurgence, taking advantage of falling costs caused by the drop in demand for oilfield services from publicly listed companies.

“We can drill cheaper,” said Wil VanLoh, head of Quantum Energy Partners, a large private equity shale investor, referring to his portfolio companies. “By definition, private capital is growth capital . . . we out-drill our cash flow until the time we get to positive free cash flow.”

It is the kind of message that public company bosses, insisting they will not be drawn into another competitive drilling binge, do not want to hear—especially as some analysts project more oil price increases. Goldman Sachs predicts Brent, the international benchmark, will rise to $65/bbl by mid-year.

Rystad’s head of shale research, Artem Abramov, says he expects 2021 to “become the best year for the industry from the perspective of free cash flow generation.” It may even allow for profitability—and new production growth, testing operators’ promises to investors.

At an average WTI price of just $52/bbl this year—around the current price—the shale operators Rystad covers would rake in almost $41 billion from operations. After capex commitments, debt payments and more than $4 billion returned to shareholders, they would still have $8 billion of net cash in hand. The question is what they do with it.

“I think they lose discipline and they probably bring on too much growth, and damage the market again—like they did every year in the past,” LeBlanc said. “They’re in a prisoner’s dilemma. They never have discipline as a group, because they’re all competing with each other.”

Onshore