On September 10th the EIA reported a production decline in the Lower 48 --
essentially shale production -- of 208,000 BOPD. That is a staggeringly
enormous number, approximately 10 percent of the estimated global
over-supply. Additionally, it was a week-over-week number which makes it all
the more impressive. Yet it received little attention through the week.
Rather, Goldman Sachs was grabbing all the headlines with its $20 call on
oil.
This week, I was looking for a possible correction in that number with a
zero decline or possibly even a gain (remember, the EIA numbers are
estimates). But instead we got another decline of 35,000 BOPD.
Back in June I
wrote about the coming decline. Shale oil wells lose a lot of production
up front, maybe 70 percent in the first year before tapering off at a 5 to 10
percent annual decline over the next few years until leveling off for the
life of the well -- maybe 20 years or so out. You can think of it as a slope.
Once you crest it, the drop is precipitous and picks up speed before finding
a bottom. We are undoubtedly now racing down that slope.
To date, we have lost about 500,000 BOPD in the Lower 48. We will lose
that again before the year is out. Pundits will claim otherwise, suggesting
that oil in the 50's or 60's will spur activity. But if that activity is in
drilling, we won't see any effect for a half a year or so. If it is in
fracking drilled but uncompleted wells ("DUC's"), that won't mean
much either over time. DUC's have been the story of 2015 though they have had
little effect on stopping the declines being put in.
Back when the onslaught began, which I mark as Thanksgiving Day 2014 --
when OPEC declined to cut -- Wall Street began talking of shale as being a
switch; as in you can turn it on and off. Well, in the perspective of a
remote offshore project and the 10 years that it takes to bear fruit, then
the answer is yes. But shale is not a switch when it comes to controlling
commodity prices, which are much more impatient. It took a full 6 to 7 months
for the falling rig count to cast a shadow over production declines. And even
then the initial declines were shallow, more of a cresting action really. So,
going forward, we may have a new metric. That is, a sudden decline in rigs
will take 6 to 9 months to show up in production in any meaningful way.
We also still have a somewhat uneducated media that continues to shrug off
its homework. We're about a year into this bear market and oil has been
covered to death on the financial news but it is still being misreported. As
I mentioned above, the thought that $60 causes a switch to be thrown is
wrong.
Operators are battered and bruised. Sensible ones like EOG are holding
onto their money. Others like Pioneer are thumping their chests claiming they
can drill anywhere any time on their better prospects (but what company is
going to claim holding mediocre acreage?). Full disclosure: I own stock in
both, but should I stumble upon a few bucks (I run a frack company so these
days I'm not counting on it) it would go to EOG.
But, for the most part, very few operators are going to run headlong into
a drilling program on a modest recovery. There is also the matter of their
banks. They won't let them. The shine is officially off shale in the debt
markets. There are the private equity folks and other bottom feeders that are
finding their way into the market but for the most part they are spending
money on distressed assets, not new oil and gas wells.
Then there are the service companies. If you imagine your worst enemy,
someone that you wanted to see suffer some punishment, then let them run a
service company right now.
When the work stops so does the income. All of it. That puts you in the
position of watching receivables, which you begin staring at very, very
closely, waiting for the cracks to develop. Back in the good old days -- 2012
or so -- a single stage on a shale job was being priced at $125,000 or more.
The money being made was giddy. In 2014, that same stage was running around
$75,000+ because of heightened competition. As of September 2015, that same
stage is now down into the $30,000's. That's underwater. Smaller pressure
pumper's are quietly accusing the goliaths of dumping. Wall Street pundits
would have you believe that there are new efficiencies being uncovered, but
the fact is that those who can are jostling for (a) market share and (b) are
using their weight to crush and snuff out the newbies that have come on in
recent years with all that private equity money.
When prices come back and operators are chomping at the bit to get back to
work, idled service equipment will have to be brought back on-line, which is
costly and time consuming. You can't just turn a key to restart a mothballed
blender or frac pump. Idled time always translates into repairs. This is when
all the weak points in your equipment are suddenly and unexpectedly exposed.
New crews will have to be hired and retrained because the old crews have
either moved onto other industries under mass layoffs or will move on once
their 6 months of unemployment benefits run out. It is time consuming to hire
and re-train. And these are only some of the challenges, the biggest being
the cost of ramping up without cash flow to rely on.
Consolidations in service providers are now well underway. We've seen
Halliburton and Baker Hughes but that was pre-downturn. There's a few other M&A
deals but for the most part it has been a story of closings and
consolidations. North American frack camps are being closed at an alarming
rate. Equipment that could only be bought new last year is now plentiful at
Richie Brother's auctions. Frack sand trailers are parked in front yards and
lots all across American's oil and gas plays. Service yards that are normally
empty in good times are stuffed right up to the chain link fence with trucks,
trailers, pickups and assorted equipment.
So much has been made of new efficiencies in the media but there really
aren't any "new" efficiencies other than changes in frack designs,
which continue to call for more sand per stage, closer spacing's between
stages (meaning more fracks per well), and some changes in additive
chemistry. Sand pricing has come way down as have chemicals, but labor
remains where it was. You still need the same number of crew on a well site.
No one has come up with robotics to set trucks and hammer in the iron and
hoses that connect them. Health insurance is going up. Vehicle, inland marine
and general liability insurance are range-bound to up. Taxes don't go away
and then there's debt. And that's plentiful and likely increasing. There are
some economies these days but the efficiency story should be ignored for the
most part.
That's just the United States. Then there's the rest of the world.
Truthfully, I don't know what the hell is going on in the Saudi oilfields,
but I'm assuming Ed Morse at Citibank does. Morse was the analyst who called
the top. A few weeks ago he stated that Saudi production could go no higher.
That was big and in my mind it likely also marked the bottom. The Saudis
chose not to cut last November, restated their 30mm BOPD OPEC objective, then
began pumping like hell. They did announce that a 200,000 BOPD increase would
be coming and maybe it has, but if they can go no higher, then global
production has plateaued. Factor in the States, and other areas in decline,
and I can't see many traders and speculators lining up on the short side when
the IEA is seeing oil demand going above 96 MBPD next year and the EIA is
throwing out staggering week-over-week declines.
But I've been wrong on this count before. I didn't see the second leg down
this summer and Goldman did. But this $20 bearish position is over-baked.
It's also too reliant on inventory numbers.
Inventories will remain high in some parts of the world and will be drawn
down in others. But overall, rising global demand and shrinking U.S.
production (and other areas as well) will begin to eat away at inventory. It
just requires some patience. And markets won't wait to adjust pricing until
we hit a balance. There will be some foreshadowing in oil prices here.
Each of the 3 stages needed to move to a sustainable price have to be given
time to play out. The rig count story has been told with a brutally fast 60
percent drop. Meaningful production declines are on. Next will be inventory
draw downs; in that order. As to the latter, we're just beginning to see the
effects of the rig count. Cushing was down 2 million bbls this week, so no
tank topping there. And non-strategic U.S. storage is off 30 million bbls
from its high. That's not even 10 percent but just wait. Large drawdowns will
be here sooner than predicted.