Apparently some oil and gas producers don't know when to quit. Or, as our group publisher, Mark Peters, put it: "I still think some people don't understand what Adam Smith was talking about in Wealth of Nations," the landmark work on economics that influenced thinkers like Alexander Hamilton and is still taught in schools.
On July 16, the analysts over at Raymond James sent out their US Research Industry Brief under the headline: "When should E&Ps slow down oily activity? Cost curve says not soon enough."
On the surface, it seems counter-intuitive that a country that is still importing crude oil would be counseled to cut back on domestic production. However, the situation is not that simple.
Ray Jay recently revised downward its crude oil price outlook and admitted they haven't exactly received many "Friend Requests" on Facebook following the move. The firm's 2013 WTI forecast is for $65/barrel crude, substantially below current pricing levels.
The Industry Brief used a graphic to show that 13 of the 20 onshore plays evaluated can break even at or below $65 at current costs and that 18 of the 20 plays will make at least a 10% internal rate of return (IRR), assuming a 10% reduction in service (well) costs.
The Raymond James analysis shows that the industry will continue to make economic returns with $65 oil in "the majority" of onshore US oil plays – well below the current WTI strip at $87. However, there are a few oil plays where the cost curve indicates problems if oil drops to the $65 level or below. These include the Anadarko Basin, Granite Wash, and Bakken Non-Core.
The three analysts credited with the report – John Freeman, Cory Garcia, and Kevin Cabla – ask the rhetorical question: Why would an E&P drill at sub-economic prices in a play anyway?
They point out that when E&P companies craft their budget plans for the upcoming year, it is common for them to budget for commodity prices that are 10% below the price at that time. However, it is often difficult for companies to alter their plans when prices plummet because they have contracted rigs, trained completion crews, secured pipeline capacity, etc.
Raymond James says that E&Ps are more prone to "ride out the storm" for what could be seen as a temporary price drop rather than risk losing ground by cancelling a rig and a crew. There are sometimes contractual obligations that have to be fulfilled, such as minimum volume commitments for third-party pipelines.
Hedges are another consideration for the company. They are intended to stabilize the cash flow of existing production rather than new wells that are brought on line during the year.
Finally, the analysts assure us that drilling to hold leases really does exist. With oil plays cropping up around the country, they expect the HBP trend to continue.
The report concludes that E&P companies have become "too good" at extracting oil and gas. "The unlocking of shale plays in recent years has jump-started the US production curve after decades of declines. On the back of seemingly constant improvements in drilling efficiency and well productivity, we must ask ourselves, have we 'drill, baby, drilled' ourselves a little too deep?"
The authors add, "As a case in point, natural gas prices have traded below $6/Mcf for more than three years – and appear to be mired at sub-$4/Mcf levels for another three years. As we now turn our sights to the remarkable surge in domestic oil supply, we must ask ourselves, how low do prices need to go in order to really slow down drilling? Our analysis shows that the industry will continue to make economic returns at $65/bbl in the majority of onshore US oil plays – well below the current WTI strip at $87/bbl."
Although it would appear that operators and producers are safe drilling and producing more oil for now, they should keep an eye on the amber light and proceed with caution. There is financial and economic turmoil in Europe where nearly every country is either in a recession or on the verge of one. Even Germany's credit has been downgraded by Moody's because of the instability of countries like Spain and Italy.
Weak economic statistics in North America and Europe suggest declining oil demand in the future, so it behooves the industry to stay alert.
