- July 27, 2016
- Posted by: Art Berman
- Category: The Petroleum Truth Report
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.
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.
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).
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.
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).
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.
The most active operators in the 3 most-productive plays–the Permian, Bakken and Eagle Ford–are shown in the table below.
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.
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.
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.
Thanks for another great article. I really enjoy hearing the other side of the story. My understanding is that tight oil accounts for less than 5% of global production. The recently added rigs, which have yet to produce a single drop of oil, can’t add more than 0.01% to global production, I would think… but will likely not even significantly offset legacy depletion. So how can the addition of this insignificant development activity cap the rally in the global oil price? I don’t see the fundamentals changed by the addition of a handful of rigs. Seems to me there is something bigger in play here. Is the transmission mechanism price manipulation through the US futures markets? Are the US financial markets that powerful? Who is crushing the price? A deep pocket player with political motivation?
Joe,
Thanks for your thoughtful comments. You make some very good points.
In the world of commodities, 1% above or below market balance is the difference between a glut and a shortage. U.S. tight oil is approximately 7.5% of world crude oil and lease condensate production (6 mmbpd of tight oil based on EIA DPR data vs 80 mmpbd based on EIA International data). 6 mmmbpd is more than enough to tip the global balance.
You are correct that many of the wells being drilled now will not go on production for a long time. Still, markets somehow anticipate the price needed to maintain supply. Right now, the markets are anticipating more than adequate supply at a lower price than they did a month ago. A lot of that change is because of renewed drilling of tight oil. A lot is also based on outages disappearing and more supply anticipated from OPEC (mostly Iran and Iraq).
U.S. markets are powerful. I don’t believe, however, that any player is powerful enough to conspire to crush prices for any meaningful length of time. The world is doing an excellent job of crushing prices just by everyone looking out for their own interests and that means cash flow even at a loss from more production.
All the best,
Art
Art, your work is phenomenal. I have read all your articles and presentations, watched all your videos and listened to all your podcasts that I could find on the Internet. Please know I am very grateful for your work.
Very grateful because until I studied your work I was unable to synthesize oil and gas data and information, markets and economics well enough to understand the truth about the upstream oil and gas industry (upstream). I have been searching for the truth for over 30 years as a veteran upstream degreed petroleum engineer.
Your work has cohered my numerous pieces of knowledge sufficiently that I am in total agreement with your work. And your work has relieved me of great pain and anxiety. I now use your work and my understanding to guide me in my decision making as a working upstream petroleum engineer. I also share your work with others to help them.
I learned of you by happenstance searching for answers and to relieve the pain and anxiety of not knowing and/or understanding the truth about the upstream. It is an understatement that I am grateful to you for your work and how much I respect and admire what you have graciously provided me and the public. Thank you.
I recognize you are very busy, but would it be possible to speak by phone or e-mail to share data, information or have short conversations that may afford us greater clarity? If yes, I would appreciate that opportunity and thank you in advance.
All the best, Art, and you and yours please stay healthy and safe. Scott.
Scott,
Thanks for your kind comments!
All the best,
Art
Art, I read you post and have for a while. I would say that companies need some kind of cash flow even if they are breaking even or loosing some in order to pay notes and hold employess.
They have no choice maybe, respectfully.
Walter,
That is what I said:
“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.”
We all make decisions.
Shale companies took the advice of their investment bankers to “leverage up” in order to get the valuation multiples based on perceived growth that would boost stock prices. Let’s never forget that the ultimate goal of most of these companies was to develop assets enough so they could sell the company and cash out, thereby liquidating the debt by having the buyer assume it.
That worked for a lot of companies and still works today (e.g. GeoSouthern’s acquisition by Devon). But it didn’t work for most because they hung on too long and then prices cratered. And, voila, the current situation.
I am not trying to be overly critical of these companies but rather, to describe the reality of their current situation. Neither am I trying to be overly sympathetic to them. My job is to inform those who are looking for industry insider insight. If I seem critical, it is because the truth is not kind to those who have made poor decisions.
All the best,
Art
Art: Why is the Permian in such favor, despite onerous royalties (25%) and wells that are generally inferior to both the ND Bakken and the Eagle Ford Shale?
For example, in Martin and Midland Counties, I find 916 horizontal wells with first production since 1/1/2010. Only 33 have managed 200,000 cumulative barrels, and 22 of those are located on just four leases.
Yet, acreage is selling for as much as $60,000 per acre, rigs are being added, and despite serious losses, the companies operating there are Wall Street darlings.
What gives? In ten years there are going to be over 25,000 15-22,000 Ft. TD well bores classified as stripper wells in the Permian Basin (under 15 BOEPD). I wish the operators of those the best of luck.
As for the STACK, when did the Woodford become an oil play, and how can wells which completely quit producing liquids in 12-24 months be considered in an oil window.
Enough of the complaining, this has just been a tough slog, not ending anytime soon, I am afraid.
Really enjoy your articles.
Shallow Sand,
The Permian basin is attractive mainly because it is perceived to have longer-term potential than the Eagle Ford or Bakken. It is ironic that shale players are having a hard time telling a growth story after only a handful of years of tight oil development considering that their narrative is unlimited potential for decades at least.
But the reality is that the core areas are defined in the Eagle Ford and Bakken and you are either a have or a have-not and there is not much that can be done to change that short of buying another company for a premium.
The Bone Spring and Wolfcamp are still being defined and have very low well densities now. Entry is still possible albeit at increasingly prohibitive prices. It is a hyper-mature basin with hugely complex leasehold and that makes it possible for companies to find ways to enter.
The other factor is cash flow. The early rates are higher for Permian plays and that is important. Everyone may be losing money but the NPV is less negative for wells that have higher early flow rates.
The Woodford confuses me. It is a gas play and the EURs that we forecast are much lower than the operators claim. We are used to that by now but it is troubling because Oklahoma production reporting is the worst. That leaves the door open to the possibility that we do not have all the data and are being mislead by it.
All the best,
Art
Thank you for your hard work. The information you give here is appreciated.
Tim,
It is gratifying to know that you appreciate the effort.
All the best,
Art
Art, in the comments the word truth is almost dominating as people understand that without truth is impossible to build anything sustainable. But the whole “shale” saga has been built on misunderstanding, ignorance, misrepresentation, and, yes, lies/. After 15 years and 70 thousand wells drilled there is no innovations except in drilling. The crazy idea that the fracking will take care about everything has blocked all attempts to lower multimillion completion costs. The bankers like to have a nice story. Initially they got a story that shale gas is something absolutely new and unknown in petroleum geology. Wrong. Now they got the idea that very long horizontals will solve all problems. Wrong. There is only a weak correlation between the length and reserves. And so on.The main result of the Shale revolution is that there are hydrocarbon reserves in naturally fractured reservoirs like, including those “shales”. But to make their development economically sustainable there is a need in step-changing geological (methodological) ideas and technical solutions. And your work, Arthur, provides for cleaning the rode by telling the truth
Simon,
Thank you for your thoughtful comments. I fully agree.
Technology is not energy. It is a means of converting energy into work.
Tight oil is a poor source of energy and, therefore, requires a huge amount of work to get it out. The oil found in shale is the residual volume that the considerable natural forces of subsurface pressure and heat were unable to expel into reservoir rocks.
The technology required to do what the earth could not requires extraordinary input of work that we can roughly measure as high cost. This is a polite and scientific way of saying, Garbage in, garbage out.
There is no way around fundamental physics but people want to believe in miracles. And they believe that technology is a miracle because they don’t understand the science behind it. I say to them, You don’t need to understand the technology; just look at the cost. That is something that everyone understands. But first, you have to get far enough beyond the propaganda and lies to ask the simple question, What does it cost?
I have told those who bother to read my articles what it costs. I am not against the shale plays. I just want people to understand the truth. The truth is that the real cost of producing a barrel of oil is 3 to 4 times what it was 15 years ago. That is the added cost of technology–technology to extract oil from shale, tar sands and deep-water reservoirs. It is neither good nor bad.
It is what happens when the world runs out of new, high-quality sources of oil.
That is the truth.
All the best,
Art
Hello Art
Firstly thanks for your great and insightful website, I really enjoy learning about the oil market from the information you concisely lay out.
Just to clarify on one point, by way of example, your chart mentions that Marathon has a Debt to Operating cash flow of 24.6x, but from looking at the latest financial statements I see total liabilities of 13.37b and operation cash flow of 1.1b which appears to be about 12.1x, am I missing something here? Was hoping to clarify how these ratios were being calculated?
Best Wishes
Fred
According to news headlines today (August 11, 2016) from the IEA the oil glut is gone. “The International Energy Agency said Thursday that the previous oil glut has disappeared, but it warned of weaker demand on a “dimmer macroeconomic outlook” in 2017.”
Where do they get their data to come to the conclusion that the oil glut is now gone? Amazing! Regardless of what IEA announces I plan to keep my eye on the 524 mm bbls that the US is holding in inventory. Regards,
[…] 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 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 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 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 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 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 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 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.” […]
[…] late July, I wrote, ‘When prices fall and oil-price volatility increases, the floodgates of capital […]