Early stages of a recovery

OGFJ: Is OPEC living up to its promises to cut production so far?

ENGLAND: I would say better than most people expected. From a historical perspective, I think OPEC so far is living up to the expected cuts. And, the market has rallied in response.

SLAUGHTER: Remember we only have a few weeks of data. The agreement was made in January, and it's through mid-year, probably extendable, so it's "early days." But the countries that committed to cut are generally cutting, particularly Saudi Arabia, which claims to be cutting even more than it committed to doing. What muddies the picture a little is that you have countries within OPEC that were excluded from the agreement - for example, Nigeria, Libya, and Iran - for valid historical reasons due to their individual situations. So we are seeing some increase from those countries, which sort of looks as if the total OPEC cuts might not be as effective as they might have been. But, the fact is that OPEC is keeping to the agreement.

OGFJ: Are we seeing sufficient economic growth globally to spur an increase in energy demand? Which countries or regions are showing growth, and which are not?

SLAUGHTER: There is an increase in demand of probably 1.3 to 1.4 million barrels per day this year, which is above the mid-range of what we usually expect in demand growth. When the global economy is weak, you tend to get an increase of 900,000 to 1.1 million bpd. When the global economy is really pumping out on all cylinders, you tend to get closer to 1.5 million bpd, so we're just around or slightly above the mid-range of that.

OGFJ: Is most of that increase coming from China?

ENGLAND: Asia generally. India is a bright spot for the future. From a demand perspective, India is a bigger factor than in previous years. And we're going to need that because energy efficiency is becoming a larger part of the equation, which offsets demand growth. The energy industry will need to see more growth from these emerging markets in the coming years.

OGFJ: India is looking to commercialize gas hydrates, which are found off both the eastern and western coasts of the sub-continent, to augment its energy sources. Manish Vaid of the Observer Research Foundation in New Delhi has written for OGFJ on this topic. He says the Indian government is pushing hard for more research into development of these resources, although he says commercialization is still at least a decade away. What are your thoughts on the possible commercialization of gas hydrates?

SLAUGHTER: Japan had a well test for gas hydrates in 2012, and the gas actually flowed for a few days. This makes the most sense in a country like Japan because it has the highest domestic prices and has to import most of its energy supplies. That means gas hydrates would be competitive earlier in a country with high prices, but I think we're still talking about several decades before it can get in the money. It will take a while before it can become competitive. I think hydrates are really the next century's big hydrocarbon resource.

OGFJ: In previous downturns, people generally looked at rig counts as a barometer as to how the industry was doing and when it was coming back. Is that still a valid means of measuring the industry's health?

ENGLAND: I think it's still worth looking at, but given how much productivity you get from a well these days, there are so many other factors to consider when you're trying to gauge the health of the industry. Looking broadly at the industry, you need to look at overall capital expenditures and production per well, which is different today from what it was a few years back. We're in the early stages of seeing improvements in the amount of productivity you can get per well. We're going to continue to see this increase dramatically in a few years, which means in the future it will be even harder to equate rig count with production. We look at all these factors as we estimate the impact on supply.

OGFJ: In recent months, oil prices seem to have stabilized in the $50 to $55 range, or perhaps a tad under $50 in the past few weeks. In your view, will upstream companies be able to thrive in this new "lower for longer" price environment?

SLAUGHTER: Prices stabilized in the $40 to $45 range and then the high $40s from early summer in 2016 through the end of the year. They cut through the $50 threshold this year after the OPEC cuts. There was that long, stable period at the end of 2016, and you did see industry confidence building up. For example, we saw an increase in activity in the upstream transaction market even in fields under development rather than fields already in production. This is a good sign that confidence is coming back. Our view of the next couple of years is that as these global inventories get burned off, prices will return to the $50s - maybe even the high $50s - by the end of this year or early in 2018. That will provide incremental cash flow for the operators. The caveat though is that the incremental cash flow won't all go into capital. There is still a lot of deleveraging and paying down debt that needs to happen as a consequence of the boom times when companies were growing too fast. So to answer your question, yes, they will do better, but it won't all go back into the drill bit.

ENGLAND: Yes, there is clearly a lot of balance sheet repair that has to happen. There will be a call on capital going forward. To your question, though, as to whether companies will be able to thrive in the new environment, I think the answer is yes. If you look at the cost reductions they've been able to achieve, the big question is how much of that is sustainable and how much came off the backs of their suppliers. So as the industry starts to recover, everyone knows we can expect to see a surge in the cost of equipment and services. But there have also been a lot of real innovation and technological advances in the sector. As a result, I think that companies will be able to make reasonable returns in this pricing environment.

OGFJ: So far we've been talking mainly about oil. What about gas plays such as the Marcellus and Haynesville? Will companies operating in those areas see a comeback in 2017?

ENGLAND: For the most part, gas producers have already made the necessary cost reductions and done a lot of things to make them economic in these tougher times. If you look at some of the successes they're having, their picture actually looks pretty good going forward because there is some demand growth that looks fairly positive for them. To some degree, they've already been through their most painful time and have a brighter future.

SLAUGHTER: The Marcellus has continued to expand even through the cycles and gas prices. Gas prices went very low and wellhead netbacks in the Marcellus went even lower due to pipeline constraints. But that basin is so prolific and the wells so high rate and economic even at low prices that gas production continued to expand.

The Haynesville is dry gas and it will benefit from location and from the build-up of some of these new demand centers on the Gulf Coast like the petrochemical industries and LNG facilities. The other factor in play is that as the oil market comes back there will be associated gas produced that will come in at very large volumes. My understanding is that the Delaware Basin is gassier than the Midland Basin. So as more drilling happens in the Permian, that will automatically bring more associated gas into the market.

ENGLAND: But this also presents some interesting opportunities on the midstream side. There will be a need for gas takeaway capacity in a lot of these oil plays. We've already seen some of this activity - transactions that are a precursor to infrastructure development - happening in the Permian.

Oilfield service companies and equipment manufacturers are the first to feel the squeeze during a downturn and are often the last to recover. They are the proverbial canary in the cage. What's in store for this industry sector?

ENGLAND: There has already been some industry consolidation, but I do think there will be some price increases. In fact, OFS firms have already started to ask for those. I expect we will start to see a comeback this year for the sector, which will have a primary focus on technology because of the need to increase productivity. That's what their customers are demanding. As a result, we can expect to see significant R&D expansion, which will require scale to do it. That means more consolidation to go along with the search for new and better technologies.

SLAUGHTER: In the past, the service sector has always been a market where you have buyer power one year and seller power the next. I think this time around the service sector has been in such distress that they've been on the front line of cost-cutting, and the companies in this sector will be looking to form closer partnerships and closer collaboration with their customers in helping them sustain those lower costs and better efficiencies. If they can do more work with customers around design and integration, around driving efficiencies through their value chain, then they will be more resilient to cycles in the future.

OGFJ: The level of M&A activity in the second half of 2016 was a pleasant surprise for many. Private equity finally began to make some substantial investments, especially in the Permian and Delaware basins. Do you expect more of the same in 2017?

ENGLAND: I think 2017 will be a good year for M&A. There's a lot of private equity money and a lot of people looking to make deals. And there are companies looking to rebalance their portfolios as we come out of the downturn. So that's driving a lot of this - people want focus, such as in a particular basin. That's what is driving a lot of the activity.

SLAUGHTER: We discussed M&A activity in the sector in detail in our recent report, and for M&A to come back, you needed two factors: You need confidence in boardrooms, which completely went away for 12 to 18 months and is coming back now. They can now think beyond next week to maybe a year, two years, or three years ahead. That's one factor. The second factor is you need a coming together in terms of valuations, and that depends on having a more common view around pricing and what it means for assets. That was really wide apart for about a year. Now that we're in a recovery - and it seems to have some legs - that is coming together. So I think we already saw some deal-making potential unlocked in 2016, and as the market goes through this slow recovery, that will start to pick up and we'll see more of it. It is absolutely about focusing portfolios for each company, and there's a lot of room for that - in the upstream, of course.

OGFJ: We hear a lot about activity in the Permian, Delaware, and Midland basins. Aside from these, do you see other shale plays like the Eagle Ford and Bakken making a comeback in 2017?

SLAUGHTER: Permian valuations for new entrants have got high. Companies that are doing well in the Permian got in before the latest upturn. New opportunities in the Permian will be scarcer and more expensive. So as the price deck goes up, that will push companies to look in new places. The SCOOP and the STACK plays in Oklahoma look very promising, and I think the Eagle Ford will probably be the next one to make a comeback.

OGFJ: If all the so-called "sweet spots" in the Permian are taken, is it likely we'll see more activity in the high-production areas of some of the other unconventional plays, such as the SCOOP, STACK, and Eagle Ford?

ENGLAND: A lot of it is about finding the sweet spots in whatever play you are operating in, and of course having access to midstream assets to get takeaway capacity. That is where everyone wants to be. For that matter, there are parts of the Bakken that are still doing very well. The DJ Basin is still exciting for some of the players there. So the outlook is still pretty positive for producers in the sweet spots in all of these plays. If you have good wells and access to markets, you are probably doing just fine. This isn't all just about the Permian. There still are a lot of opportunities in other basins, especially given the cost reductions that have been achieved.

SLAUGHTER: As John said earlier, experience and technology after you're in a play can improve it. As you drill more wells, you drill better wells.

ENGLAND: If you look at the recovery rates and how far we could go, there are a lot better economics still to come.

OGFJ: The US has recently begun to export LNG. As more of these facilities come online and the volume of exports increases, how will this impact gas producers in the US?

ENGLAND: LNG exports don't do a huge amount to move prices for US gas, but it is positive in that it is another source of demand. While it's helpful, it's probably not going to drive up prices. Andrew can walk us through a little from Deloitte's recent study on this.

SLAUGHTER: By 2020, we're looking at about 10 bcf/day of export capacity in the US, and most of that is Gulf Coast, although there is some on the Atlantic side. That compares to domestic production of about 75 bcf/day, so it's material. But as John says, the resource base is huge at very economic costs. We think that production can easily grow to accommodate LNG exports without too much pressure on prices for consumers. However, producers can still make money.

OGFJ: I imagine that power generation would be more relevant than LNG exports, especially with the decline of coal. Nearly all new power generation uses natural gas or renewables.

ENGLAND: I think that's exactly right. The economics of natural gas for power generation make it the fuel of choice. This is an economics story more than anything. We have an abundant supply of low-priced natural gas, and we're going to have that for a long time. Once power producers got comfortable with the idea that the supply was there and that prices were not going to fluctuate wildly, they began to settle on natural gas as a stable and reliable fuel source.

SLAUGHTER: Gas has overtaken coal as the main fuel for power generation in the US, and I don't see that turning around. There are coal plants being shut down in many regions of the US, and once they're gone, they don't come back. There is virtually no investment in new coal-fired generation. There are one or two plants that are under construction to be finished off and commissioned, but the move to gas has happened and we're not going back to coal. There is a lot of renewable power as well, but the big central generation has moved to gas. As the big nuclear plants are decommissioned, that will present even more opportunities for gas generation.

OGFJ: Mexico is the leading importer of natural gas from the United States. Several pipelines are under construction or in the development stage that will move even more US gas to Mexican commercial and industrial centers. In your view, are these opportunities likely to be negatively impacted by US political policies in a Trump administration? As you know, there has been discussion of a 20% tariff on US imports, which, if implemented, could result in some form of economic retaliation by Mexico.

ENGLAND: Mexico presents a tremendous opportunity on a number of fronts - from a gas export perspective, from an investment perspective, for upstream players, and even as a market for refined products. Those are all very positive opportunities for US companies. So policies between the two countries is always a risk factor, and there is some uncertainty around that. But overall, I'd say the economics and the opportunities there are likely to overcome some of those risks. The opportunities are that great. There is a lot of excitement about the deepwater opportunities in the Mexican portion of the Gulf of Mexico. So people will factor in those risks, but as they come to investment decisions, I think they will find a way to make things work.

SLAUGHTER: Mexico is really going quite strong and hard in acquiring gas to serve its industrial sector, particularly in the northern areas bordering Texas. They are not developing domestic gas reserves, but as their industries have grown, they are building pipelines to import gas from the US. These run through South Texas and across the border. Projections show that there will be a lot more gas flowing to Mexico from the US over the next few years. It's a natural market for US producers.

ENGLAND: Getting back to your original question about US policy and a border tax, people are still trying to analyze what all this means. It's still very early in the new administration, and much of this is conjecture at this point. Obviously there is a lot of trade between the two countries. So a lot of companies are still trying to determine what some of these possible US tax reforms could mean to US-Mexico trade relations, and there is still a great deal of uncertainty. We'll learn more as this subject is debated in Congress in the coming weeks.

OGFJ: Will the offshore industry in the Gulf of Mexico see a comeback this year? If not, when? Will the rollback of some government regulations by the Trump administration help accelerate a recovery in this sector?

SLAUGHTER: Most of the offshore service and supply companies, rig operators, drillship operators, etc. are international companies. So they have the option of contracting a rig in the Gulf of Mexico, offshore West Africa, or offshore Indonesia. They truly look at offshore as a global market, and they will go where operators contract them to go. Having said that, the offshore is not homogenous, so there is a tendency to re-examine the types of things we look to develop in places like the Gulf of Mexico. Certainly, big new fixed-facility projects have been re-engineered to be standardized at lower costs. More significantly though, I think there is a lot bigger focus on subsea completions and tiebacks where you already have the infrastructure - the platform in place, the pipeline to market in place - so those require significantly less capital and faster lead times than the big spars that people think of in offshore projects. We'll see a lot more of these lower-cost subsea developments, even in the Gulf of Mexico, going forward.

ENGLAND: That is obviously an impact of the downturn we've just been through. There is a lot of focus of capital allocation toward shorter cycle, less-risky projects. Everyone is playing up the Permian and US unconventionals because they like the short-cycle nature of that. But ultimately, we need some of these large projects to assure long-term supplies. So I think that companies that have long-term horizons will still be looking at deepwater as a very attractive option, not only in the Gulf of Mexico but in places like Brazil, which recently enacted some energy reforms that will make investment in Brazil's deepwater by US and other players more attractive. I think we're going to see more capital allocation for those long-term projects by the larger players that have that long-term horizon.

OGFJ: Final question. Have we lost as many seasoned professionals during this down cycle as we have in previous downturns? If so, how do we replace them?

ENGLAND: In terms of numbers, the losses are somewhat staggering. Globally, I think it's about 350,000, including about 150,000 to 160,000 in the US. Huge numbers. The big questions are (1) Will they come back? and, (2) How do we draw the high-powered young people we need into the oil and gas industry? We need to figure out how to make this industry attractive to the best-educated young people and how to become the employer of choice in a very competitive environment. Obviously we need to overcome some of the negative stereotypes about the industry. We need to keep working to rebrand the petroleum industry as a high-tech and innovative industry, not just one that is steeped in old-school thinking.

SLAUGHTER: There is a consequence to the downturn in the sense that some of the people laid off don't have the appetite to come back. The cyclicality of the industry and the risks to their careers was too much for them. On the other hand, digitization has brought about a lot of changes that will be attractive to many people. Automation and remote monitoring means that we might not need the same number of people going forward, although we'll certainly need highly skilled, highly qualified people. The industry needs to work closely with engineering and computer science schools to assure we get the best people available.

OGFJ: Thank you both for your time today.