The one given in this industry is that the analyst community is consistently wrong about where the price of oil is going in the near to mid-term. Just as $100 oil was a sentiment driven price that baked in the risk of every potential negative impact on the supply chain, $28, $30 or $40 dollars is equally sentimental, assuming that any and all incremental barrels are and will be available AND demand will slow or stop.
2013 and 2015 forecasts. (forecasting sentiment is hard) Image Sources: EIA
So let’s just step away from the current noise and focus on a non-controversial outcome… that oil will be much more valuable in the future than it is today. What, exactly, will that future look like?
Today’s pricing sentiment is driven by a global economic “Pick 6” today…
- US production rates,
- Saudi Arabia’s ability to grow production,
- Iran’s latent ability to produce more oil,
- Chinese economic slowdown and its impact on consumption,
- Russia’s ability to add global production, and
- OPEC’s inscrutable strategy.
First, people will produce existing wells at rates that aren’t sustainable to preserve cash flow or compete for market share, because the cost to drill and bring online is already sunk. Second, new wells will not be drilled if there isn’t at least an outlook to breakeven producing them. That means an expectation of a sustained price over 1-3 years or until the well has been paid out.
US Production Rates
Image Source: Drillinginfo Production Report for Unconventional US Onshore Plays (Combined MBOE 20:1) over last six years. Note the lag in production reporting means Q42015 and even some Q32015 reports are not finalized.
First, let’s look at the US, the simplest and most transparent of the “Pick 6” issues bandied about as a price driver. Certainly the unconventional revolution has been a huge factor in global production increases over the last 6 years. The item NOT generally recognized is that production typically lags drilling by some 5 months, thus the drilling in December 2014 is discernible in production records in April 2015. That analysts were alarmed at increasing production and supply during the 1st half of the year suggested that they DIDN’T understand this dynamic, nor did the business press. We predicted in April that monthly production would peak in May and then jump around between -100k bopd and -350k bopd for the rest of the year. When looking at additional production month over month, it is important to remember that it is building on a sloping foundation of natural decline. For instance, in 2014, as the US added some million barrels of daily production, it had to produce 2.2 million NEW barrels of production to do so. The slope of that foundation required 1.2 million NEW barrels to just flatten it out. First year production in the US has had a blended annual decline that has increased from 41% in for 2010 era wells to 47% for 2013 era wells. Therefore, 2014 era wells were likely to have declined 49% and 2015 by 51% in their first year. Second year declines show less of a pattern, ranging from 10-20% decline from the end of the prior year. In other words, we will see REAL production declines in 2016 as the full impact of 2015 drilling reductions are cycled through. Depending on the variability of the second year declines, this could range from -400k BOPD to well over -1MM BOPD. So, the US isn’t going to be the bringer of oil glut news going forward. In fact, the US oilpatch has severely damaged its capacity to rebound from an Oil Field Services point of view, with companies foregoing normal maintenance to just survive. This deferred maintenance will have permanent consequences. SCORE: NOT a Driver.
Saudi Arabia’s Ability to Grow Production
Whereas Saudi’s rig count is up, so is it’s production. They are producing record amounts and most analysts believe that there is little if any behind valve production. SCORE: NOT a Driver
Iran’s Latent Ability To Produce More Oil
When sanctions hit Iran, they immediately dropped 600k BOPD from their official production levels. That they report the same production to the barrel since cause their official number to be quite suspect. Iran has not been investing in their infrastructure and they require outside dollars to reinvest in existing production, ranging from $30 billion to $500 billion over the next 5 years, depending on the source to maintain what they have. $30 oil is not an environment amenable to outside tender offers. Some claim that there will be no NET new production in the near term, that Iran will merely start to recognize the production of oil it has sold in the black market. In any case, 500k NEW BOPD are baked in as of last week. SCORE: NOT a Driver
Chinese Economic Slowdown and its Impact on Consumption
As the year has progressed, the Chinese economy exhibits signs of extreme duress, suggesting that demand growth could weaken materially. Imports of metals and building materials are down substantively. Oil is not. China continues to import crude oil at increasing rates, most likely taking advantage of the low price environment to strengthen strategic reserves. China’s growing “guns vs butter” investment shift isn’t likely a bearish sign for crude oil, either. The IEA and EIA’s production growth estimates both suggest that the market isn’t going to elastically respond to lower crude prices, in essence saying that lower price will not drive higher consumption for the first time ever AND despite the surprise increase in consumption in 2015 SCORE: NOT a Driver.
Russia’s Ability to Add Global Production
Russia found itself in a fun position in 2015 as economic sanctions hammered the ruble down 50%. Essentially, Russia had a half price drilling environment and was effectively hedged by its cratering currency because it pays for new wells in rubles and sells its crude in dollars. This advantage doesn’t exist at commodity prices this low. Russia isn’t likely to spend a buck to get back 20 cents in the first year. SCORE: NOT a Driver.
OPEC’s Inscrutable Strategy
Forget all the rest of the “Pick 6”. If anyone assumed OPEC wasn’t in charge of global oil prices, they were dead wrong. And by OPEC, let’s be honest and say Saudi Arabia. Only Russia, Saudi Arabia, and the US technically have the production base to unilaterally affect the price of crude without completely undermining their net production rates, and the US regulatory environment is focused on efficiency and safety and not price, because, alone of these three, the US until recently was thought to be a net beneficiary of low priced crude oil. Saudi Arabia, tired of being the only player ceding market share in an organization comprised of members that continually and habitually cheat on their production allotments, is flexing their global geopolitical muscle to enforce their control over the organization and to affect the amount of money available to global E&P projects in light of the new beta in crude oil pricing that is recognized today. So, as a result, the US finally sees production declines of the celebrated unconventionals; Iran and Russia are starved of cash, along with the rest of the OPEC members, some to the point of existential crisis. How big a stick does Saudi Arabia wield right now? Very big, I think.
So what about the US oilpatch? The global price of crude is as ridiculously priced today as it was at $120 per barrel. A 2% oversupply in a world where we cannot even measure within 5% with any certainty drops the price of crude over 70% and has every analyst that claimed just 2 years ago that we would never see crude below $100 again now claiming that we won’t see oil above $40 anytime soon. They were wrong then, and they are wrong now.
Image Source: https://www.bloomberg.com/news/articles/2016-01-18/oil-speculators-raise-bets-on-falling-prices-to-all-time-high
What IS different is that the cost of capital in the US has gotten much higher. That won’t be changing soon. Banks and other lenders have already started changing the cost of capital. Warrants are being demanded at closings. Even when oil recovers, this will not change rapidly. Watch the industry get a lot better, because their breakeven for cost of capital will have gotten worse. The oilfield service sector has suffered more than a glancing blow. It will not be able to ramp up as quickly as it was laid down. A lot of its equipment is shot for lack of proper maintenance.
The Fed is reported to be advising banks to push for asset liquidation in lieu of bankruptcy. This is actually a good idea if the point is to preserve value for lenders and equity holders. There is nothing more damaging to producing oil and gas assets as a bankruptcy trustee. Great for the eventual acquirer, bankruptcy trustees know how to make sows ears from silk purses by their reluctance to fund what Texas Independent Producers and Royalty Owners (TIPRO) chairman Raymond Welder calls the “recurring, non-recurring” expenses such as workovers necessary and common in the oilfield.
Your Turn
What do you think? Leave a comment below.
Allen Gilmer
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Thank you for a very interesting article. I would be very grateful if you would comment on these queries.
1) You say that during 2014 when US production increased by over a 1 M bopd, it was overcoming a legacy drop of 1.2 M bopd. That suggests that the drop in production from legacy wells was 100,000 bopd per month. The EIA in its drilling productivity reportshttps://www.eia.gov/petroleum/drilling/?src=home-b6 covering the 7 main unconventional basins shows 2014 legacy drops of 100,000 to 300,000, suggesting a 2014 average of 200,000 bopd per month. That is twice your estimate. Would you care to comment on the difference between the figures?
2) You mention annual drops in well production from 41% in 2010 to 51% in 2015. Most curves of unconventional well production show a drop in the first year of 60 – 70%, becoming more asymtopic in years 2 through 5. Again there is quite a difference in the estimates. Is it because your data base includes both conventional and unconventional wells, or is your first-year estimate of production decline in unconventional wells more modest than shown in most type curves?
Refer to the chart of unconventional production by quarter by cohort of drill year for well. Note the increasing amount of decline to be made up. Every year and how it progresses.
Second, although an average well may decline by 60% in year one, looking at the aggregate numbers of those wells by year drilled, and take the average of each annual summed cohort, it is the 41 increasing to 50% on the data shown. It is likely reflective of the increasing numbers of wells drilled month over month and summing them that causes this.
Thank you for a very interesting article. I would be very grateful if you would comment on these queries.
1) You say that during 2014 when US production increased by over a 1 M bopd, it was overcoming a legacy drop of 1.2 M bopd. That suggests that the drop in production from legacy wells was 100,000 bopd per month. The EIA in its drilling productivity reportshttps://www.eia.gov/petroleum/drilling/?src=home-b6 covering the 7 main unconventional basins shows 2014 legacy drops of 100,000 to 300,000, suggesting a 2014 average of 200,000 bopd per month. That is twice your estimate. Would you care to comment on the difference between the figures?
2) You mention annual drops in well production from 41% in 2010 to 51% in 2015. Most curves of unconventional well production show a drop in the first year of 60 – 70%, becoming more asymtopic in years 2 through 5. Again there is quite a difference in the estimates. Is it because your data base includes both conventional and unconventional wells, or is your first-year estimate of production decline in unconventional wells more modest than shown in most type curves?
Refer to the chart of unconventional production by quarter by cohort of drill year for well. Note the increasing amount of decline to be made up. Every year and how it progresses.
Second, although an average well may decline by 60% in year one, looking at the aggregate numbers of those wells by year drilled, and take the average of each annual summed cohort, it is the 41 increasing to 50% on the data shown. It is likely reflective of the increasing numbers of wells drilled month over month and summing them that causes this.
Allen: thank you for your intelligent & well-presented position. A week ago, some friends were saying they heard “it’s going to break $10″. My reaction was basically the same as yours: this is as dumb as the ‘never see Crude below $100 again’ cry.
Amazing technological advances haven& are occurring because of this price-crunch. The Bakken (I’m from North Dakota, a former commodity trader/hedger) is a great example. Not long agai, it was taken as a”fact” that the Bakjen required $55/brl minimum. I’m njecheRinv $40, maybe less.
Thanks again!
Allen: thank you for your intelligent & well-presented position. A week ago, some friends were saying they heard “it’s going to break $10″. My reaction was basically the same as yours: this is as dumb as the ‘never see Crude below $100 again’ cry.
Amazing technological advances haven& are occurring because of this price-crunch. The Bakken (I’m from North Dakota, a former commodity trader/hedger) is a great example. Not long agai, it was taken as a”fact” that the Bakjen required $55/brl minimum. I’m njecheRinv $40, maybe less.
Thanks again!
I thought Iraq’s production was also a significant price driver?
No question that Iraqi production in the last several years has surprised to the upside. The question moving forward is whether current levels can be maintained in light of fiscal and technical constraints. For example, the Common Seawater Supply Project, needed to maintain pressure in the southern oil fields, needs long-term funding. Parsons has been selected to design front-end engineering for the facility, but no contractor has yet been named to build the facility.
I thought Iraq’s production was also a significant price driver?
No question that Iraqi production in the last several years has surprised to the upside. The question moving forward is whether current levels can be maintained in light of fiscal and technical constraints. For example, the Common Seawater Supply Project, needed to maintain pressure in the southern oil fields, needs long-term funding. Parsons has been selected to design front-end engineering for the facility, but no contractor has yet been named to build the facility.