A case for sub-$40 oil

Aug. 13, 2017
Recent years have proved painful for the oil and gas industry, yet through this tumultuous period came an incredible resilience by US shale producers.

RECENT YEARS HAVE PROVED PAINFUL for the oil and gas industry, yet through this tumultuous period came an incredible resilience by US shale producers. As prices hovered around the mid-$40/barrel mark, the drilling rate by said producers jumped. And, while output doesn't follow in lock-step with drilling (drilled but uncompleted wells have hit record rates), the number of rigs deployed is still viewed by many as a key production indicator, and both complicate attempts to balance markets. DUCs in mind, the growth in US oil production has been too aggressive, and some say to relieve the pain we need...more pain.

Reiterating its previously-stated concerns of a US onshore activity overshoot, Wolfe Research analysts, in a July 13 note, detailed the need for a rollover in rig activity-a process that has yet to begin. For this to happen, the analysts said, "we think E&Ps must feel more pain (i.e., lower oil prices). However, with OPEC propping up oil prices with production cuts, a sub-$40/bbl oil price may have to wait until later this year when it becomes more apparent that US oil production is growing too aggressively. And the longer it takes for US onshore activity to rollover, the deeper and longer the next dip in activity."

As of this writing, the Baker Hughes US land rig count is down by 933 rigs (-50%) since the November 2014 peak of 1,864, but rig activity "accelerated off the bottom too quickly, adding 490 (+156%) horizontal rigs since last May's trough," the analysts continued.

With the increased rig activity, ESAI Energy projects that US shale oil production will reach 5.6 MMb/d by year-end 2017, an increase of over 1 MMb/d from year-end 2016, but predicts the pace of US shale growth to slow in 2018. "Cost inflation and falling marginal productivity," coupled with lower than expected oil prices "will give producers pause in deploying additional capital to their drilling programs," ESAI Energy noted in a June 20 press release. But, noted ESAI Energy analyst Elisabeth Murphy, "US shale production is forecast to be about 500,000 b/d higher in 2018 than 2017, still very impressive growth."

Development outside geological core areas and other factors may push production growth estimates downward, but oversupply concerns, and the likely resulting hit to oil prices and profitability, remain.

Getting back to the numbers, according to Wolfe Research, 409 of the aforementioned 490 horizontal rigs added since May 2016 had sights set on oil. The number of horizontal rigs targeting oil sits around 657. At that level alone, the analysts project US unconventional oil could exit 2018 with production numbers near 8 MMb/d - "simply too much oil growth," they said, and, to avoid another glut, suggest "200 horizontal oil rigs need to be laid down, falling from ~650 currently to 450-500 by mid-18, thus implying a mid-'18 trough total horizontal rig count of ~600.

"The sooner these rigs are laid down, the better."

From meetings with E&P companies in Denver in early July, Capital One Securities Inc. offered takeaways from some regarding activity. "Most companies sound locked and loaded on activity plans for the rest of '17, but at least a few companies implied a slowdown in activity for '18 if oil prices shake out in the $40 - $45 range or below," they noted.

Resolute Energy "will likely continue with current 2-rig program at $45/bbl oil," but the company is "less likely to add 3rd rig later this year if oil remains in the mid-$40s," Capital One Securities said. SRC Energy Inc. (formerly Synergy Resources), will likely maintain its two rigs throughout 2017, but it "sounds like if prices fall to $40 or below, SRCI would likely cut to 1 rig," the analysts noted.

Wolfe Research looked into oil and gas conference transcripts and found, like Capital One Securities, movement from current activity unlikely, but a sense that some E&Ps are "reevaluating 2018 and may slow activity late in the year if they believe crude will stay in the low $40s versus returning to ~$50.

"Pioneer has 3-4 rigs it currently plans to add in late 3Q/4Q; however, it suggested that its 2018 volume growth would largely be set by then and these rig additions are more impactful to 2019 production," Wolfe analysts detailed.

"Devon indicated it would continue its 2017 program unless oil prices collapsed further," the analysts said, quoting Tony Vaughn, Devon's COO, who commented: "We're still moving forward on our 2017 plans. We like the operational momentum that we're seeing in both the STACK and the Delaware position. So we're going to keep moving towards that 20-rig case."

What the commentary shows, and Wolf Research points out, is that "mid-$40s oil price is not low enough to incentivize [E&Ps] to drop a meaningful number of rigs," and "without lower oil prices, US oil rig activity does not decline, which, without a material decline from current levels, would lead to extremely robust US onshore oil production growth next year, thus pressuring oil prices even more than we expect during 2018 (sub $40 later this year and during 1H18). Delaying the pain is never good for anyone."