Morgan Stanley: Exploring implications of permitting, leasing moratorium across sectors

This week, the Biden administration ordered a 60-day suspension of oil and gas permitting and leasing on federal land. While the permit portion of the ban is expected to be lifted, the move signals a more restrictive policy backdrop, Morgan Stanley said, exploring implications across subsectors.

On Jan. 20, Acting Sec. of the US Department of the Interior (DOI) signed an order that suspended the issuance of both leases and new permits on federal land for 60 days. The order, if permanent, would effectively ‘ban’ drilling on federal land (once current permits are used or expire). The move is more aggressive than President Biden's messaging prior to the election which focused on restrictions for new leasing, not permitting on existing leases.

Around 25% of US oil production, or 2.7 million b/d, is tied to federal lands and waters. Within this, higher decline, shale production comprises about 40%, and the remainder consists of conventional production in the Gulf of Mexico and Alaska. Among the shale plays, the majority of federal production is located in the Permian and Bakken. While the frac ban would not impact currently producing wells, it would impact new wells that offset natural declines in current production. Currently, just 14% of active land rigs are on federal land, 73% of which resides in the New Mexico portion of the Permian basin, which has the highest proportion of undeveloped acreage on federal land.

Declines in federal production can be partially offset by activity re-allocation. By itself, the DOI's order does not materially impact the industry. Federal drilling permits extend 2 years, at which time they can stretch another 2 years with approval from the Bureau of Land Management (BLM). Moreover, companies generally maintain a permit backlog that could sustain activity for multiple years. However, if the permitting moratorium becomes permanent, there is a scenario where drilling on federal land could cease after current permits expire. For companies with diversified operations, Morgan Stanley would expect much, if not all, of planned capital on federal land would be reallocated towards oil and gas development on non-federal land. 

Nevertheless, given the significance of federal drilling to employment and tax revenue in key Democrat states (New Mexico), Morgan Stanley expects the permitting ban to ultimately be lifted, but expect more stringent environmental review of new permits going forward and potentially more explicit emissions limits (flaring and methane). Leasing restrictions, which have a fairly limited impact on the industry, could become permanent. Perhaps more importantly, the order signals a more challenging regulatory backdrop ahead – one that likely includes restrictions on methane emissions, more stringent infrastructure permitting, and potentially, carbon regulations. In effect, this policy backdrop is constructive for the oil and gas macro – constraining supply and putting upward pressure on the marginal cost of shale production without impacting short-term demand.

Also, Morgan Stanley explores implications of the DOI's permitting order and potential further regulations across energy subsectors. Equity impacts are limited for the overall industry but select producers with outsized exposure to federal lands do have a large amount of value at risk. Generally, larger companies with diversified geographic exposure are better positioned to manage rising regulatory risk, while those with sub-scale operations (particularly small independent E&Ps) may begin to face a more difficult operating environment. However, the industry in aggregate has begun to more broadly embrace sustainability initiatives, and in many cases has begun to push for more proactive federal policies to reduce emissions - a key to maintaining a 'social license' to operate and a pillar of a still constructive energy outlook.

• US E&Ps. Upstream equities with among the most exposure to federal land (EOG, DVN, MUR, COP & XEC) declined an average of 9% following yesterday's posting of the DOI's order. However, even under the most bearish scenario – no value for federal acreage beyond an assumed 2-year permit runway – we still see upside to valuations for COP (OW), XEC (OW), DVN (OW) and MUR (EW), suggesting 'frac ban' risks are mispriced. Relative to our expectation for a generally more restrictive regulatory backdrop, shale operators with scale, such as FANG (OW & no federal land exposure), and globally diversified companies, including HES (OW) and APA (EW), are more advantaged over smaller shale pure plays – within our coverage, CPE (EW) & CLR (UW).
• US Majors / Integrated Oil. Global footprints and overall scale make US majors more resilient relative to both drilling restrictions and more broad policy implications of the Biden administration. Moreover, they could benefit to the extent President Biden's policies tighten the supply/demand balance for global oil & gas markets.
• Canadian Oil & Gas. Morgan Stanley would expect increased reliance on Canadian crude and natural gas supply in the event of a US federal lands fracking ban. As Canadian crude makes up 55% of the total oil imported in the US, any policy that restricts the growth or potentially moderates US supply will result in higher North American oil benchmarks, which should benefit Canadian producers. 
• Refining & Marketing. A federal lands fracking ban would pose a risk to the advantaged cost structure of US refiners vs. global peers. This could further tighten the supply available to inland US refineries, increase the draws on Cushing, and elevate domestic crude prices relative to international benchmarks. As a result, the historical advantage of running more domestic crude vs. imported crude, which has been a key factor of higher absolute US margins vs. global peers, would likely be moderated. Further, with less associated gas production, the resulting upward pressure on natural gas prices could increase operating costs for US refiners.
• Oil Services. Morgan Stanley estimates that a US federal land activity ban would put 15-25% of US upstream capex and activity at risk (5-15% of US onshore + nearly 100% of US offshore), or 5% of global capex and activity. Service assets are broadly mobile and thus the greatest risk onshore would come from a large reduction in federal lands capex without offsetting investment elsewhere in the US onshore arena. In this scenario, the broader US-focused small cap group would all face a declining market size, but this could be an extreme outcome. Risks here are more relevant to select small caps, particularly those with meaningful US offshore exposure, where virtually all investment is on federal acreage.