- April 9, 2017
- Posted by: Art Berman
- Category: The Petroleum Truth Report
Shale companies have pushed break-even oil prices below $40 per barrel—but so have major oil companies.
Analysts commonly portray cost reduction as something unique to the tight oil companies. Data from annual reports filed with the U.S. SEC (Securities and Exchange Commission) suggests otherwise.
Along with tight oil companies, ExxonMobil, Royal Dutch Shell, ConocoPhillips and ChevronTexaco all had 2016 break-even prices below $40 per barrel (Figure 1).
SEC 10-K and 20-F filings include the standardized measure, a projection of discounted (10%) future net cash flows from production of proved oil and gas reserves. By dividing the standardized measure by the volume of proven reserves, break-even prices can be calculated by subtracting the future cash flow dollar-per-barrel amount from the SEC average price for the year.
How is it possible that ponderous major oil companies have similar break-even prices as much smaller, innovative shale companies? Simple–costs have fallen for everyone since 2014 as oil field service companies competed for limited projects by working at a loss.
In fact, the oil and gas well drilling producer price index fell 45% between March 2014 and January 2017 (Figure 2). As I wrote in an earlier post, sharply lower break-even prices are 10% technology and 90% industry bust.
And for those who think that unconventional oil and gas are low-cost resources, those plays resulted in a 4-fold increase in the cost of drilling wells between March 2003 and March 2014. That’s why oil cost more than $90 per barrel for 4 years before the price collapse.
So much for technology solving all of our energy problems.
And when you hear about tight oil companies breaking even at $20 to $30 per barrel—that’s not what they told the SEC in filings made just a few weeks ago.
The Downside of Lower Break-Even Prices
The downside of lower break-even oil prices is that companies make a lot less money in the future. Companies must write down reserves whose development costs are greater than their market value at lower oil prices. Figure 3 shows that future net cash flows were on average reduced by about two-thirds in 2016 compared with 2014.
Companies are effectively high-grading their assets by writing down wells with poorer performance. Break-even price is lower because only most profitable wells are included in the calculation. Plus, the burden of taxes in addition to property and equipment costs associated with written down assets are removed.
The key take-away is that 85% of lower break-even prices were realized in 2015. Incremental improvement in 2016 was only 15%.
Advances in technology and efficiency are real but falling break-even prices are no miracle and are not a shale company exclusive. Instead of celebrating lower break-even oil prices, we should be lamenting lost future cash flows that an oil industry depression has wiped out.
Art,
You’re comparing apples and oranges. There is not enough public data to actually do a good analysis. The thing that matters is the break even on a new development. Practically everyone can break even when you don’t include developments costs. Also the majors benefit from production sharing agreements that serve as a way to stabilize profit in down cycles. This doesn’t mean that new development is break-even at $50. In fact it is usually profitable far below $50 except that they have to share the revenue with a local government. So for the majors to make money in this environment they way they used to be able to, local governments have to be willing to take a lower split. That may happen but hasn’t yet, which is why Exxon needs to drill in the Permian. This unique aspect of international projects is why cycles can be so long in the oil industry.
Best,
HS
Best,
HS
HS,
I value and appreciated your comments and concerns but do not agree with you. The standardized measure does include development costs and provides the closest thing to a levelized basis for comparison of companies with quite different exposures. I don’t think that international PSAs vs less complex U.S. land-based assets make as much difference as you believe when the measure is discounted net future cash flows.
All the best,
Art
Art,
Likewise, I value your opinions. And I think in terms of global oil production over many years, shale is likely to be a retirement party (because I think it will be harder for the rest of the world to execute on what has happened in the US), but it is hard to say how long. That said, it is a technological revolution nonetheless and if one looks at what has happened to gas prices over the past decade, that should be clear. Although I am not bullish on natural gas, this is not to say it will stay below $3/Mcf forever, but we’re not headed back to an environment from where we came, so yes a technological revolution (thank you George Mitchell).
As for PSAs, given that they are and have always been written so that the majors are able to recover costs in all price environments, I do in fact think they are totally different in terms of analyzing break-even prices and without having the detail about the value of the undeveloped resources vs. already developed or in-process, it is impossible to compare across the sector. I will not also note that PXD for example, as a matter of policy includes almost no PUDs in their reserve report, which also makes comparing across even shale problematic. My opinion on the matter is that companies should have to release their whole reserve report, but due to political lobbying by the companies that never happened. There are ways to try and decipher the value of these reserves and they vary by company and they are not anywhere near perfect. The more complicated the company the harder it gets.
We do live in an uncertain world and predicting where the largest commodity in the world will trade in 5 years is extremely difficult. Because 5 years ago few where talking about the Permian, and 5 years before that few would have predicted how shale would have affected gas prices, and five year hence who knows what they will be talking about (though I have some ideas). It’s interesting that people are willing to invest capital (and even create a bubble) in a space that has gone through such a technological revolution in such a short period of time. There is a paradox embedded in shale, which is that if there is a lot of acreage that really is worth $20,000 an acre in the Permian (and the Permian is very big) at today’s oil prices then how can people really be expecting oil prices to go up a lot also (which is implied in the valuation of pretty much all E&P companies). One of these is wrong, and maybe both. Now that is fascinating.
In most cyclical industries, the valuations fluctuate a lot from the top of the cycle to the bottom of the cycle, in the oil industry apparently that doesn’t apply. Exxon not really off that much from the high (Pioneer and EOG also). And while spot prices are well off their lows, the forward prices are not very far from their lows. And yet the private market value of all the shale acreage is substantially higher than it was a few years ago (back to my paradox). The equity investors are a little crazy, the private equity investors are a little crazy. The sane people at the table are likely the traders who set the forward prices. The .com bubble is was started by a technological innovation (the Internet) that provided vast benefits to consumers, and got a lot of investor very excited about the opportunities, but very few companies ended up doing well as a result of the innovation. Sound familiar?
I think we’re range bound between $40 and $60 for a good long while, unless the people who set equity and private equity values wake up. Because as an operator, if you have a lot of acreage that you have told your investors “works” at $40, then you have to ramp up drilling at $50, otherwise you’re a liar (commitment/consistency). I am using real price here, not nominal, if there is service sector inflation oil will be nominally higher, but just because we’re in a service sector depression, doesn’t mean we’re going to have a massive spike here. Usually that requires a long depression in the service sector because things like rigs don’t just vanish in a few years, they’re just stacked and we very likely have more than we need for a good long while (generalizing here).
All the best,
HS
I do not believe we are range bound at “40 to 60” as the previous commenter predicted.
I expect continuation of significant declines in ex-US non-OPEC production in 2H17, as opposed to IEA’s prediction of production growth.
I expect IEA to adjust its production forecast significantly given record-low ex-US rig count persisting through March, despite higher oil prices.
We are headed for significantly supply deficit in 2H17, whether OPEC cuts get extended or not.
“The…investor is neither right or wrong because others agreed or disagreed with him; he is right because his facts and analysis are right.” – Ben Graham
Yaman, I await your facts and analysis…
HS
Does that mean that the oil companies are cash flow positive at $40 for the time being and the risk of bankruptcy shifts to oil service companies? Or they make profit only if you exclude taxes, interest, amortization etc.?
Thank you,
alt
This seems like a 180. Not long ago you published this chart
http://euanmearns.com/what-is-the-real-cost-of-oil/
that shows 2016 break even prices being higher than this current article. Why are these number so much lower than what you put out before?
Shale is it’s own worst enemy. I thought the price crash would have instilled some discipline in the capital markets (drillers are going to drill that’s what they do.) Instead Firms managed to double down with the same exaggerations as before (this time on the Permian) as a new and creative way to con the markets into supplying fresh capital. The lack of consolidation of the shale fields into the hands of operators with a semblance of a decent balance sheet never really happened. This will continue to be self-defeating for oil prices particularly in the Permian where we may end up with a giant bottleneck in pipeline capacity for both oil and gas. This will (and already is) forcing steep wellhead discounts. Go take a look at XOM, Shell, and CVX’s presentations on the Permian. If they spend the kind of money on developing the Permian that they are setting out in these presentations then West Texas is going to drown in oil along with most major storage facilities.
That said, the Permian does appear to work at $50 oil in quite a few places offering return on investment not just breaking even. I do my own decline analysis, discounted cash flow etc. so I am not just basing this on what these companies say. I was skeptical at first but a wide range of well results now coming online look pretty impressive. I would be happy to offer examples if we are not on the same page concerning the data. As we speak, the service companies are coming for their pound of flesh. In this sense, $60 oil is essentially no different than $50 could be worse. Pressure pumping services, sand etc. are all reflating due to serious lack of supply. Rigs are probably next.
As an investor, none of this matters. The promise of what these firms COULD make in the future is always more exciting than what they will make when the time comes. This is baked into market psychology and has injected an unsustainable growth premium into the share price of mostly all firms. If you have to be invested in this sector, I suggest the service companies with pricing power and scarcity of service who can corner the Permian. Some of them still look cheap too.
Best,
Ryan,
Thanks for your usual excellent insights. I agree that there are areas of the Delaware basin that make some economic sense at $50 WTI. Two cautionary notes: extremely high decline rates for recently drilled high-rate wells, and 75-80% water cuts.
All the best,
Art
Ryan,
I agree with you that excluding land cost, there are quite a few places in the Permian that work fairly well at $50 (have also done decline curves of my own). Once you include any semblance of a market value for land (and as an operator what you paid is irrelevant to the analysis…I’m looking at you Mr. Sheffield), then none of it works. What some of the PE companies and large operators have figured out is that if you have to deploy capital in the space you might as well pay top dollar for top quality acreage. In theory you have leverage to higher prices and because you’re current drilling doesn’t lose money (ex: land) you can survive until the next cycle without the losses that the people with 2nd tier acreage take. So there is a rationality to their approach given the crazy environment and the fact that they have to deploy capital that had been raised for E&P investments. Of course if you’re not a part of the solution, you’re a part of the problem and this is definitely making the problem worse. But which private equity company is going to hand back capital and tell their investors that there are no opportunities in the space? Despite what my four year old daughter believes, there are no unicorns.
I am curious on your statement about there being cheap service companies out there. Most of what I see, in the public market at least, are hard asset service companies that trade above the replacement value of their equipment. Private market values are definitely lower if that’s what your’re talking about. My understanding is that there was quite a large list of private companies that were looking to IPO to arbitrage this value differential, but that most of these are in process of being shelved as nothing turns off buyers like a long list of sellers…
Best,
HS
Very interesting fodder on this topic and one that my colleagues and I turn over daily. What we are witnessing right now is the power of money and an overheated Private Equity push into oil. PE firms have turned the Permian into a “Land” play versus a regular shale oil play. Yes, some of the economics work at $50 oil and some don’t. We mostly hear what the arm-wavers want us to hear which is their best wells…on their best acreage. Art is mostly correct about breakeven costs going down for everyone…HS is mostly right also about some of the wells being true “monsters”. Again, we don’t hear about the ho-hum wells because it doesn’t serve any companies’ interest to do so.
PE Firms have turned the Permian into a “Land” play: The turn-and-flip goal of PE firms works as long as they can get in and out in their 3-5 year window. They are not usually fans of hanging around for the long haul like EOG, Concho, Pioneer, etc. who have to make it work from “cradle to grave”. Eventually, the land price bubble will pop and the party will be over for the PE firms. I’ve read a lot of the press releases about recent land prices and they have been paying up to 4 times as much for land as they were when oil was ~ $100! This feeding frenzy must eventually stop.
To summarize, Yes, oil companies can make positive cash flows at $50, however, I can promise you that none of them are doing well in the traditional sense. Heck, the market is rewarding oil companies for almost breaking even…
I have also enjoyed the exchange. TL one for you…wasn’t the Eagle Ford one big “Land” play too? EOG being the biggest winner.
It’s interesting that both EOG and and it’s former CEO have done a 180 on the Permian. I agree no one is doing well in the traditional sense. It’s interesting the both Exxon and EOG (the most level headed of both sides of the spectrum) have both recently done acquisitions in the Permian with stock (even though neither traditionally issues stock for acquisitions). Yes there are definitely parts of the Permian that work quite well. For Exxon there might be some global benefit from demonstrating to the world that they have other opportunities in a $50 price environment (on top of the fact that at its current valuation issuing stock is likely a very good move).
I too have been waiting for the bubble to pop and thought the oil price collapse would have brought it…wrong! The whole thing is a bit complicated (talking about shale in general, not just the Permian) because if the markets (public and private) were to get some discipline and stop providing capital, then oil prices would rise, and the acreage would then possibly be worth some of the prices being paid. So the logic is a bit circular. Regardless, the amounts that we’re talking about with PE firms are substantial but they are not that much when measured against the plans by some of the majors to aggressively ramp drilling in the Permian. Which in my opinion is what will keep a lid on prices.
As a side note (and I’m going to continue to pick on Pioneer), when you have drilling opportunities for 30+ years (in theory, reality might be different) it is very hard to make enough money on the market value of those drilling opportunities to justify maintaining that much option value (read: acreage), but as long as the equity market continues to value them the way it does, they have no good option, but to continue issuing equity and using that capital to ramp up drilling. This is another example of rational behavior within a bubble, that doesn’t help the situation (but should help keep a lid on prices). The next logical step is for Exxon or Chevron to use lots of stock to buy either EOG or Pioneer, but then the market has been waiting for this for ages…
HS,
Don’t forget that ExxonMobil acquired XTO with stock.
All the best,
Art
Thanks Art for your reply, and again, good points. The Eagle Ford was similar to what we’re seeing in the Permian now, but the difference to me is the influence of PE money. The Eagle Ford was the proving ground for oil from shales…and it worked, technically and economically (especially with higher oil prices). It worked best for EOG who got in early when land was cheap, hence what they call “First Mover” advantage. The same first movers into the Permian (or at least the companies that were already there for other reasons) have been richly rewarded by their land prices increasing dramatically. In the case of Pioneer, they couldn’t help the manna from falling from heaven so to speak since others proved up their legacy acreage for them. They took advantage of being in the right place at the right time. However, for the majority of the PE firms, as well as some of the late-comers to the Permian, they currently have very little margin to work with if they want to develop leases in the traditional sense due to the high cost of entry. So the “Land Play” to me is just that. The PE firms are flipping land because that is the way they have found to make a quick dollar in this market. Everyone is feeding the hype, although perhaps for their own particular reasons. The public companies are waving arms and dancing for Wall St. analysts, while the PE firms are perpetuating the feeding frenzy that is critical to their continued success, and still others are just happy that other people are happy. It is truly an interesting time in our industry…very frustrating, but interesting. I had long stints at a couple of the companies that we’ve mentioned in the thread, and some of the recent prices paid for land are too high unless there is sustained political unrest in certain parts of the world that would threaten supply and thereby bolster prices. All the best to everyone, TL
Yes Art. Good point. XTO was not exactly a stellar deal, but outside of Asia (and Guyana) nothing they have done has been very stellar for quite a while. The oil sands screw up in Canada was just massive. Fabricating large pieces of equipment overseas that you haven’t adequately thought about how you’re going to get to the site you’re building is one for the history books…
Best to everyone,
HS
Art,
Your readers owe you a big thank you- not just for the websites content but also for your responsiveness. In an era of internet trolls and detractors, that is truly an admirable quality. Especially considering that the commentariat here (me included) is unlikely as qualified nor skilled at parsing through the abundance of data and extracting insightful meaning.
I always enjoy your posts and subsequent commentary. Thank you for engaging with your readers as we all take a collective step towards understanding the “new normal” in this industry. For me personally, my job description is fairly limited to buying leases and making sure my field contractors support me with title but my curiosity about my company and many others “end goal” is not so limited. I have set out to better understand the short term and long term economics of shale. Along the way, I have found your voice to be especially prescient regarding how we view the truth (whatever that may be) of shale’s value. I do not always agree with your conclusions but I respect them and use them to challenge my own biases. I would like to add a couple more non-sequitars to the thread:
1.) Land values. I have never bought a single lease in the Permian so I might not have all my facts straight. In the EF, price per acre got pretty high at times. It mostly paled in comparison to the development cost and when amortized over the life of lease (assuming it would be in-filled) did not have a significant impact on the well economics. Some of what I am hearing in the Permian (20 k+) may change that dynamic although many of the deals we are hearing about include “flowing BOE” which accounts for more of the cost than just the raw land. Maybe it was HS who mentioned the “cradle to grave” companies. IMHO, this is likely the best model. Shale was never designed to spin off fcf for investors in the short run. However, if a company has a large enough runway- the idea would be to drill wells that can return capital plus a small profit within 3 years leaving the tail of the well to build a pillow of cash flow over a long period of time either through divesture or hoping the production covers the opex for long enough to keep a company-wide backend rate stable. The problem is these companies never stop exploring and thus are forced to drill a bunch of step-out, delineation, or HBP wells which hurts the discipline needed to profit.
2.) Service Companies. Certainly not all are cheap and the days of $100 dollar oil windfalls are over. As an investment idea it is more about matching valuation to companies who can grab a piece of the money that will be spent on the Permian in the next few years. Not really wanting to pump specific stocks but Select Sands and Trinidad Drilling would be my picks.
3.) The PE companies are doing the same song and dance they did in the other plays. The greater fool theory if you will. Unfortunately, the greater fool is usually the equity markets. Case in point, Halcon: Floyd Wilson was supposedly one of the smartest oil men around. He built up position of fringe acreage in EF that needed $120 plus oil to work. Sold some stock, probably made a bunch of money for himself, went bankrupt, wiped out legacy shareholders, re-organized, and sold new equity to buy some more fringe wolfcamp acreage in Pecos County. I don’t know if I consider this kind of thing relevant to our business. Stupid people winning stupid prizes like the kids say.
4.) For Art, I looked at your Shell chart. While I have not studied the data enough to know if declines are worsening as the vintage data suggests, I would like to point out that significant progress has been made on the front end for the Delaware wolfcamp. Intuitively, it seems that operators stand a better chance of improving EURs on the front end where completion technique, well bore landing etc. can play a bigger role. This also intimates that percentage declines will be higher as the well becomes bounded by the reservoir traits. This could wind up being positive or negative. Faster payout is certainly better. Sweeping the reservoir and drilling inefficient fill-ins not so positive. You have made some pretty compelling points to the latter in some of your other posts. I still think that is the Trillion dollar question. Shale needs lots of predictable locations to work in the long run.
Also, I agree with your analysis of high water cut. I may be improperly modeling opex for many of these wells. I find it hard to put down a number for that though. Most operators are going to build out SWD facilities (one would think) as relying on trucking is exceedingly expensive.
5.) Shell- I do have a small quarrel with Shell. They are either really bad at drilling these wells as the data from their offset operators would suggest or they have sub-optimal acreage in the Delaware. I think it is likely both. The lower GOR wolf camp in Southern Loving doesn’t look so good to me. The border of Loving Lea where they share a contiguous position with EOG has got me puzzled. The 18 month cum rates for EOG are almost double that of Shell. The data is pretty skewed across the vintages as well. To me, EOG’s decline rates don’t appear to have changed much from months 6-18 although the first 6 months has improved. What gives with Shell?
6.) For HS, I’ve noticed that you cited Mark Papa’s new company a few times. I would argue that he executed the PE model quite well. I find CDEV to be one of the only investable names out there. (only shale co in my portfolio.) Stockholders wrote him a check upfront to shop around the shale patch when it was at its lowest point. He picked a nice area with well economics that work at $50. At least the core of it does assuming high-grading. No legacy debt. No unproductive acreage. Optionality on different Wofcamp benches and bone spring at higher prices. The high GOR Silverback acreage looks particularly nice with the last round of wells looking pretty stellar. He did do a 180 on the Permian since his time at EOG but if you look at the Wolfcamp wells drilled in Reeves in 2012/2013 they were pretty dismal. So as it goes: things change.
Best to All,
Thanks, Ryan. The information you provide on details of the tight oil plays is very useful.
Art
Ryan,
I respect both Papa and EOG (as well as Exxon). And all of these recent transactions furthered my conviction that there is a decent amount of acreage that works well at $50 in the Permian.
The reason XTO didn’t work for Exxon is that they looked at the reserves and the acreage and assumed a price deck for gas and said, “yeah this works” (they were also “buying a management team”). But the reason it “worked” was the same reason why the price deck was unsustainable – there was too much gas that “worked” at the price deck they used (Marcellus/Utica was the nail in the coffin).
The question now is weather the Permian does to oil, what the Marcellus did to gas. I am going to out on a limb here and say, “I don’t know.” My sense is that since we are dealing with a global oil market (rather than a NA gas market) the Permian will provide a mechanism to avoid spikes in oil prices for several years (3-10 year?) depending on the economics in the Permian, the runway of opportunities, and what happens to rest of world production. This last part is the wild card in the math- because we are dealing with perceptions here. If OPEC+R becomes convinced that oil will stay around $50-55, they may start competing for market share, rather than cutting production to support prices. And they do have cheaper oil.
On Centennial, if you calculate the public market’s implied valuation on this acreage that Papa bought (>$50k last time I did it), I think people should ask themselves if they would be willing to pay that price for the acreage, because buying stock in a company that is valued at that price is the same as paying that price for acreage. Taking nothing away from Papa, I don’t really think the price works at the current valuation, but I’m not close to the situation. Of course I am generally opposed to blank check companies, and just because this one has worked (so far) doesn’t mean the next one will. I was merely citing this (blank check companies) as an example of more signs of a bubble.
Art, I also respect your opinions. If anything, I think your views take a long-term perspective to an industry that is very important to the global economy. My views are shorter term because as an investor in oil and gas, thinking more than 10 year out is too long in my opinion – too many things can change.
Finally I have to give credit to TL for the “cradle to grave” comment. Though before anyone gets to the grave, there are usually marriages, divorces, and remarriages…
All the best,
HS
“Analysts commonly portray cost reduction as something unique to the tight oil companies.”
What analysts are these?
To my knowledge, Exxon and Total have been operating efficiently so thst I’m not aware of major redundancies during this downturn from them. Everyone else in the oil industry (from major to medium size operators and service companies) have had SEVERE cost reductions
“Analysts commonly portray cost reduction as something unique to the tight oil companies.”
What analysts are these?
To my knowledge, Exxon and Total have been operating efficiently so thst I’m not aware of major redundancies during this downturn from them. Everyone else in the oil industry (from major to medium size operators and service companies) have had SEVERE cost reductions
Hugo,
I don’t understand your question or your point. Are you seriously doubting the flood of commentary about how tight oil plays are revolutionizing energy production through technology and efficiency gains?
US shale is ready for a comeback, Texas is once again making life difficult for OPEC and Shell’s New Permian Play Profitable At $20 A Barrel
All the best,
Art
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