The title of this note says it all. Energy investors who thought that they'd already seen the worst of it got a rude awakening this week as they watched oil drop through $60 like it was nothing, which of course led traders to dump anything to do with oil… even some of the gas-weighted stocks weren't spared. In terms of explaining the drop, there are a number of contributing factors out there, which include: continued strength of the USD, OPEC defending market share vs. U.S. unconventional oil, coordinated effort to reduce revenue base of Russia, Iran, and maybe even Venezuela, weak global growth, resumption of supply from some conflict areas (e.g. Libya)… the list goes on and on. When a market the size of the oil market speaks so loudly it's almost foolish to not just fall in line and listen. The "why" is somewhat academic at this point, because at the end of the day the end result is the same; oil stocks have been crushed and traders and investors alike are wondering how it all seemed to fall apart so fast…
Staggering U.S. domestic liquids production growth has taken U.S. production to its highest level in 25 years. Something like 2.5-2.75 million barrels a day of production was added to the U.S. production base in the last two years alone. Over the last five years, the U.S. has added something in the neighbourhood of 4 million barrels a day of production. U.S. domestic production had started to rival that of Saudi Arabia and Russia. These are all very general numbers, but you get the point… high oil prices led to an absolute boom in the oil sector… a sector that pretty much invented the phrase "boom and bust". Increasing oil production to 25-year highs certainly counts as a "boom".
Sure enough, "bust" is in the air now and the media and analyst community is piling on. Telling someone you’re buying oil stocks is usually met with either an eye roll or a sympathetic counseling session. With WTI prices falling sub-$60 on Friday, there are a lot of jittery high-yield bond holders out there wondering about their paper and the equity holders underneath them are pretty much crying mercy already. From what I've seen from a number of different sources, most domestic unconventional oil plays have break-even prices somewhere in the $50-75 range. When prices start approaching break-even, there is absolutely no way that equity inflows, capex, and cash flow will not be affected. However, there is also an inherent desire within most companies to still try to maintain or even increase year-over-year production. That's a problem, because the shale oil sector isn't known for its ability to self-fund. Any number of articles out there will point out the massive difference ($270 billion) between capex and cash flows within the oil sector over the last several years. If you assume all-in capital efficiencies of $50,000/flowing barrel (I'm picking that number out of the air somewhat), that's 1.35 million barrels per day per year of overspending (at $30k/flowing, it's more like 2.25 mmbbls/d/yr). Some of that was just to offset declines on existing wells, while the rest was for growth. Shut off that extra funding, and production is going to shrink, no doubt about it.
Even if my numbers are way off (and I bet they are at least in the parking lot of the ballpark), you can't argue with the fact that U.S. production growth has been dependent on capital inflows in the form of equity and debt support from the capital markets. At $40-60 WTI, those capital inflows are going to slow and cash flow is going to be crimped. Balance sheets for producers in general are still ok, and the hope of higher future prices will have companies "curtailing" drilling programs initially, not "slashing" them, and it's very hard to know just what the supply response will look like. Clearly some rigs are going to get laid down, but no one really knows how quickly U.S. production will fall off because since the oil boom only started in earnest around 2010 and we haven't seen what a bust looks like yet.
So what does it all add up to? I think the answer is "uncertainty"… and the market hates uncertainty. That fact alone is enough to keep capital away. Less capital means less rigs and less rigs means less production. Outside of that, it's anyone's guess.
I'm not about to try to predict oil prices, but there are certainly a few headwinds, including: sentiment (that pendulum does swing both ways after all), likely continued devaluation of the Euro and Yen / upward USD pressure (especially in the face of strong recent US GDP numbers), global growth concerns, OPEC's apparent unwillingness to cut, and the (convenient) financial pressure that an oil price drop exerts on certain oil-dependent regimes. Aside from geopolitical flare-ups that are sure to create short term shocks, I'm not sure that it's sustainable for oil market participants to maintain confidence in "$80-plus" WTI in the face of an OPEC that seems unwilling to play the role of swing producer. After all, the U.S. just showed us that with expectations in the $80-100 range (that's really a pretty tight range of $10 on either side of a $90 average), the domestic oil industry was able to add something like 1.5 mmbbls/day of new liquids production in just one year. Clearly, with growth numbers like that, something had to give. Why is it always so clear in hindsight?
What we do know is that in an $80+ WTI oil price environment, the U.S. has the capability to ramp up production big-time. Intuitively, it seems that oil needs to take a breather at least until whatever explanation(s) of the day for its price collapse is/are resolved. We've seen what domestic oil companies can do when capital is readily available. Now, I think that everyone (i.e., OPEC) wants to see just what the new domestic production curve behaves like when those market-driven capital inflows start to dry up. Lots of predictions can and will be made, but only time will tell.
Aside from some nausea, my initial reaction to a slowing domestic shale oil development program was one of opportunity. I thought about what this might mean for natural gas, as it's likely that a lot of gas is associated with this recent boom in oil production.
First off, I've read a number of analyst reports talking about oversupply in the gas market and the prevailing consensus market position has generally been to be short natural gas on strength. Over the last year I have often heard people say things like, "These condensate wells are so economic, they can give the gas away for free." Gas has been an afterthought. Aside from a few industry players that have been buying dry gas assets on the cheap, the mere mention of a dry gas company has been enough to induce a gag reflex in most portfolio managers. Remember the concept, ‘buy low, sell high’? I've read stories about the "gas glut", just like everyone else. It has felt for some time like the gas market makes sense… gas is of no interest. That’s the consensus view. Well, that's usually the case until it isn't and I'd be willing to bet that "associated gas" is a term that analysts and financial media outlets could be talking about at some point in the next twelve months as they seek to explain an eventual rise in the natural gas price.
Lately I’ve been asking people: “How much gas production could drop out of the supply side of the equation with the oil price in the tank?” I ask, because I don’t really know, though I can make some inferences based on the volume of detailed play-by-play EIA data out there.
As an example, over 2009-2013 period, Eagle Ford oil production increased by 1 million barrels a day (almost from a standing start) and with that oil came over 4 Bcf/day of gas. The average GOR (gas-oil-ratio) of an Eagle Ford well implied by the following chart is a little over 4:1.
Looking at the Eagle Ford production chart above, it would be almost impossible to say that the oil and gas production curves are not related in some way. At the very least, the term "oil and gas" company means that the production growth has something to do with capital flows into the sector as a whole, right? Now, as an example, let's suppose that for a "gas" well with a GOR of 8, an Eagle Ford developer is evaluating his 2015 budget using a price deck of $80/bbl for oil and $4/mcf for gas. With a GOR of 8:1, recall that's 8 thousand cubic feet of gas (mcf) per barrel of oil produced, so every barrel of oil produced actually yields 2.3 barrels of oil equivalent using a 6:1 mcf/bbl ratio. If gas is $4 and oil is $80, that's 8 * $4/mcf + 1 * $80/bbl… for total a revenue per boe of $112/2.3 which is $48.70/boe. Note that 71% of that well revenue is from the oil… 71%! If we see $50/bbl oil and gas stays at $4/mcf, that will mean producers are looking at a 27% drop in revenue per boe. That’s going to smart a little.
Marcellus aside, I just can't see how associated gas volumes aren't going to fall as the industry starts to feel the pinch. That's 10 Bcf/day in the Eagle Ford, Permian, Utica, and Bakken that's in play. The pain that oil-weighted companies will feel in terms of their cash flow will force broad capex cutbacks as the companies just try to maintain somewhat reasonable balance sheets. Companies that have significant shale oil production will have to cut back on not just oil wells, but also gas wells… simply as a function of fewer dollars being around to drill wells of any sort. After all, for most companies it's not easy to maintain (let alone grow) production at $4 gas and/or $50 oil.
The "liquids rich" Eagle Ford is thought to have a break-even price around $50/bbl, while the Permian and Bakken apparently have break-even prices in the $65-70/bbl range. Anyone reading this will know that oil is going to be a house of pain for a while in these plays unless something changes dramatically. The market HATES oil right now; that much is clear.
Does all of this mean anything? Maybe, maybe not. My analysis here is simplistic and based on intuition and very few data points, but it certainly seems worthy of at least some consideration. I'd be willing to bet that a downturn in the oil price will have an effect on gas supply, but I have no real sense of what the magnitude of that effect might be other than to say we appear to be experiencing a “significant” event in the oil market. Also, in the interests of keeping this post short-ish, I haven't discussed a commonly held view that shale gas drilling to date has been focused in "sweet spots" (i.e., top tier lands in terms of productivity per well), of which there are obviously a finite amount. For now, I'm keeping an eye on the gas market to see if it looks like a theme is starting to emerge. A lot of gas-weighted (>80% gas) companies are being sold like they are oil companies, which is a clear dislocation due to market pressures and not fundamentals as far as I can tell, as some of these gas weighted companies are >95% gas and have pristine balance sheets. If I start seeing discussions in the news about how the reduction in shale oil drilling is going to hurt gas supply, I'd like to have my homework done ahead of time because it's possible that while the sun sets on the North American oil boom, it may just be rising for well-positioned gas producers. Time will tell.