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Shale Revolution In Perspective: Tight Oil & Long-Term Debt Cycle

Art Berman, Labyrinth Consulting Services – Putting the Permian Basin in Perspective: Tight Oil & The Long-Term Debt Cycle, September 27, 2017

Putting the Shale Revolution in Perspective

  • 1st Bubble 1974-1980: oil shocks and price increase from $23 to $117 led to massive E&P investments, over-production, demand destruction & oil-price deflation until 1998
  • 2nd Bubble 1994-2014: flat global output & growing Asian demand led to increasing oil prices from $17 to $148 by 2008
  • After the 2008 GFC – OPEC cuts, declining OPEC spare capacity, falling OECD inventories, near-zero interest rates – led to the longest period of high oil prices in history from 2011-2014
  • Over-investment resulted in a massive oversupply, mostly from US, and bubble burst in 2014

Oil Prices & The Long-Term Debt Cycle

  • Petroleum Age after WWII produced unprecedented economic growth; oil shocks of 1974-1986 threatened to end that party
  • Demand destruction & oil production bubble resulted in 18 years of cheap energy
  • Debt restarted economic growth & debt-based growth of China challenged oil supply after 2004
  • 2nd oil shock made unconventional oil possible. Zero interest rates led to 2nd oil bubble
  • Longest period of high oil prices in history
  • That bubble burst in 2014 and prices collapsed but without demand destruction
  • Now, we are near the end of long-term debt cycle but denying that the economic basics have fundamentally changed since the post-war era

Low Interest Rates Created A Capital Bubble For Tight Oil & The Permian Basin

  • Oil price collapse coincided with the end of QE3 and the beginning of US rate increases
  • Continued low interest rates caused margin hunters to focus on tight oil and later on the Permian
  • $30 oil prices brought large capital flows to a select group of producers seen as winners
  • Tight oil and Permian rig counts have more than doubled since August 2016
  • Increased rig count and fear of ongoing oversupply is a major drag on oil prices
  • Failure of OPEC cuts to quickly balance oil markets has tightened capital flows since March

False Premise that Tight Oil Plays are the New Swing Producer: the “Call on Shale”

  • Widespread belief that US shale production controls world production surplus results in over-emphasis on US rig count as a leading indicator
  • “Call on shale” thesis: just-in-time nature of shale supply means that production can start and stop quickly based on price and inventory signals
  • Implies that shale is the new swing producer of the world effectively replacing OPEC
  • Being a swing producer means that there is spare capacity to turn on/off based on market signals
  • “Call on shale” is a ridiculous idea: volume of shale production change cannot be correlated to oil price or inventories as promoters claim
  • Shale output reacts to price just like all plays – slowly & in long-period cycles
  • Shale plays have no spare capacity – they are just-in-time
  • Producers cannot control output because they are constrained by completion crews and capital
  • DUCs are not spare capacity because they are not ready to produce
  • US output has been flat since OPEC cuts and higher oil prices. 43% of US supply is tight oil. Where is the surge in just-in-time production from the call on shale?

Shale Cost Reductions Mostly Industry Bust, Threshold for Growth >$50 WTI

  • Lower costs of production widely attributed to technology and efficiency
  • Cost deflation was 90% due to depression in oil industry (10% due to technology)
  • Over for now and prices have increased 8% in 2017
  • Rig count data indicates that expectation of $55-60 necessary for drilling growth
  • Drilling does not translate into production because of OFS limitations
  • Shale growth has more to do with investor money than breakeven prices
  • WTI is not the price that producers get. Discount $5 to $15/bbl

Comparative Inventory Remains the Most Useful Indicator of Future Price Trends

  • Comparative inventory (CI) is the key to understanding oil prices and future trends
  • CI has fallen 116mmb since mid-February but the gap between inventories & 5-year average is still very large
  • Flat yield curve of WTI vs CI – large decreases in CI do not create meaningful price increases
  • Most likely range of CI indicates possible year-end WTI price range of $50-$56/bbl
    • This assumes that CI will fall 3.75 mmb/week, average for the last 30 weeks

Strong Refined Product Demand & Lower Net Imports Drive Inventory Reductions

  • 2017 YTD consumption is at record levels. It fell after the hurricanes but has recovered to above the YTD average
  • Net refined product imports have fallen 600kbpd in 2017
  • Lower net crude imports, and falling gasoline and distillate stocks are the key components

How Effective is OPEC-NOPEC Compliance with Production Cuts?

  • Libya and Nigeria are chief OPEC over-producers
  • Saudi Arabia has also increased production since Q1 2017
  • Maximum OPEC-NOPEC production cuts were in March-April 2017
  • August output was 1.3mmb/d less than in November 2016 vs. sanctioned cuts of 1.8mmb/d

Oil Futures Have Moved into Backwardation in September

  • WTI has moved into full backwardation in September (Brent also)
  • This signals a perception of supply tightening that favors selling oil rather than storing it

Shale Plays & Sweet Spots ($40 Commercial Areas)

  • Bakken, Permian, and Eagle Ford all have considerable commercial areas at $40 wellhead prices
  • Bone Spring commercial area is almost twice as large as Bakken or Eagle Ford
  • Bone Spring has 1/3 the well density of the Bakken or Eagle Ford
  • Bone Spring and Eagle Ford have lower breakeven EUR than Bakken
  • Higher early rates and lower well costs account for advantages to Bone Spring and Eagle Ford
  • Permian production should continue to increase into the mid-2020s; Eagle Ford and Bakken will probably not reach 2015 peak production levels; Bakken should decline more than Eagle Ford

Bakken EUR, Gas-Oil Ratios & Water Cut Trends

  • EUR decreased and decline rates increased for wells with 1st production after 2013
  • GOR increased and then decreased
  • Water cuts increased for all wells with 1st production after 2013
  • These trends suggest depletion and that the play has been over-drilled (inconclusive without pressure data)

Tight Oil is a Marginal Business at Best

  • Despite claims of ever-decreasing costs and breakeven prices, balance sheets and income statements do not reflect profitability for most pure tight oil players
  • Most lose money, few break even (Diamondback is the only pure tight oil player that made money in 2017)
  • Only integrated companies with diversified portfolios outside of tight oil plays (e.g. Chevron, Conoco, Statoil, Oxy) make money
  • Disparity between breakeven and IRR claims, and corporate financial data: 1) selective data in claims vs average well EUR and costs; 2) exclusion of many costs in claims that are part of the cost of doing business; 3) misleading emphasis on production costs vs full costs

Energy Stocks Have Suffered in 2017, Permian Stocks More Recently

  • Capital flows to tight oil have slowed in 2017
  • Share prices have declined as markets tired of mediocre financial returns
  • Continued capital flow is the chief factor in tight oil growth, not reserves or economics

Tight Oil and The Long-Term Debt Cycle

  • Shale revolution must be put in perspective
  • High oil prices 2005-2014 plus massive debt & low interest rates after 2008 created a capital bubble that drove tight oil development and growth – much of it uneconomic
  • Continued availability of external capital is the most critical factor for production growth & maintenance
  • True breakeven price for tight oil is not <$50 but is closer to $60 wellhead price
  • Tight oil plays are not the new swing producer of the world
  • Comparative inventory remains the best indicator of future oil prices
  • CI has tightened in spite of OPEC’s modest compliance but will this continue?
  • Year-end 2017 WTI prices could be $55 but forward curves are in backwardation
  • Permian plays are good but will probably continue to deliver low returns and lower production growth than many analysts predict
  • Enthusiasm for tight oil innovation must be balanced by the desirability of years of depressed oil prices

Image Source: Labyrinth Consulting Services, Inc., artberman.com

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