The Petroleum Truth Report

My goal is to offer clear and direct explanations of energy reality. These posts are data-driven interpretations of oil and gas topics that often challenge conventional thinking.
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Saudi Permian: A Race To The Bottom For Tight Oil

Remember the shale gale and Saudi America? The scale of those outlandish delusions has now dwindled to plays in a few counties in West Texas and southeastern New Mexico. Saudi Permian.

It’s a race to the bottom as investors double down on the tight oil companies that can still tell a growth story. Permian-weighted E&P companies are the temporary darlings of Wall Street as other tight oil plays have lost their luster.

A Silly Price Rally: Catch-22

We are in the middle of a truly silly price rally. Other rallies of 2015 and 2016 took place despite substantial production surpluses and too much inventory. Then, there was some hope that higher prices might result if over-production could be brought under control. Now, the world’s production and consumption are near balance but oil prices remain mired in the $40 to $50 per barrel range.

This current rally will end badly because there is something more fundamental keeping prices low. Despite repeated assurances from IEA and EIA that demand growth is strong, it is not strong enough to draw down outsized global inventories.

Hope for an OPEC production freeze at next month’s meeting in Algiers is the main factor driving this rally. The problem is that the world liquids market is as close to balance as it ever gets—over-supply has been less than 0.5 million barrels per day for the last two months (Figure 1). Oil prices were more than $100 per barrel at similar or greater production surpluses in 2013 and 2014.

World Market Balance 0.5 mmbpd Aug 2016

Figure 1. World liquids production minus consumption shows that the present market is as close to balance as it ever gets. Source: EIA and Labyrinth Consulting Services, Inc.

In 2015, when the average production surplus was 2 million barrels per day, it was a different story. Over-production is not the problem now as it was then. If OPEC freezes production, it won’t make any difference.

Inventories exceed all historical levels. The world remains over-supplied because there is too much oil in inventory.

As long as oil prices are are range-bound between about $40 and $50 per barrel, it makes more sense to store oil than to sell it. The carrying cost of storage is less than what can be made by rolling futures contracts over each month. Inventories will stay high until prices break out of their current range but outsized inventories make that impossible. Catch-22.

Four Oil-Price Cycles in 2015 and 2016

There have been four oil-price cycles in 2015 and 2016–the first three each lasted approximately 6 months (Figure 2). Each new cycle began with high price volatility that fell as price peaked. We are currently in the upward arc of Cycle 4.

Four volatile oil-price cycles since mid-2014

Figure 2. Oil-price and oil-price volatility cycles since 2014. Source: EIA, CBOE, Bloomberg and Labyrinth Consulting Services, Inc.

The oil-price volatility index has fallen to levels similar to when prices peaked during the last cycle suggesting that current WTI futures prices just above $48 per barrel may already be near the peak for this cycle. Prices may increase into the low-$50 per barrel range as they did in June before falling again.

The latest cycle began when NYMEX futures prices fell below $40 per barrel in early August. In the succeeding two weeks, they have climbed to more than $48 (Figure 3). A factor beyond a possible OPEC freeze is the weakened U.S. dollar because of expectations that the Federal Reserve Bank will not raise interest rates at least until December. The value of the dollar against other major currencies has fallen 3% over the last month (36% annualized). WTI futures prices have increased 22% since August 1.

WSJ Dollar Index and WTI NYMEX AUG 2016

Figure 3. 2016 U.S. dollar index and WTI NYMEX futures prices. Source: EIA, Wall Street Journal and Labyrinth Consulting Services, Inc.

A third factor driving the current price rally is long-term concern about supply because of under-investment in oil development projects and exploration since the oil-price collapse. Recent statements by the International Energy Agency that demand may outpace supply in the next few years underscored that anxiety.

Figure 3 shows that oil prices appear to be range-bound between about $40 support and $51 per barrel resistance levels. The upper boundary is largely controlled by record-breaking volumes of U.S. and world crude oil inventories and the fact that producers add rigs and production with each upward swing in oil prices.

The 200-day moving average of NYMEX futures prices suggests similar range boundaries of about $38 and $52 per barrel (Figure 4).

NYMEX Resistance & Support Levels August 2016

Figure 4. Two-hundred day moving average of WTI NYMEX futures prices. Source: EIA, Bloomberg and Labyrinth Consulting Services, Inc.

Staggering Inventories

This market looks for any excuse to raise prices.  Every price upswing is seen by some as the beginning of a return to oil prices above $70 per barrel. We seem to selectively forget that the staggering inventory levels of crude oil make this impossible until those volumes are drawn down substantially. Oops.

U.S. crude oil inventories fell 2.5 million barrels this week but have increased a net 1.6 million barrels over the last month during what is supposed to be de-stocking season (Figure 5).

Crude Oil Stocks_5-Year AVG MIN MAX 6 FEB 2016

Figure 5. U.S. crude oil inventories and comparison with 2015 levels and the four years preceding. Source: EIA and Labyrinth Consulting Services, Inc.

Storage volumes are 57 million barrels more than at this time in 2015 and are 143 million barrels higher than the 5-year average. This is definitely not a basis for a sustainable oil-price rally. Until inventories are drawn down by at least another 125 million barrels, a recovery to somewhere approaching mid-cycle 2014 levels of about $80 per barrel is technically impossible.

The Permian Basin Dominates Rig Count Increases

Five new horizontal rigs were added last week to drill tight oil objectives in the Permian basin and 12 rigs were added the previous week. Only 1 rig was added in the Bakken play after losing 2 rigs a week ago. No rigs were added in the Eagle Ford after losing 1 rig the previous week. More capital is being spent in the Permian basin than in all the other plays put together.

Overall, 67 tight oil rigs have been added since early June. Forty eight of those are in the Permian basin, 5 in the Bakken and 6 in the Eagle Ford play (Figure 6). Four rigs were added in the Niobrara, 3 in the Granite Wash and 1 in Other. Rig count increases began as oil prices peaked above $50 per barrel in early June and continued through the slump toward $40 prices before the latest upward swing to $48 per barrel.

PERMIAN RC-NYMEX-OVX 13 august 2016

Figure 6. Permian basin, Bakken and Eagle Ford tight oil horizontal rig count, NYMEX WTI prices and oil-price volatility index. Source: Baker Hughes, EIA, Bloomberg and Labyrinth Consulting Services, Inc.

Weekly changes in the Permian basin rig count are the leading indicator of capital flows and expenditures. Permian rig count is more responsive to capital flows than the other tight oil plays because there is more money available for Permian-weighted companies.

In late July, I wrote, “When prices fall and oil-price volatility increases, the floodgates of capital open. Every genius-investor wants to buy low and sell high. Rig count rises with fresh capital, production increases and oil prices fall.”

In fact, the Permian basin accounts for 64% of the total U.S. horizontal tight oil rig count (Figure 7).

PERMIAN RC is 60 Percent of Tight Oil RC

Figure 7. The Permian basin rig count represents more than 60 percent of the U.S. horizontal tight oil rig count. Source: Baker Hughes and Labyrinth Consulting Services, Inc.

This is curious because Permian production from the Bone Spring, Wolfcamp and Trend-Spraberry horizontal plays represents only 21% of total tight oil production (Figure 8).

Permian Tight Oil Prod 21 Pct of Total

Figure 8. Permian basin daily production from the Bone Spring, Wolfcamp and Trend Area-Spraberry plays is only 21% of total U.S. horizontal oil production. Source: EIA, Drilling Info, North Dakota Department of Natural Resources and Labyrinth Consulting Services, Inc.

It is even more curious because Permian basin tight oil proven reserves rank 42nd in the world just behind Denmark and Trinidad and Tobago based on the latest EIA data (Figure 9).

Proven Reserves World and Permian Basin August 2016

Figure 9. Permian basin tight oil proven reserves compared with world crude oil reserves. Source: EIA and Labyrinth Consulting Services, Inc.

Some will argue about potential and possible Permian resources and reserves preferring Pioneer CEO Scott Sheffield’s view of things to reality. I won’t debate them but the point is that Saudi Permian is a stretch based on any reality-based interpretation of existing data.

It’s A Stock Play, Not An Oil Play 

Eleven companies now operate 3 or more rigs in the Permian basin (Figure 10). These represent a mix of independents and major oil companies. Concho operates the most rigs with 15 and Pioneer is second with 13. Energen, Anadarko,  Chevron and Apache all operate 5 rigs or more. Companies that operate at least 3 rigs include Cimarex, Diamondback, Oxy, Parsley and Callon.

Permian Rig Count

Figure 10. Companies that operate three or more rigs in the Permian basin. Source: Drilling Info and Labyrinth Consulting Services, Inc.

The stock performance of all oil companies correlates strongly with oil prices but many Permian basin-weighted stocks have significantly out-performed ETFs (exchange-traded funds) by 2-to-1 to as much as 4-to-1 since the current price rally began in early August (Figure 11).

Permian Producers Stock Prices August 2016

Figure 11. Stock performance of many Permian-weighted independent stocks out-perform ETFs by 2:1 to 4:1 since the current oil-price rally began. Source: Source: Google Finance, EIA, Bloomberg & Labyrinth Consulting Services, Inc.

Callon’s stock price has increased 34% since August 1, 2016. Parsley’s and Energen’s have increased 22%, Pioneer’s has risen 18% and EOG’s, 17%. These companies have all beaten the 16% increase in WTI futures prices over the same period and have substantially out-performed oil ETFs (Energy Select XLE and Vanguard Energy VDE)  whose returns averaged only 8% in August.

Most of the Permian companies with strong stock performance also have sizable debt loads and high debt-to-cash from operations (EBITDA) ratios. The average debt-to-cash flow ratio is 5.4:1 and 4:1 is considered the current threshold for bank loan risk (Figure 12). Among the independent companies with high stock performance, only Diamondback and Energen have ratios less than 4:1. Parsley, Cimarex and Concho all exceed 7:1.

Debt-Cash Flow Q2 2016 Sampled E&Ps July 2016

Figure 12. Most Permian operators have debt-to-cash flow (EBITDA) ratios that exceed bank-risk threshold of 4:1. Source: Google Finance and Labyrinth Consulting Services, Inc.

Another reason for the highly volatile stock prices of most Permian companies is in their stock valuations.On average, the ratio of current to mid-2014 stock valuations is double the ratio of first half 2014-first half 2016 NYMEX WTI oil prices (Figure 13).

2016-2014 stock valuations is double the ratio of 2016-2014 WTI futures prices

Figure 13. The average ratio of 2016-2014 stock valuations is double the ratio of 2016-2014 WTI futures prices for Permian-weighted companies. Source Google Finance, EIA and Labyrinth Consulting Services, Inc.

Stock prices of shale companies with good positions in the Bakken and Eagle Ford have also increased but those companies have a harder growth story to tell. At $70 per barrel wellhead prices, average well density in the Permian horizontal plays is about 1 well per 860 acres. That is less than half of the 1 well per 382 acres per well in the Bakken and one-fifth of the 1 well per 172 acres per well in the Eagle Ford play (Table 1).

PERMIAN-BAKKEN-EAGLE FORD WELL DENSITY SUMMARY TABLES 13 JUNE 2016

Table 1. Well densities for commercial Bakken, Eagle Ford and Permian locations at $70 per barrel wellhead oil prices. Source: Drilling Info and Labyinth Consulting Services, Inc.

Among the high stock performers, both EOG and Pioneer also have positions in the Eagle Ford and EOG is also represented in the Bakken play.

A Race To The Bottom

The main cause of the collapse of global oil prices in 2014 was a production surplus. That continued to be the key factor throughout 2015. Now, over-production is still a concern but the market has been close to balance for the last 6 months.

For most of 2016, however, liquids consumption growth has declined. It increased with falling oil prices and peaked at the end of 2015 when monthly average oil prices were near $30 per barrel (Figure 14). As prices recovered into the $40 to $50 range, consumption growth dropped. The global economy is apparently too weak for prices in this range.

Consumption growth is decreasing with increasing oil prices

Figure 14. World liquids consumption growth is decreasing with increasing oil prices. Source: EIA and Labyrinth Consulting Services, Inc.

Growth occured only when oil prices were below disturbingly low thresholds. Declining consumption growth is the likely cause of persistent high inventory levels and range-bounded prices.

The dream of Saudi America has fallen on hard times since oil prices collapsed. Persistent and often misleading claims about technology, efficiency and lower cost have kept hope alive for true believers. The truth is that production costs are more than oil prices.* The present situation cannot be sustained without even more carnage in the oil industry.

Investors have identified the plays and companies that are in the best position to survive and they are in the Permian basin. As the field of attractive companies dwindles, more short-term investment is directed toward the perceived winners. These favored companies can go to the capital markets more or less at will with new stock or bond offerings and easily raise hundreds of millions to billions of dollars. This allows them to continue drilling and spending, and accounts for the upsurge in Permian rig counts at the beginning of every new price cycle.

Those who bought stock in Permian-weighted companies made a good profit this month.Those companies are attractive to investors not because of their underlying financial strength. It is because they satisfy the reach for yield that is no longer met by Treasury bonds or other conventional investments in a low-interest rate and low-growth economy.

Like the companies, the Permian plays are attractive mostly because they don’t lose as much money as the other tight oil plays and have a better growth story.They are the best of a bad lot. But they still lose money at oil prices less than $50 to $60 dollars per barrel at the wellhead. There is about a $5 differential between Permian wellhead and benchmark price so $55 to $65 per barrel WTI prices are needed for Permian tight oil plays to break even.

Permian basin tight oil production will peak around 1 million barrels per day and begin to decline in the mid-2020s based on our models. Those models assume a return to $75 to $80 oil prices in the next 3 to 5 years and that capital will be readily available to fund ongoing drilling. If either assumption is too optimistic, the plays will peak later but will not produce any more oil. The Permian basin has good, prolific plays but it is no Saudi Arabia.

The Bakken and the Eagle Ford were all the rage for investors until lower-for-longer oil prices were accepted as the new reality during the second half of 2015. Now, investors believe that the Permian basin is the only place with profitable plays at low oil prices. Eventually, they will tire of the Permian also and may be lured back to the Eagle Ford or Bakken by some new tall tale about technology or efficiency.

Investors will provide capital as long as the stock plays earn them the yield that they need. Companies will dress themselves and their plays up in order to compete for the capital offered. Meanwhile companies continue to produce about 3.5 million barrels per day of tight oil that loses money on each barrel.

With every new price rally, investors and companies think that this time oil prices will finally recover to a level where the companies can make money again. But with every price rally, rig counts and production increase, demand falters, inventory rises and prices fall back.

It is Einstein’s definition of insanity–doing the same thing over and over again and expecting a different result.

It is race to the bottom.

—————————————————————————————————————————————————
*I get many emails and data from readers with “real” examples from companies of wells that break even at oil prices less than $40 per barrel. These all require an average well EUR of 1 million boe or more.

Does anyone realize how very few wells in world history have produced 1 mmboe?

Most Permian horizontal wells produce at least as much water as oil. So, if you believe that every well will produce 1 mmboe, you must also believe that it will produce at least 1 mmb of water. Water disposal costs of $1 to $2 per barrel are seldom found in these break-even economics from the “real world.”

These examples rarely include the discounted cost of capital, production taxes or royalty payments. Nor do they include any operational risk so every mile-long lateral and multi-stage fracture stimulation goes flawlessly and there are never any unexpected costs.

 

 

Pioneer’s Permian Oil Costs Compete With Saudi Arabia—Is That A Lie?

pinocchio

Image from ShortList.com

Pioneer CEO Scott Sheffield made headlines last week when he claimed that his company’s Permian production costs “…can compete with anything that Saudi Arabia has.”

Is that a lie?

Pioneer’s Q2 2016 Earnings presentation shows that production costs for Permian basin horizontal wells are $2.25 per BOE (Figure 1).That cost cannot be verified because only company-wide production costs are included in the company’s 10-Q Quarterly Report.

Cash Margins by Asset from 2016-07-28 Q2 2016 Earnings revised

Figure 1. Cash margins by asset. Source: Pioneer Natural Resources Q2 2016 Earnings presentation, Slide 18.

The footnote in Figure 1 indicates that its stated production costs are untrue because they do not include all production costs. A lie is not a lie if you tell everyone that it is a lie.

By including the next line item “Production and ad-valorem taxes,” production costs become $4.13 instead of $2.25 per BOE. As Figure 1 shows, Pioneer’s overall production costs are $6.66 per BOE.

In fact, Pioneer’s total variable costs for the second quarter of 2016 were almost $18 per BOE (Table 1).This is the standard method to evaluate a company’s costs. It does not include considerable expenses for salt-water disposal because they are not mentioned in the company’s 10-Q.

PIONEER 2ND QUARTER 2016 10-Q SUMMARY TABLE JULY 2016

Table 1. Pioneer Natural Resources variable costs summary table. Source: 10-Q Filing July 2016 and Labyrinth Consulting Services, Inc.

Pioneer’s realized price for the first half of 2016 was $28.95 per BOE so the truth is that the company only has about $10 of margin before major capital expenditures of $7 million to drill and complete each well, much less pay royalties and income taxes!Break-even price for Pioneer’s average Trend Area-Spraberry well is about $52 per BOE. I’m sure the Saudis are scared to death about that.

Pioneer has “cherry-picked” the very best of their production and focused only on its production expenses thereby excluding 85% of its stated variable costs—to what end? Pioneer is a solid company that compares favorably to its competitors. After a rough first quarter for all companies, performance improved markedly in the second quarter and first half of 2016 (Figure 2).

Pioneer H1-Q1 2016 & FY 2015 CE-CF D-CF Chart

Figure 2. Pioneer’s financial performance improved in the second half of 2016. Source: Company documents and Labyrinth Consulting Services, Inc.

The company outspent cash flow by 2-to-1, down from almost 5-to-1 in the first quarter. Debt-to-cash flow moved back within today’s bank-risk tolerance of less than 4-to-1 after exceeding 8-to-1 in the previous quarter. Why couldn’t Sheffield have pointed to this data as evidence that Pioneer is a strong performer among the shale players?

Sheffield is known for grandiose flights of fantasy. In 2013, he stated “The Spraberry Wolfcamp could possibly become the largest oil and gas discovery in the world,” comparing it to Ghawar, the world’s largest oil field. A year ago, Pioneer published a news release claiming Spraberry Wolfcamp “EURs averaging approximately 1 MMBOE, with IRRs averaging 50% to 60% at current strip commodity prices” that were around $45 per barrel. My work indicates an average EUR for those horizontal wells of approximately 300,000 BOE and financial results for Pioneer hardly reflect the returns stated in that release.

No credible oil and gas analyst believes those claims any more than recent statements that Pioneer’s well costs can compete with Saudi Arabia.

The shale gas and tight oil companies have developed a culture of exaggeration and misrepresentation. They have consistently tried to make the ludicrous case that a terrible reservoir and super-expensive technology can somehow out-perform much cheaper wells and better reservoirs in conventional plays.

It’s an unnecessary case to make because we’ve been out of those better, cheaper plays in the U.S. for decades. But, once you get started with embellishment, it leads to deception and then, it’s hard to remember what the truth is or even why you’re telling such unbelievable stories in the first place.

Investors play a role too. Many prefer a make-believe reality where America is great again, and they can dream of making crazy profits like in the good old days.

Seventy percent of Pioneer’s production is in the Permian basin (Table 2) and 80% of Permian production is from horizontal wells. So, 55% of Pioneer’s production is from the same subset of wells that Sheffield says can compete with Saudi Aramco.

Pioneer Production Table from PioneerNaturalResourcesCompany_10Q_20160728

Table 2. Pioneer production by area. Source: Pioneer 2016 10-Q Report.

If I were a Pioneer investor, I would ask Scott Sheffield at the next earnings call why he doesn’t just sell all of the company’s assets except horizontal wells in the Permian basin. Then we will find out if his comments are a lie or not.

 

The Price Rally Is Over: Capital Drives the Oil Market to Low Prices

The current oil-price rally is over.

U.S. rig counts have surged as oil prices sink.  Capital is driving the oil markets and it enables bad behavior by producers. That is why oil prices will stay low.

The oil-price rally that began in February is over. Prices rose from $26 per barrel to $51 by early June and are now below $42 (Figure 1). If they fall through $40, the next likely support level is at $36 per barrel.

The Current Oil Price Rally Is Over

Figure 1. The current oil-price rally is over. Source: EIA, Wall Street Journal and Labyrinth Consulting Services, Inc.

Capital Drives The Oil Market and Prices

Most people think that fundamentals–supply and demand–drive the oil market but capital drives the market and oil prices.

More than anything, rig count reflects capital flow. Many believe that price drives rig count but it is really capital flow that drives rig count and production and that affects oil prices.

When prices fall and oil-price volatility increases, the floodgates of capital open. Every genius-investor wants to buy low and sell high. Rig count rises with fresh capital, production increases and oil prices fall (Figure 2). The weekly change in tight oil horizontal rig count is the leading indicator of capital expenditures. Price trends roughly follow the inverse path.

Capital flows drive the oil market

Figure 2. Capital flows drive the oil market. Source: EIA, CBOE, Bloomberg and Labyrinth Consulting Services, Inc.

When oil prices were around $100 per barrel in mid-2014, oil-price volatility was low. When prices fell below $90 per barrel in October 2014, oil-price volatility began to increase. When prices bottomed below $46 in January 2015, volatility peaked. Correctly believing that a price floor had been reached, investors poured capital into the markets and oil companies were flush with money to start drilling again. Prices rose to $60 per barrel by May 2015.

As drilling proceeded, oil-prices began to fall as market confidence in a price recovery faded. In July 2015, prices began to fall. As they fell to near $40 per barrel by late August, price volatility increased again. Investors saw another price floor and opened their wallets.

Prices rose 18% to more than $48 by early October but by then, confidence in a price recovery again faded with increased drilling and global economic concerns about Chinese growth and oil demand. Oil prices fell below $30 in late January 2016 and by mid-February, oil-price volatility reached its highest level since the Financial Collapse in November 2008.

Once again, investors saw a price floor and the floodgates of capital opened. Pioneer and Diamondback raised almost $1.5 billion in share offerings in January 2016, probably the darkest time for oil markets since 1998.

In the first half of 2016, more capital has flowed to E&P companies than during 2013, the previous record year when oil prices were more than $100 per barrel and the tight oil boom was in full bloom (Figure 3).

2016 Secondary Share Offerings from Bloomberg Gadfly July 2016

Figure 3. U.S. E&P companies have sold more stock so far this year than in the whole of the record year of 2013, when oil averaged almost $100 a barrel. Source: Bloomberg.

Rig Count Surges and Oil Prices Fall

During the current price rally, prices increased from $26 in mid-February to more than $51 per barrel by early June. Meanwhile, the rig count change rate has exploded (Figure 2). Predictably, oil prices have fallen below $42 per barrel as hopes for a price recovery fade once again. This repeating process qualifies under the standard definition of insanity namely, continuing to do the same thing that got you in trouble before.

66 land rigs and 47 tight oil horizontal rigs have been added since early June (Figures 4 and 5). Last week, prices were crashing but 18 rigs were added, the biggest increase in almost 2 years.

Rig count has increased as oil prices have fallen

Figure 4. Rig count has increased as oil prices have fallen. Source: Baker Hughes, EIA and Labyrinth Consulting Services, Inc.

Those added rigs, however, resulted from decisions and a process that began weeks or even months ago. After a company decides to add a rig, negotiations follow. More time passes between signing a contract and a rig showing up on location. Empirically, there is about a 5-week lag between changes in price trends and a response in rig count (Figure 5).

Changes in rig count lag price changes by about 5 weeks

Figure 5. Changes in rig count lag price-trend changes by about five weeks. Source: Baker Hughes, EIA and Labyrinth Consulting Services, Inc.

Who Are Those Guys?

Which companies are adding rigs and do their financial results support more drilling at these oil prices?

About 60% of rigs added in the tight oil plays during the last few months are in the Permian basin where there are currently 145 rigs operating (Figure 6). The rest of the new drilling is fairly evenly spread among the Bakken, Eagle Ford, Niobrara, Mississippi Lime and Granite Wash plays.

Permian Rig Count

Figure 6. Permian basin rig count: 145 rigs despite low oil prices. Source: Drilling Info and Labyrinth Consulting Services, Inc.

The most active operators in the 3 most-productive plays–the Permian, Bakken and Eagle Ford–are shown in the table below.

TIGHT OIL RIG TABLE 25 JULY 2016

Table 1. Leading tight oil rig operators for the week ending July 22, 2016. Source: Drilling Info and Labyrinth Consulting Services, Inc.

In the Permian basin, Concho Oil & Gas currently operates 15 rigs, Pioneer Natural Resources operates 12 rigs, and Energen operates 8.  Apache, Chevron and XTO each operate 6 rigs, and Anadarko and Endeavor each operate 5. Cimarex, Diamondback, EOG and Parsley all operate 4 rigs.

The most active operator in the Eagle Ford play is EOG with 5 rigs. EOG is followed by Chesapeake and Marathon each with 3 rigs. In the Bakken, Continental Resources is the leading operator with 5 rigs. Hess operates 4 rigs, Whiting operates 3 and Oasis, 2 rigs.

So how are these operators doing financially?

Terribly, despite preposterous stories of technology gains, costs approaching zero, and single-well EURs of 1 million barrels of oil equivalent.

Figure 7 shows the main rig operators in the Permian, Bakken and Eagle Ford plays. These companies spent an average of 4 times as much as they earned in the first quarter of 2016.  And it’s been going on for years. Imagine doing that yourself.

Among Permian operators, Parsley spent more than 10 times cash flow and Energen, more than 6. Pioneer and Chevron spent 5 times more than they earned. Anadarko had negative cash from operations meaning that it didn’t even earn enough to pay for well operations.

Tight oil companies spend 4 times more than they earn

Figure 7. Tight oil companies spend 4 times more than they earn. Source: Google Finance and Labyrinth Consulting Services, Inc.

EOG leads the drilling in the Eagle Ford play and only spends twice what it earns–among the best of a bad lot. Marathon, on the other hand, outspends earnings by more than 6-to-1 and ConocoPhillips is not much better at more than 4-to-1. Like Anadarko, Chesapeake has negative cash from operations and, therefore, does not appear in Figure 4.

In the Bakken play, Hess cannot even pay for well operations from its cash flow yet operates 5 rigs. Continental Resources leads Bakken drilling and has a respectable capex-to-cash flow ratio only spending $1.30 for every dollar it earns. Whiting outspends cash flow by almost 6-to-1 and Oasis has negative cash from operations.

The debt picture is equally grim.

It would take top tight oil rig operators an average of 10 years to pay off debt if all cash earned from oil and gas sales were exclusively for that purpose based on first quarter 2016 financial data–in other words, no drilling, no salaries, no nothing except debt payments (Figure 8). That’s way above standard tolerance for this critical measure of bank risk which is now about 4:1 but before 2012, it was closer to 2:1.

Tight Oil Debt to Equity

Figure 8. Tight oil companies would take 10 years to off debt using all cash from operations. Source: Google Finance and Labyrinth Consulting Services, Inc.

In the Permian basin, most operators have a debt-to-cash flow ratio of about 6:1 or 7:1. Chevron and Pioneer are much higher at 9.3:1 and 8.2:1, respectively. It would take Apache 8 years to pay off its debt and 7.4 years for Concho. Cimarex is somewhat lower at 4.4 years and not surprisingly XTO (ExxonMobil) is at 2.2 years.

In the Eagle Ford play, EOG has more debt than it could pay off in 6 years and Marathon has a stunning debt-to-cash flow ratio of almost 25! Conoco is not far behind at almost 18-to-one.

In the Bakken play, Continental would need 6 years to pay off its debt but Whiting leads all major tight oil players with a debt-to-cash flow ratio of 29-to-1!

Meanwhile, these companies tell investors tall tales of fantastic rates of return even at low oil prices that clearly do not pass even a superficial fact check using Google Finance or Yahoo Finance. Why would any rational investor give money to most of these companies?

Short-Term Price Spikes In a Few Years

There is an important difference between oil supply and reserves. Supply is available on demand and reserves require long-term, capital-intensive investment to develop.

Tight oil is really a supply project because reserves can become supply one well at a time. Tight oil development can be turned on or off at will as prices rise and fall because at-risk capital is incremental–basically the cost of the number of wells in a rig contract.

While tight oil supply has overwhelmed markets in recent years, remaining reserves are relatively small–a few tens of billions of barrels–compared with true reserve projects like conventional and deep-water oil or oil sands that involve hundreds of billions of barrels. True reserve projects have been largely deferred because of uncertainty about how long low prices will continue.

The insane cycling of oil prices will continue as long as tight oil production keeps the market in a supply surplus. At some time in the next few years, the market will go into deficit as deferred investment in reserve projects comes back to haunt us. Then, inventories will finally be drawn down to 5-year average levels and prices will probably spike.

If that happens, it is likely that prices may go well above $90 per barrel. This may last for a year or somewhat longer based on what occurred in 1979-1981 (27 months), 2007-2008 (13 months) and 2010-2014 (48 months) when prices were more than $90 per barrel. Then, demand destruction will set in and prices will fall. Because the global economy is so much weaker now than during those past periods of high oil prices, I suspect that it will only take a few months to a year before prices fall hard.

Lower Prices Ahead

The current oil-price rally led many to believe that a full price recovery was underway.  But inventories have been too large for that to happen short of epic supply interruptions. Current OECD inventories stand at 3.1 billion barrels and untold millions of barrels in places like China and Russia that do not report storage volumes.

In mid-April, I cautioned:

Two previous price rallies ended badly because they had little basis in market-balance fundamentals. The current rally will probably fail for the same reason.

You don’t have to be a genius to figure this stuff out. Attention to data and recent history is all it takes.

So, why do producers mis-read price signals so badly and act in ways that lower prices and hurt their own businesses?

They can’t help themselves. Give them money and they will spend it. That’s what E&P companies do.

The cost of credit dictates the precedence of cash flow over common sense even as more debt and the growing burden of debt service dictate even more production to meet new cash flow demands.

It is a vicious cycle that cannot be broken unless the capital stays away. That has not happened because other options for similar yields at acceptable levels of risk cannot be found. And so it continues.

The longer companies continue to produce at a loss and make absurd claims that they are making money at low prices, the more that investors believe them. The market graciously obliges by shorting oil prices.

I see no graceful way out of all of this.

 

Oil Prices Lower Forever? Hard Times In A Failing Global Economy

Two years into the global oil-price collapse, it seems unlikely that prices will return to sustained levels above $70 per barrel any time soon or perhaps, ever. That is because the global economy is exhausted.

The current oil-price rally is over as I predicted several months ago and prices are heading toward $40 per barrel.

Oil has been re-valued to affordable levels based on the real value of money. The market now accepts the erroneous producer claims of profitability below the cost of production and has adjusted expectations accordingly. Be careful of what you ask for.

Meanwhile, a global uprising is unfolding.

The U.K. vote to exit the European Union is part of it.  So is the Trump presidential candidacy in the U.S. and the re-run of the presidential election in Austria. Radical Islam and the Arab Spring were precursors. People want to throw out the elites who led the world into such a mess while assuring them that everything was fine.

The uprising seems to be about immigration and borders but it’s really about hard times in a failing global economy. Debt and the cost of energy are the pillars that underlie that failure and the resulting discontent. Immigrants and infidels are scapegoats invented by demagogues.

Energy Is The Economy

Energy is the economy. Energy resources are the reserve account behind currency. The economy can grow as long as there is surplus affordable energy in that account. The economy stops growing when the cost of energy production becomes unaffordable. It is irrelevant that oil companies can make a profit at unaffordable prices.

The oil-price collapse that began in July 2014 followed the longest period of unaffordable oil prices in history. Monthly oil prices (in 2016 dollars) were above $90 per barrel for 48 months from November 2010 through September 2014 (Figure 1).

Oil Prices in 2016 Dollars, 1950-2016

Figure 1. Oil Prices in 2016 Dollars, 1950-2016. Source: EIA, Federal Reserve Bank of St. Louis and Labyrinth Consulting Services, Inc.

That was more than 3.5 times longer than the period from September 2007 through September 2008 just before the Financial Collapse. It was almost twice as long as the period from September 1979 through November 1981 that preceded the longest oil-price collapse in history.

There is nothing magic about $90 per barrel but major economic dislocations have occurred following periods above that level. Few economists or world leaders seem to understand this or include the cost of energy in their models and policies.

There is a clear correlation between oil price and U.S. GDP (Gross Domestic Product) when both are normalized in real current dollar values (Figure 2). Periods of low or falling oil prices correspond to periods of increasing GDP and periods of high or rising prices coincide with periods of flat GDP.

CPI-Adjusted US GDP + Trendline & WTI October 2015_150

Figure 2. U.S. GDP and WTI Oil Price. Source: U.S. Bureau of Labor Statistics, The World Bank, EIA and Labyrinth Consulting Services, Inc.

Economic growth is complex and some will object to this correlation. Fine. But energy is also complex. Most people think about it as an independent topic or area of our lives. Like business, politics, economics, education, agriculture, and manufacturing, there is energy. This is understandable but wrong.

Energy underlies and connects everything. We need energy to make things, transport and sell things and to transport ourselves so that we can work and spend. We need it to run our computers, our homes and our businesses. It takes energy to heat, cool, cook and communicate. In fact, it is impossible to think of anything in our lives that does not rely on energy.

When energy costs are low, the costs of doing business are correspondingly low. When energy prices are high, it is difficult to make a profit because the underlying costs of manufacture and distribution are high. This is particularly true in a global economy that requires substantial transport of raw materials, goods and services.

The global economy expanded in the mid-1980s through 1990s when oil prices averaged $33 per barrel. Then, oil prices nearly doubled to an average of $68 per barrel from 1998 to 2008, and subsequently increased after 2008 to 2.5 times more than in the 1990s. When oil prices exceed $90 per barrel, the global economy is no longer profitable.

America’s Golden Age

The United States experienced a golden age of economic growth and prosperity during the 25 years following World War II. This period forms the basis for U.S. and indeed global expectations that growth is the norm and that recessions and slow growth are aberrations that result from mis-management of the economy. This is the America that today’s populists want to return to.

The Golden Age, however, was a singular phenomenon that is unlikely to recur. After 1945, the economies and militaries of Europe and Japan were in ruins. The U.S. was the only major power that survived the war intact.  Having no competition is a huge competitive advantage.

The U.S. was the first country to fully convert to petroleum, another competitive advantage. A barrel of oil contains about the same amount of energy as a human would expend in calories in 11 years of manual labor.  Crude oil contains more than twice as much energy as coal and two-and-a-half times more than wood. And it’s a liquid that can be moved easily around the world and put in vehicles for transport.

In 1950, the U.S. produced 52% of the crude oil in the world and was largely self-sufficient. Texas was the largest U.S. producing state and the Texas Railroad Commission (TXRRC) controlled the world price of oil through a system of allowable production that also ensured spare capacity.

Oil was cheap, the U.S. controlled its price and had a positive balance of payments.

Oil Shocks of the 1970s and 1980s

That began to change toward the end of the 1960s. A re-built Europe and Japan rose to challenge American commercial dominance and the costs of fighting the spread of communism–especially in Vietnam–weakened the American economy. In 1970, the U.S. economy went into recession and President Nixon took drastic steps including the end of backing the dollar with gold reserves. The rest of the countries that were part of the Bretton Woods Agreement did the same resulting in the largest global currency devaluation in history.

In November 1970, U.S. oil production peaked and began to decline. In March 1972 the TXRRC abandoned allowable rates. The United States no longer had any spare capacity. OPEC had long objected that oil prices were held artificially low by the U.S. Now OPEC had the clout to do something about it.

In October 1973, OPEC declared an oil embargo against Israel’s allies including the U.S. during the Yom Kippur War. This was really was just an excuse to adjust oil prices to the devalued Western currencies following the end of the Bretton Woods Agreement.

The price of oil more than doubled by the end of January 1974 from $22 to $52 per barrel (2016 dollars). When the Arab-Israeli conflict ended a few months later, oil prices did not fall.

Real oil prices more than doubled again in 1980 to $117 when Iran and Iraq began a war that took more than 6 million barrels off the market by 1981. The effect of these price hikes on the world economy was devastating. World demand for oil decreased by almost 10 million barrels per day and did not recover to 1979 levels until 1994 (Figure 3). Real prices did not recover to $40 until 2004 except for a brief excursion during the First Persian Gulf War in 1990.

OPEC-World Liquids Compared to 1979 July 2016

Figure 3. OPEC and world liquids production compared to 1979 and world oil prices. Source: BP and Labyrinth Consulting Services, Inc.

The Miracle of Reagan Economics: Low Oil Price

Ronald Reagan is remembered as a great U.S. president because the economy improved and the Soviet Union fell during his administration. Both of these phenomena were because of low oil prices.

After U.S. oil production peaked, imports increased 5-fold from 1.3 to 6.6 mmbpd from 1970 to 1977 (Figure 4).

U.S. Crude Oil Production, Imports and Oil Price in 2016 Dollars

Figure 4. U.S. crude oil production, imports and oil price in 2016 dollars. Source: EIA, Federal Reserve Bank of St. Louis and Labyrinth Consulting Services, Inc.

When oil prices rose to nearly $110 per barrel during the Iran-Iraq War, the U.S. went into recession from mid-1981 through 1982. Oil consumption fell more than 3 million barrels per day. Production from Prudhoe Bay began in 1977 and somewhat dampened the overseas outflow of capital but it did not help consumers with price.

Federal Reserve Chairman Paul Volker raised interest rates to more than 16% by 1981 to bring the inflation caused by higher oil prices under control (Figure 5). This worsened the economic hardship for Americans in the short term but also became the foundation of the Reagan economic revival.

U.S. Public Debt 1950-2016

Figure 5. U.S. public and consumer debt and interest rates. Source: U.S. Treasury, U.S. Federal Reserve Banks and Labyrinth Consulting Services, Inc.

Much of the developing world had survived the oil shocks of the 1970s by borrowing from U.S. commercial banks. Higher U.S. interest rates put those countries into recession and that helped keep oil demand and prices low. By 1985, oil prices had fallen below $40 per barrel and would not rise above that level again until 2005.

Volker found an opportunity in the demand destruction from oil shocks. By raising U.S. interest rates, he managed to roll back oil prices almost to levels before the 1973 oil embargo and created a great economic boon for the U.S.

“He [Volker] used the strategic price that America continued to control—namely, world interest rate—as a weapon against the price of the strategic commodity that America no longer controlled, which was oil.”
James Kenneth Galbraith*

High interest rates attracted investment. Along with low oil prices, a strong dollar, tax cuts and increased military spending, Volker and Reagan restored growth to the U.S. economy. By 1991, the Soviet Union collapsed under the strain low oil prices, debt, and military spending.

Things Fall Apart; The Center Cannot Hold

Treasury bonds became the effective reserve asset of the world. The U.S. put economic growth on a credit card that it never planned to pay off. Public debt increased almost 6-fold from the beginning of Reagan’s administration ($1 trillion) in 1981 to the end of Clinton’s ($6 trillion) in 2000 (Figure 5). By the end of Bush’s presidency in 2008, debt had reached $10 trillion. It is now more than $18 trillion.

The 1990s were the longest period of economic growth in American history. There are, of course, limits to growth based on debt but the new economy seemed to be working as long as oil prices stayed low. Then, Prudhoe Bay peaked in 1985. Total U.S. production declined, and imports increased sharply as the economy improved (Figure 4). Similarly, the world economy slowly recovered after 1985 with lower oil prices.

Consumer credit expanded under President Clinton through mortgage debt. Manufacturing had been progressively outsourced to Latin American and Asia, and the evolving service economy was underwritten by consumer debt that increased 7-fold from less than $0.5 trillion in 1981 to $2.6 trillion in 2008 (Figure 5).

The “dot.com” market collapse in 2000 and the September 11, 2001 terror attacks pushed the U.S. economy into recession and the Federal Reserve reduced interest rates below 2%, the lowest levels in U.S. history to date. Mortgage financing boomed.

The 1993 repeal of The Glass-Steagall Act allowed banks to package mortgage debt into complex, high-risk securities (CDOs or collateralized debt obligations). In what can only be described as out-of-control speculative greed and institutional fraud, CDOs, synthetic CDOs that bet on the outcome of CDO bets, and the credit default swaps that bet against both propelled the economy to levels of leverage and instability not seen since the 1920s.

“This was the new new world order: better living through financialization.”
–James Kenneth Galbraith**

From 2004 through 2008, world liquids production reached a plateau around 86 million barrels per day (Figure 5). Increased demand from China and other developing economies pushed oil prices higher as traders and investors worried that Peak Oil had perhaps arrived.

World Liquids Production and Oil Price in 2016 Dollars

Figure 6. World liquids production and oil price in 2016 dollars. Source: EIA June 2016 STEO and Labyrinth Consulting Services, Inc.

Oil prices soared to more than $140 per barrel and interest rates rose above 5%. The adjustable interest rates that underlaid much sub-prime debt also rose. Mortgage holders began to default and world financial markets collapsed in 2008.

The Second Coming

Debt and higher oil prices had spoiled the party. The problem was addressed with more debt and higher oil prices.

The Federal Reserve Bank brought interest rates to almost zero, created money and bought Treasury bonds while the government bailed out the banks and auto industry. OPEC cut production by 2.6 million barrels from December 2008 to March 2009 and oil prices recovered from $43 to $65 by May, and were more than $80 by year-end propelled by a weak dollar and easy credit.

Tight oil, deep water and oil sands projects that needed sustained high oil prices took off. Unconventional production in the U.S. and Canada increased 5 million barrels per day between January 2010 and October 2015 (Figure 7).

Incremental World Crude Oil + Condensate Production

Figure 7. Incremental world crude oil + lease condensate production. Source: EIA and Labyrinth Consulting Services, Inc. after Crude Oil Peak.

Tight oil used the same horizontal drilling and hydraulic fracturing technology that had been pioneered in earlier shale gas plays. The technology was expensive but once oil price topped $90 per barrel in late 2010 and stayed high for the next 4 years, the plays were deemed successful by producers and credit markets.

U.S. tight oil and deep-water production resulted in a second coming of sorts with monthly crude oil output reaching 9.69 million barrels per day in April 2015. That was 350,000 bopd less than the 1970 peak of  10.04 million bopd.

The difference of course was cost. In 1970, the market price of a barrel of oil in 2016 dollars was $20 per barrel versus $100 from 2011 to 2014, and $55 per barrel in 2015.

And this is precisely the problem with the almost universally held belief that technology will make all things possible, including making a finite resource like oil infinite. Technology has a cost that its evangelists forget to mention.

The reality is that technology allows us to extract tight oil from non-reservoir rock at almost 3 times the cost of high-quality reservoirs in the past. The truth is that we have no high-quality reservoirs left with sufficient reserves to move the needle on the high global appetite for oil. The consequence is that to keep consuming and producing as we always have will inevitably cost a lot more money. This is basic thermodynamics and not a pessimistic opinion about technology.

Nevertheless, in a zero-interest rate world, there was great enthusiasm for yields greater than conventional investments like U.S. Treasury bonds and savings accounts that continue to pay less than 2%.  Bank and mezzanine debt, high-yield corporate (“junk”) bonds and share offerings promised yields in the 6 to 10% range. As long as prices were high and the plays were marginally profitable, risks were downplayed and capital was almost unlimited. Two years into the oil-price collapse, capital is more limited because banks and investors have been burned.

Producers continue the mantra that costs keep going down and well performance keeps getting better. Those with some history and perspective, however, know and remember that they always say that but the balance sheets never reflect the claims.

In 1996, the late Aubrey McClendon made the following statement about the Louisiana Austin Chalk play:

“Today, because of improvements in horizontal drilling technology, you’ve got a play that could be the largest onshore play in the country, not only in size of potential reserves but also in a real extent.”

That play was a total failure for McClendon’s Chesapeake Energy Corporation and today Chesapeake is on the verge of bankruptcy for the second time.

People want to believe that things keep getting better and that they won’t have to change their behavior—even if these beliefs defy common sense and the laws of nature.

Slouching Toward Bethlehem

The oil-price collapse that began in July 2014 was technically about over-production. A surplus of unconventional oil from the United States and Canada, and a hiatus in geopolitical outages upset the world market balance and pushed prices lower.

Some have tried to emphasize the role that demand played. But there is simply no comparison to the 10 mmbpd demand destruction that occurred between 1979 and 1983 nor is this anything like the 2.6 mmbpd demand decline in 2008-2009.

This price collapse is simply different than the others. It more fundamental. The economy has been pushed beyond its limits.

Post-Financial Collapse monetary policies, the cumulative cost of nearly four decades of debt-financed growth, and the return of higher oil prices have exhausted the economy. Most debt is non-productive, interest rates cannot be increased, and 2016’s low oil prices are still one-third higher than in the 1990s (in 2016 dollars).

Producers and oil-field service companies are on life support. One-third of U.S. oil companies are in default.  Yet some analysts who have no experience working in the oil industry proclaim break-even prices below $40 per barrel and breathlessly predict that the business will come roaring back when prices exceed $50. Producers don’t help with outrageous claims of profitability at or below current oil prices that exclude costs and are not generally applicable to their portfolios.

As a result, the public and many policy makers believe that tight oil is a triumph of American ingenuity and that energy will be cheap and abundant going forward. The EIA forecasts that U.S. crude oil production will exceed the 1970 annual peak of 9.6 mmbpd by 2027 and that tight oil will account for almost 6 million barrels per day. Although I have great respect for EIA, these forecasts reflect a magical optimism based on what is technically possible rather than what is economically feasible.

Renewable energy will be increasingly part of the landscape but its enthusiasts are also magical thinkers.

In 2015, renewables accounted for only 3% of U.S. primary energy consumption. No matter the costs nor determination to convert from fossil to renewable energy, a transition of this magnitude is unlikely in less than decades.

Solar PV and wind provide much lower net energy than fossil fuels and have limited application for transport–the primary use of energy– without lengthy and costly equipment replacement. The daunting investment cost becomes critically problematic in a deteriorating economy.  Although proponents of renewable energy point to falling costs, more than half of all solar panels used in the U.S. are from China where cheap manufacturing is financed by unsustainable debt.

It is telling that energy and its cost can hardly be found among the endless discussions about the economy and its failure to grow. Technology optimists have disparaged the existence of an energy problem since at least the 1950s. Neither unconventional oil nor renewable energy offer satisfactory, reasonably priced, timely solutions to the dilemma.

As political leaders and economic experts debate peripheral issues, the public understands that there is something horribly wrong in the world. It is increasingly difficult for most people to get by in a failing global economy. That is why there are political upheavals going on in Britain, the United States and elsewhere.

The oil industry is damaged and higher prices won’t fix it because the economy cannot bear them. It is unlikely that sustained prices will reach $70 in the next few years and possibly, ever.

The British exit from the European Union adds another element of risk for investors. Lack of investment will inevitably lead to lower production, supply deficits and price spikes. These will further damage the economy.

The future for oil prices and the global economy is frightening. I don’t know what beast slouches toward Bethlehem but I am willing to bet that it does not include growth. The best path forward is to face the beast. Acknowledge the problem, stop looking for improbable solutions that allow us live like energy is still cheap, and find ways to live better with less.

—————————————————————————-

*J.K. Galbraith, 2014, The End of Normal, p.54. Much of the economic interpretation in this post is based on Galbraith’s work.
**J.K. Galbraith, 2014, The End of Normal, p.57.

Rig Count Matters: Separating The Signal From The Noise in Oil Market Opinion

Rig count matters. Saying that it doesn’t is like a realtor saying that location doesn’t matter.

Rigs Don’t Produce Oil

The holiest mystery of shale plays is that so much production is possible with ever-fewer rigs.

But if we look at the number of producing wells, the mystery evaporates. That’s because rigs don’t produce oil and gas. Wells do.

Horizontal wells in a few tight oil plays tell most of the story for U.S. production. Figure 1 shows the rig count and number of producing wells for the Bakken, Eagle Ford, Permian, Niobrara, Mississippi Lime and Granite Wash plays.

Tight Oil Rig Count & Number of Prod Wells

Figure 1. Tight oil horizontal rig count and number of producing wells. Source: Baker Hughes and Labyrinth Consulting Services, Inc.

Although rig counts decreased dramatically beginning in late 2014, the number of producing wells continued to increase until very recently. This may be a technical triumph for the drilling industry but it is no cause for oil producers to celebrate.

Average well costs are approximately $6 million so, despite falling rig count, the tab for new producing wells was about $3.9 billion per month in 2015. Add to that the cost of wells waiting on completion and other non-capital costs of doing business.

Many analysts and producers want us to believe that producing tight oil has become almost free thanks to awesome advances in efficiency and technology.

A rough rule of thumb is to multiply the monthly change in tight oil horizontal rig count by $6 million to approximate how much money is spent for new producing wells. There were about 2,400 more producing wells in 2015 than a year earlier in the Eagle Ford ($6 million per well) and 2,600 more in the Permian basin plays ($6.5 million per well). That works out to about $14 billion and $17 billion, respectively. For the Bakken where wells are about $8 million apiece, the cost for 2015 was $13 billion.

$45 billion for new producing wells in the 3 main tight oil plays in 2015—almost free.

Rig Count Matters

Rig counts are sensitive to price changes and generally excellent indicators of future oil production.The 4-week aggregate of weekly rig count changes accurately and quickly reflects changes in WTI price (Figure 2).

Tight Oil Rig Count Change and WTI Price

Figure 2. Tight oil rig count change and WTI price. Source: Baker Hughes, EIA and Labyrinth Consulting Services, Inc.

Oil prices began to fall in October 2014 and reached an initial bottom in January 2015. Monthly rig count change went negative in December 2014 and reached a maximum negative change in February 2015. When prices began to increase in April 2015, rig count change responded almost immediately.

Similarly, oil production followed changes in horizontal tight oil rig count quite closely and this includes total U.S. crude oil production, not just tight oil production (Figure 3) .

Tight Oil Rig Count Change & Crude Oil Production

Figure 3. Tight oil rig count change and U.S. crude oil production. Source: Baker Hughes, EIA and Labyrinth Consulting Services, Inc.

Production began to decline after April 2015 only 2 months after the maximum negative rig count change occurred in February.

Separating The Signal From The Noise

Oil companies tell us stories about new fracking technology, drilling productivity gains, and drilled uncompleted wells. These are mostly noise designed to distract us from the fundamental signal that the companies are losing a lot of money.

In order to navigate the uncertainties of investment, it is essential to separate the signal from the noise.

Companies and the minions of analysts and journalists would have us believe that rig count no longer matters. Pad drilling has relegated it to an anachronistic past that no longer applies in the brave new world of shale production where energy is impossibly cheap, abundant and profitable. This is a magical world where as the number of rigs approaches zero, oil production approaches infinity.

In this brief post, I have shown how that looks against the stark backdrop of facts. Rig count matters but it is only one factor that serious analysts use to try to decipher the signal amidst the deafening noise of oil-industry commentary.

The real signal is that all tight oil plays are losing money at current prices and will continue to lose money until oil prices reach and sustain approximately $65-75 per barrel. That scenario makes the doubtful assumptions that vast amounts of new capital will be available to E&P companies, and that the oil-field service industry will recover quickly.  It is equally probable that oil prices languish well below the cost of production too long and that the E&P and service industries may never be the same again.

Investors should contemplate those alternative realities carefully. That will be possible only if the signal can be separated from the noise.

Permian Basin Break-Even Price is $61: The Best of a Bad Lot

The break-even price for Permian basin tight oil plays is about $61 per barrel (Table 1). That puts Permian plays among the lowest cost significant supply sources in the world. Although that is good news for U.S. tight oil plays, there is a dark side to the story.

Just because tight oil is low-cost compared to other expensive sources of oil doesn’t mean that it is cheap. Nor is it commercial at current oil prices.

The disturbing truth is that the real cost of oil production has doubled since the 1990s. That is very bad news for the global economy. Those who believe that technology is always the answer need to think about that.

Through that lens, Permian basin tight oil plays are the best of a bad, expensive lot.

OPERATORS-RESERVOIRS 24 APRIL 2016

Table 1. Weighted average break-even price for top operators in Permian basin tight oil plays. Source: Drilling Info, company documents and Labyrinth Consulting Services, Inc.

Not Shale Plays and Not New

The tight oil plays in the Permian basin are not shale plays. Spraberry and Bone Spring reservoirs are mostly sandstones and Wolfcamp reservoirs are mostly limestones.

Nor are they new plays. All have produced oil and gas for decades from vertically drilled wells. Reservoirs are commonly laterally discontinuous and, therefore, had poor well performance. Horizontal drilling and hydraulic fracturing have largely addressed those issues at drilling and completion costs of $6-7 million per well.

Permian Basin Overview

The Permian basin is among the most mature producing areas in the world. It has produced more than 31.5 billion barrels of oil and 112 trillion cubic feet of gas since 1921. Current production is approximately 1.9 million barrels of oil (mmbo) and 6.6 billion cubic feet of gas (bcfg) per day.

The Permian basin is located in west Texas and southeastern New Mexico (Figure 1). It is sub-divided into the Midland basin on the east and the Delaware basin on the west, separated by the Central Basin platform.

Permian Basin Image File June 2016

Figure 1. Permian basin location and tight oil play map. Source: Dutton (2004), Drilling Info and Labyrinth Consulting Services, Inc.

The first commercial discovery in the Permian basin was made in 1921 at the Westbrook Field (Figure 1). It was followed in 1926 with the 2 billion barrel (bbo) Yates Field (San Andres & Grayburg reservoirs), the 2.1 bbo Wasson Field (Glorieta and Leonard reservoirs) in 1936, and the 1.5 bbo Slaughter Field (Abo and Clear Fork reservoirs) also in 1936. Reservoirs were chiefly high-quality limestones although the Wasson and Slaughter fields also produced from mixed sandstones and limestones that are equivalent to reservoirs in today’s Bone Springs tight oil play.

The Spraberry Field (1949) was the first discovery whose primary reservoir was among the present tight oil plays (Figure 2). Its ultimate production before horizontal drilling was estimated at 932 mmbo. The field had low recovery efficiency of  8-10% and was only marginally commercial prior to the recent phase of tight oil drilling.

Tight Oil Plays

I evaluated the three main tight oil plays.  The Trend Area-Spraberry play is located mostly in the Midland basin while the Wolfcamp and Bone Spring plays are located mainly in the Delaware basin (Figures 1 and 2).

Permian Stratigraphic Column June 2016

Figure 2. Permian basin stratigraphic column showing principal tight oil plays. Source: Dutton (2004), Drilling Info and Labyrinth Consulting Services, Inc.

The Wolfcamp play has produced the most oil and gas—205 million barrels of oil equivalent (mmBOE)*—and has the largest number of producing wells, followed by the Trend Area-Spraberry and Bone Spring plays (Table 2). All of the plays produce considerable associated gas and only the Trend Area-Spraberry is technically an oil play. The Wolfcamp and Bone Spring are classified as gas-condensate plays based on liquid yield.

PERMIAN PLAY CUM SUMMARY TABLE

Table 2. Permian horizontal tight oil play cumulative production, number of producing wells, liquid yield and oil classification. BO=barrels of oil; MCF=thousands of cubic feet of gas; BOE=barrels of oil equivalent using a 15:1 conversion from mcf to BOE; BPM=barrels of liquid per million cubic feet of gas. Source: Drilling Info and Labyrinth Consulting Services, Inc.

The Bone Spring play is the most commercially attractive of the tight oil plays with an estimated $49 per barrel of oil equivalent (BOE) break-even price for the top 5 operators. The Spraberry play has a break-even price of $55 per BOE for the top 5 operators but considerably higher well density and, therefore, lower long-term potential. Results from the Wolfcamp play are mixed with an average break-even price of $75 per BOE for the top 5 operators but $61 per BOE excluding one operator with poorer well performance.

Trend Area-Spraberry Play

I evaluated the 5 key operators in the Trend Area-Spraberry play with the greatest cumulative production and number of producing wells: Pioneer (PXD), Laredo (LPI), Diamondback (FANG), Apache (APA) and Energen (EGN) (Table 3).

TREND OPERATOR SUMMARY TABLE

Table 3. Trend Area-Spraberry play key operators’ cumulative production, liquid yield and number of producing wells. Source: Drilling Info and Labyrinth Consulting Services, Inc.

I did standard rate vs. time decline-curve analysis for those operators. The matches with production history were generally good as shown in the examples in Figure 3.

Permian TREND DCA Figure

Figure 3. Trend Area-Spraberry play examples of decline-curve analysis. Source: Drilling Info and Labyrinth Consulting Services, Inc.

Much of the gas production in the Permian basin is irregular because of periodic flaring so matching gas production history was sometimes difficult. Oil reporting in Texas is by lease rather than by well so there are periodic upward excursions of oil production as new wells on the same lease come on line. For these reasons, I feel that the decline-curve analysis results are probably optimistic.

The average Trend Area-Spraberry well EUR (estimated ultimate recovery) for the 5 operators is approximately 265,000 BOE using an economic value-based conversion of natural gas-to-barrels of oil equivalent of 15-to-1 (Table 4). The break-even oil price for that average EUR is approximately $55 per BOE. Laredo has the best average well performance with a break-even oil price of about $43 per BOE and Apache has the poorest well performance and highest break-even price of almost $92 per BOE.

TREND EUR-BE-OPERATOR SUMMARY TABLE

Table 4. EUR (estimated ultimate production) from decline-curve analysis and break-even oil prices for key operators in the Trend Area-Spraberry play. Source: Drilling Info and Labyrinth Consulting Services, Inc.

Economic assumptions are shown in Table 5.

PERMIAN ECONOMIC ASSUMPTION

Table 5. Economic assumptions for Permian basin plays. Source: Company documents and Labyrinth Consulting Services, Inc.

Wolfcamp Play

The top 5 producers in the Wolfcamp play are Cimarex (XEC), Anadarko (APC), EOG, Devon (DVN) and EP (EPE) (Table 6).

WOLFCAMP OPERATOR SUMMARY TABLE

Table 6. Wolfcamp play key operators’ cumulative production, liquid yield and number of producing wells. Source: Drilling Info and Labyrinth Consulting Services, Inc.

Examples of decline-curve analysis for this play are shown in Figure 4.

Permian WC DCA Figure

Figure 4. Wolfcamp play examples of decline-curve analysis. Source: Drilling Info and Labyrinth Consulting Services, Inc.

The average Wolfcamp well EUR for the 5 operators is approximately 228,000 BOE (Table 7). The break-even oil price for that average EUR is approximately $75 per BOE. That is because of poor well performance by Devon and EP whose break-even oil prices are more than $100 per BOE.

By eliminating EP from the calculations, the average EUR for the play is approximately 303,000 BOE and the associated break-even price is about $61 per BOE.

Anadarko has the best average well performance with a break-even oil price of about $45 per BOE and EP has the poorest well performance and highest break-even price of almost $177 per BOE.

WOLFCAMP EUR-BE-OPERATOR SUMMARY TABLE

Table 7. EUR (estimated ultimate production) from decline-curve analysis and break-even oil prices for key operators in the Wolfcamp play. Source: Drilling Info and Labyrinth Consulting Services, Inc.

Economic assumptions are shown above in Table 4.

Bone Spring Play

The top 5 producers in the Bone Spring play are Cabot (COG), Devon (DVN), Cimarex (XEC), Energen (EGN) and Mewbourne (Table 8).

BONE SPRING OPERATOR SUMMARY TABLE

Table 8. Bone Spring play key operators’ cumulative production, liquid yield and number of producing wells. Source: Drilling Info and Labyrinth Consulting Services, Inc.

Examples of decline-curve analysis for this play are shown in Figure 5.

Permian BS DCA Figure

Figure 5. Bone Spring play examples of decline-curve analysis. Source: Drilling Info and Labyrinth Consulting Services, Inc.

The average Bone Spring well EUR for the 5 operators is approximately 294,000 BOE (Table 9). The break-even oil price for that average EUR is approximately $49 per BOE.

Cimarex has the best average well performance with a break-even oil price of about $42 per BOE and Mewbourne has the poorest well performance and highest break-even price of almost $78 per BOE.

BONE SPRING EUR-BE-OPERATOR SUMMARY TABLE

Table 9. EUR (estimated ultimate production) from decline-curve analysis and break-even oil prices for key operators in the Bone Spring play. Source: Drilling Info and Labyrinth Consulting Services, Inc.

Economic assumptions are shown above in Table 4.

Commercial Play Areas

I made EUR maps for the 3 Permian basin tight oil plays using all wells with 12 months of production. I then used the average play EUR to determine commercial cutoffs for $45 and $60 per BOE oil prices using the economic assumptions in Table 4.

TREND EUR $45 & $60 6 JUNE 2016

Figure 6. Trend Area-Spraberry commercial area maps at $45 and $60 per barrel of oil equivalent prices. Source: Drilling Info and Labyrinth Consulting Services, Inc.

WOLFCAMP EUR $45 & $60 6 JUNE 2016

Figure 7. Wolfcamp commercial area maps at $45 and $60 per barrel of oil equivalent prices. Source: Drilling Info and Labyrinth Consulting Services, Inc.

BONE SPRING EUR $45 & $60 6 JUNE 2016

Figure 8. Bone Spring commercial area maps at $45 and $60 per barrel of oil equivalent prices. Source: Drilling Info and Labyrinth Consulting Services, Inc.

Using the calculated EUR-cutoffs for the two oil-price cases, 26% of Permian tight oil place well break even at $45 per BOE, and 40% break even at $60 per BOE price (Table 10).

COMMERCIAL WELLS TABLE AT $45 & $60 ALL PLAYS

Table 10. Number and percent of commercial wells for the Trend Area-Spraberry, Wolfcamp and Bone Spring tight oil plays at $45 and $60 per BOE oil prices. Source: Drilling Info and Labyrinth Consulting Services, Inc.

Current well density was calculated by measuring the mapped area of the $60 commercial area and dividing by the number of producing wells within those polygons. The Wolfcamp has the lowest well density of 1,269 acres per well and, therefore, the most development potential (Table 11). The Bone Spring also has considerable infill potential with 725 acres per well.

PERMIAN PLAY $60 AREA WELL DENSITY

Table 11. Current well density for the $60 commercial areas of the Trend Area-Spraberry, Wolfcamp and Bone Spring plays. Source: Drilling Info and Labyrinth Consulting Services, Inc.

The Trend Area-Spraberry has additional development potential but a comparatively lower current well density of 281 acres per well because there are more than 6,000 vertical producing wells within the $60 commercial area defined by horizontal well EUR. These vertical wells have produced 203 MMBOE to date, approximately equal to the 206 MMBOE for all horizontal wells both inside and outside of the commercial area.

Operators routinely stress the large number of potential infill locations in their investor presentations and press releases based on very close well spacing of, for example, 40 acres per well. Although well density is important for determining play life, I doubt that well spacing of much less than 100 acres per well is economically attractive because of potential interference between wells that are drilled horizontally and hydraulically fractured.

Investors should understand that more wells is not better. Superior economics result from drilling the fewest number of wells necessary to optimize production.

Operators also stress the potential for additional potential reservoirs within the same play reservoir. That is undoubtedly true but those are not yet discovered and are, therefore, resources and not reserves of any category based on the SPE Petroleum Resources Management System. If they are so attractive, why haven’t they been drilled and produced already?

Love In The Time of Cholera

Tight oil and shale gas plays emerged at a time of worry and angst about impending resource scarcity and the decline of America as an world energy power. For some, these plays renewed faith in the ingenuity and technology that made America great. Now, there are even widespread delusions about becoming energy-independent and using new-found resources for global political and economic advantage.

Tight oil was a story of bittersweet success because the plays were commercial only at very high oil prices. When prices dropped in 2014, many expected that these plays would collapse. Instead, producers have taken advantage of the lowest oil-field service prices in decades and the plays have emerged as low-cost leaders among important suppliers of the world’s crude oil.

Low oil-field service costs won’t last and neither will the low break-even prices shown in this post. Still, tight oil plays and two of the Permian basin plays in particular, will break-even at lower prices that almost all OPEC producers once fiscal costs are included (Figure 9). The cost to balance a fiscal budget is the equivalent of corporate overhead for a country whose principal source of income is oil.

But just because tight oil is low cost compared to other expensive sources of oil doesn’t mean that it is cheap. Nor is it commercial at current oil prices.

Projected 2016 Break-Even Oil Prices for OPEC & Unconventional Plays

Figure 9. Projected 2016 Break-Even Oil Prices for OPEC & Unconventional Plays. OPEC prices are IMF estimates that include revenue to balance fiscal budgets. Source: IMF, Rystad Energy, Suncor, Cenovus, COS & Labyrinth Consulting Services, Inc.

Since 2009, oil has never been more expensive. The average price in real May 2016 dollars is $83 per barrel, the highest in history (Figure 10). This average includes the year of low oil prices in 2009 after The Financial Crisis and the two years since the mid-2014 oil-price collapse.

CPI-Adj WTI Oil Price AVG Price Steps June 2016

Figure 10. Oil Prices in May 2016 Dollars, 1950-2016. Source: EIA, Federal Reserve Bank of St. Louis & Labyrinth Consulting Services, Inc.

Even during the period of the oil shocks from 1974 to 1986, real oil prices were far less averaging $68 per barrel. Today’s price of $48 per barrel remains higher than the average real price of $45 since 1950.

Those who believe that Peak Oil is a failed observation do not understand that it was never about running out of oil. Peak Oil was always about running out of cheap oil. That is an indisputable fact.

The Bone Spring and Trend Area-Spraberry plays of the Permian basin are cheaper than any major world source of oil except Kuwait. They are the best of a bad lot.

Gabriel García Márquez’s masterpiece Love In The Time of Cólera is a story of forbidden love. Cholera is, of course, a disease that comes from infected water supplies and can result in prostration from the loss of fluids (Cólera more commonly means anger or rage in Spanish).

Like a disease, the high cost of energy and debt, its corollary, have drained the life from our global economy over the last several decades. The economic benefits anticipated from lower oil prices after the price collapse did not materialize because prices never stayed low enough for long enough.

The period of high oil prices from 1974 to 1986 created great economic distress for most of the world including the United States. Those who want to make America great again recall the economic prosperity of 1987 to 1999 (Reagan-Bush-Clinton years) when real oil prices averaged only $33 per barrel.

The economic problems that lead up to the 2008 Financial Collapse included high oil prices from 2000 through 2008. The massive new debt incurred to remedy that crisis along with even higher oil prices have thwarted a recovery.

Since the 2014 price collapse, monthly oil prices were less than $33 per barrel for only two months in January and February of this year.

Many talk hopefully about renewed drilling now that oil prices are near $50 per barrel. I doubt that prices will stay at $50 but will, instead, follow the 2015-2016 pattern of cyclicity. Prices should trend higher but I don’t expect a major shift to new drilling or a return to the peak production rates of 2014 and early 2015. The industry is wounded and will not heal for many years if ever.

Tight oil may have bought us a few years of abundance but the resulting over-supply, debt and prolonged period of prices below the cost of production have exacted a terrible cost. Under-investment, a damaged service sector, weak oil company balance sheets and a decimated work force practically ensure cripplingly higher prices a few years in the future.

The calamity of our time of cholera is that we cannot escape ever-higher costs of oil production.
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*I use a 15 mcf per barrel equivalent conversion based on the price of natural gas and crude oil. The conversion based on energy content is approximately 6:1 and is used by most producers to calculate BOE EUR. The EUR reported by producers are, therefore, higher than those shown in this study especially for plays and wells with high gas-oil ratios.

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