- August 22, 2016
- Posted by: Art Berman
- Category: The Petroleum Truth Report
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.
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.
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.
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).
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).
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.
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).
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).
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).
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.
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).
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.
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).
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).
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.
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.
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*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.
I suppose OPEC and Russia will continue to produce as much oil as they are able as long as the US shale oil “miracle” continues on.
I presume if there were a coordinated freeze or cut, capital would just flow more quickly to the US public shale companies.
I have wondered, however, if this might be in OPEC and Russia’s best interests. Based on the information you provide above, the EFS and Bakken appear to be running out of locations. A 2 year drilling boom in the Permian may result in the same?
Shallow Sand,
It is unclear that OPEC has a strategy except to react in order to maximize advantages and minimize disadvantages. All of the explanations for OPEC/Saudi Arabia’s failure to act came from analysts, not OPEC.
An OPEC production cut would move oil prices a lot higher for awhile and then lower–maybe much lower–because everyone would increase production. A freeze would push prices somewhat higher for a shorter period of time until everyone figured out that it had no effect whatsoever.
I did not mean to give the impression that there are no more locations to drill in the Bakken and Eagle Ford, just that there are a lot more in the Permian. The well density values in Table 1 assume $70 wellhead oil prices. There are few commercial locations at today’s prices in any of the plays that can be identified with certainty ahead of drilling. As I wrote, Permian wells just lose less money than Bakken and Eagle Ford wells at this price.
All the best,
Art
With the world consuming 94 million bbl daily, I find it truly amazin’ that 150 million bbl over the average of 350 million bbl “on the shelf” is considered a glut. Seems like it wouldn’t take much of sumpthin’ to set things to “lean” right quick.
But I’m not concerned as I am sure the government is monitoring all this.
Arf Arf
Who’s producing what, daily (per https://en.wikipedia.org/wiki/List_of_countries_by_oil_production):
1 United States 11,973,000
2 Saudi Arabia (OPEC) 11,624,000
3 Russia 10,853,000
4 China, People’s Republic of 4,572,000
5 Canada 4,383,000
6 United Arab Emirates (OPEC) 3,471,000
7 Iran (OPEC) 3,375,000
8 Iraq (OPEC) 3,371,000
9 Brazil 2,950,000
10 Mexico 2,812,000
11 Kuwait (OPEC) 2,767,000
12 Venezuela (OPEC) 2,689,000
13 Nigeria (OPEC) 2,427,000
14 Qatar (OPEC) 2,055,000
15 Norway 1,904,000
16 Angola (OPEC) 1,756,000
17 Algeria (OPEC) 1,721,000
18 Kazakhstan 1,719,000
19 Colombia 1,016,000
20 India 978,000
21 Oman 951,000
22 Indonesia (OPEC) 911,000
23 United Kingdom 906,000
24 Azerbaijan 856,000
25 Argentina 715,000
26 Malaysia 697,000
27 Egypt 667,000
28 Template:Country data Yer Da (OPEC) 557,000
29 Libya (OPEC) 516,000
30 Australia 478,000
31 Thailand 422,000
32 Vietnam 316,000
33 Turkmenistan 276,000
34 Equatorial Guinea 269,000
35 Sudan and South Sudan 262,000
36 Congo, Republic of the 259,000
37 Gabon 240,000
38 Peru 180,000
39 Denmark 171,000
40 Italy 169,000
41= Germany 160,000
41= South Africa, Republic of 160,000
43 Japan 137,000
44 Yemen 127,000
45 Brunei 124,000
46 Trinidad and Tobago 116,000
47 Ghana 106,000
48 Romania 104,000
49 Chad 103,000
50 Pakistan 98,000
51 Uzbekistan 85,000
52 Cameroon 81,000
53 South Korea 79,000
54 Timor-Leste 76,000
55 Bolivia 67,000
56 Ukraine 66,000
57= Bahrain 64,000
57= Netherlands 64,000
59= France 61,000
59= Turkey 61,000
61 Tunisia 59,000
62 New Zealand 50,000
63 Cuba 49,000
64 Spain 40,000
65 Poland 39,000
66 Ivory Coast 37,000
67 Papua New Guinea 34,000
68 Syria 33,000
69 Belarus 32,000
70 Austria 27,000
71 Philippines 26,000
72 Hungary 25,000
73 Taiwan 22,000
74= Albania 21,000
74= Myanmar 21,000
74= Mongolia 21,000
74= Serbia 21,000
78= Congo, Democratic Republic of the 20,000
78= Niger 20,000
78= Singapore 20,000
81 Croatia 18,000
82= Chile 15,000
82= Virgin Islands, U.S. 15,000
84= Guatemala 14,000
84= Suriname 14,000
86= Belgium 13,000
86= Estonia 13,000
88 Sweden 12,000
89 Czech Republic 11,000
90 Finland 10,000
91= Lithuania 9,100
91= Slovakia 9,100
93 Greece 8,700
94 Portugal 7,100
95 Mauritania 6,000
96 Israel 5,800
97 Morocco 5,100
98 Bangladesh 4,800
99 Switzerland 3,900
100 Bulgaria 3,400
101 Aruba 2,800
102 Jamaica 2,100
103 Paraguay 2,000
104 Belize 1,800
105 Netherlands Antilles 1,500
106 Uruguay 1,200
107= Barbados 1,000
107= Georgia 1,000
107= Latvia 1,000
110 Ireland, Republic of 900
111 Puerto Rico 700
112= Costa Rica 300
112= Slovenia 300
114= Jordan 200
114= Malawi 200
114= Tajikistan 200
114= Zambia 200
118= Ethiopia 100
118= Hong Kong 100
118= Zimbabwe 100
Trader Joe,
What’s your point? Seriously.
All the best,
Art
So as I have mused for over a year now, with this repetitive cycle of Saudi chatter pushing up prices and high inventories pushing them back down again. How will we break into a reasonable price bracket? Will it take anarchy in countries that heavily lean on their oil revenues? We aren’t far away in Venezuela or in southern Nigeria. The Saudi/Iran paradigm will certainly keep a freeze in the realm of imagination.
Jesze,
It does seem that it may take outages to push prices to a “reasonable” level because demand is weak except at very low prices. That may be the most important take-away from my post.
I agree that a production freeze is mostly theater now as it was in late January and February. Sentiment is the only force available to move a market with such an outrageous inventory overhand. A chronically ill person has bad days and better days. So does this market.
Traders have to trade based on something because that’s what they do to earn a living. Lacking substance to bid the market up, sentiment must suffice. It’s not the Saudi’s or OPEC’s fault although they are not naive. It’s just the weird way that markets work.
All the best,
Art
Art,
I appreciate your arguments, you always provide ample support for one to follow your logic. I tend to agree with your correlation of Permian rig counts relative to Permian market share of US Tight Oil production, however you are ignoring several thousand DUCs that exist purely to satisfy continuous drilling clauses and make no sense to produce at current commodity prices. I would really like your work to be more forward thinking, these look back analyses lack substance. The are killing me.
Be good, keep up the good work,
The Armchair QB
Armchair,
I do not ignore the untold number of DUCs. They are Rumsfeldian unknown unknowns. I remember similar apocalyptic fears of shale gas DUCs in 2009-10 that turned out to be Y2K revisited. There are lots of DUCs when times are good so the interesting thing would be to know how the unknown number of DUCs compares with the ambient number.
I am a petroleum geologist. As a scientist, I deal with the present and its analogues in the past to help clarify probable directions for the future. I find that plausible explanations of the present are hard to find in the blizzard to analysis in the oil and gas industry. I try to fill that void.
Like you, I am interested in the future. I have learned, however, after a decade of public writing and speaking that most in the mainstream consider my analyses of the present to be controversial at best. Imagine the fodder that I would provide if I did what you want and began to speculate about the future!
I disagree that the present and past lack substance. I think that perhaps you are simply not very interested in them.
All the best,
Art
Hi Art
1. I see you using EIA and IEA data all the time but have never discussed the accuracy of the numbers. Lots of experts feel the EIA and IEA data are not always good numbers. What are your thoughts?
2. It is very clear that storage in the USA is at an elevated level. Other countries are starting to show some storage draw downs. There was an article on oilprice.com a while ago that shows storage in Saudi Arabia is waaay down.
http://oilprice.com/Energy/Energy-General/Saudi-Arabias-Oil-Storage-Falling-As-Exports-Exceed-Production.html
Do you have a sense for what the global storage levels are at? You start the article with a nice chart showing the world production/consumption but then your storage level chart is only the USA.
Art, I don’t think anyone knows which way the oil winds blow. It seems to me that even the data is faked, not to mention the jawboning by OPEC producers.
I say oil is headed to $70 barrel based on the mere fact that no one can service their debt selling it for less!
Touche Art, Touche.
FWIW, this is a conversation we should be having over a drink. Look, I get where you’re coming from – I have an M.S in Geology. I was about vague in my original post, so I’ll use an analogy; at my house we have one rule – if you want to complain about something you have to offer a solution.
So, don’t tell me that we have a balance in supply and demand and that’s why we have a false price rebound. Instead, show me a tornado plot of the sensitivities that could tilt us either way. Show me what happens to global supply/demand when Iran brings in Oxy or Denbury for secondary/tertiary recovery efforts. Hell, show me what happens to commodity prices in Q3 of presidential election years where the incumbent is not running.
Look, I love the work. I just find myself asking the proverbial ‘so what,’ more than I think I should. Like I said, this is probably a much more meaningful conversation in person…
Thanks Art, keep kicking ass,
Your Armchair QB #10
Art,
You briefly mention “long-term concern about supply because of under-investment” but isn’t it THE whole point? At these prices we lose close to 4mbpd from the legacy production, so as launches of projects started years ago (Kashagan, Pre-Salt) taper off next year, what is going to step into the void? Even using Sheffield’s rosy projects 3mbpd extra from Permian before 2020 can’t plug that hole unless prices go way up. And about OPEC. Iran is projecting 500kbpd increase from 2020 to 2025. KSA/Russia/Iraq are pumping at max, what is the spare capacity?
BRs,
Che
Nice. Two quibbles. First, Venezuela doesn’t have more oil than the House of Saud, they have lots of tar crud that isn’t the same thing. Same with Canada … and any guess of the true size of OPEC reserves are likely to be wrong. I like Colin Campbell’s quip that with these reports the only correct numbers are the page numbers.
The downslope in fracking due to debt and depletion is likely to trigger the next economic shock, probably in the Clintons third term (next year or 2018?).
Armchair, Art’s point about not speculating on the future is a profound inference based on his experience.
Exactly what Ben Graham said in an earlier time, the greatest investor who ever lived. Markets would be well advised to focus on the past and what it may mean in broad terms for the future and protect themselves from the nature of unforeseeable events rather than speculating on them.
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Dear Art,
You did a fantastic piece on US Nat Gas earlier in the year.
“Natural Gas Price Increase Inevitable in 2016”
I was wondering if you were thinking of doing an update to that piece (it would seem to me that your thesis is playing out spot on, which would suggest that 2017 is going to get very interesting).
Much appreciate all your hard work,
Thanks
Alex
I wrote a comparison of water handling in production cost between Midland PXD and STACK NFX.
http://seekingalpha.com/instablog/35805355-nuassembly/4914375-comparing-cost-water-midland-stack
I think PXD is hiding the real cost. Don’t you hear that Permian is also having more earthquakes now?
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