We need meaningful cuts from OPEC

Saudi Arabia's issue here is mainly about its relationship with other OPEC countries that historically have done little to cut production when there is a supply-demand imbalance. The Saudis are not happy that they're the ones who typically do most of the production cutting. For example, during the crash in oil prices during late 2008 and early 2009, OPEC agreed to cut 4.2 million barrels a day from the September 2008 output of about 29 million barrels a day. The cuts were led by Saudi Arabia, which trimmed its production by nearly 2 million barrels a day from 10 million to 8 million. Also, the Saudis want to pressure Russia to bear a portion of any eventual production cuts. Third, Saudi Arabia wants to gain as much market share as it can prior to the formal lifting of sanctions against Iran. Finally, the oversupply and lower prices are pressuring the US shale plays and slowing the growth of production.

Woven into this complex mosaic are the underlying geopolitical issues. The Saudi government is led by Sunni Muslims, while Russia provides economic and military backing to the Shiite-led Iranian government, which in turn provides benefits to the Alawite-led government of Syria. The Alawites follow a branch of the school of Shiite Islam.

OGFJ: If Saudi Arabia is having supply issues with other OPEC countries, what are those countries?

WHITE: Iraq has ramped up its oil production significantly. According to the most recent OPEC report, Iraqi production for October was just over 4 million barrels a day, about a 750,000-barrel-a-day increase compared to its average of 3.3 million barrels a day in 2014. Part of this surge in Iraqi production is from Kurdistan, which is exporting more than 500,000 barrels of oil a day. The Kurds have been very creative is getting their oil out of the country amid protests from the central government in Baghdad. They hired a veteran oil trader who had worked for Glencore to assist in executing trades, make shipping arrangements, and learning who they could work with. The Saudis also want Venezuela and Nigeria to bear a good portion of eventual cuts.

One thing is clear - US production growth has slowed. It reached a high earlier this summer of about 9.7 million barrels a day and recently dropped to about 9.3 million barrels per day. The declines have been led by declines in the major shale plays. We are seeing production roll over in the Eagle Ford, Bakken, and the Niobrara, but not quite yet in the Permian, which was the last major basin where the industry began to use horizontal drilling and hydraulic fracturing completion technology. It will be interesting to see how all this plays out in 2016 with the sharply lower rig count and the high decline rates in shale production. The industry is truly in uncharted waters here because never before have we had about 3 million barrels per day of production from shale.

On the demand side, people are watching the slowing of economic growth in China, which recently had a currency devaluation and several months of sub-50 PMI figures. China's nearby trading partners have also suffered from slow economic growth with recent disappointing economic figures out of South Korea and Japan.

OGFJ: Commodity markets, historically, tend to be highly reactive to global events that might impact supply or demand. That doesn't seem to be happening anymore. The Middle East, which is a huge supplier of oil and gas to overseas markets, is in turmoil with strife and political unrest throughout the region. Given this situation, one would think that markets would be concerned about the continued availability of energy supplies - yet prices haven't gone up. What is different today?

WHITE: I think part of it is the geography of where the oil fields are located. For instance, most Iraqi production is in the southern region, which is a good distance away from the area in and around Baghdad and the border with Syria where ISIS has been active. There has been a revolution in Yemen, but that country is a minor oil exporter. Libya, in North Africa, has been an on-again, off-again exporter. It has a capacity of about a million barrels a day of exports, but the loss of Libyan production has been offset by the surge in production from Iraq. With the amount of oil in storage and the current oversupply, the markets just don't seem to be affected by the unrest. Now, if the strife were to spread to southern Iraq or to Saudi Arabia, the reaction would be drastically different.

OGFJ: Oil prices have been on a roller coaster the past year, moving up and down with at least one apparent recovery in the spring, followed by a second downturn. Will prices continue to bounce around, mostly between $40 and $50?

WHITE: Not to be flippant, but we can expect a recovery when the market gets balanced. There are so many moving parts in the price equation. While we have declines in US production, we also have the worries about Iranian production coming back that will offset those declines. That's a real wild card. The sanctions have been in place for a number of years, and there is no credible information on what additional Iranian capacity might be in the near or intermediate term.

OGFJ: If the current downturn, which has already lasted more than a year, continues for another year or longer, as many analysts predict, how severe an impact will this have on shale development in North America and elsewhere?

WHITE: Let's look at the "elsewhere" first. Shale development requires a huge amount of well-established infrastructure in terms of drilling rigs, sophisticated downhole equipment, large amounts of readily available sand or proppants, and a lot of talented technical crews to execute these horizontal wells and to perform the fracking and completions. The US has the most intensive oil service industry in the world, and you just can't find the same intensity of oil service equipment and operations in other countries. Of the other countries, Argentina is perhaps best suited for shale development. The Argentines have a major resource in the Vaca Muerta shale play, and Argentina is an established oil producer with good oil service infrastructure already in place.

To answer the first part of your question, we've seen how resilient and how innovative American oil and gas companies can be when faced with the challenge of lower prices. They have reacted with creative technology, and we're seeing a continuation of the themes of longer laterals, more sand, and more sophisticated drilling equipment in order to keep the drill bit in the right part of the shale while drilling the horizontal portion. Companies have also been very creative on the production side in order to manage these decline rates. A good example is Earthstone Energy, which is experimenting with a managed choke-and-pressure production system. A lot of operators flow these shale wells flat out during the initial several months of production. Earthstone has reported good results in using smaller chokes flowing at lower rates, but with higher pressures over an extended period of time.

OGFJ: Where does Earthstone operate?

WHITE: These wells are in their core Eagle Ford area.

OGFJ: How has the offshore Gulf of Mexico been affected by the downturn?

WHITE: The GoM has two parts, the shallow-water shelf and the deepwater. There are a relatively small number of players operating on the shelf. A decade ago, there were 12 to 15 publicly-traded companies actively drilling on the shelf, offshore Louisiana and Texas. Today, my relative-value sheet has only four or five companies operating there, and several are very highly leveraged. It will be another fingers-crossed situation for the shelf GoM players.

As for the deepwater, the reserve targets are very large and require very long lead times to develop. This is generally regarded as a province for the major oil companies. The price horizon for them is $35 to $40 oil for their deepwater projects. Because of the large reserve targets, I expect these to continue to move forward. These deepwater reservoirs are typically 100 million barrels and higher.

OGFJ: I realize this is a difficult question to answer, but I'd like to pose it anyway. Do you see the industry recovering in a series of fits and starts, or will it come back in a steady upward trend? What factors into a recovery?

WHITE: If demand growth holds pretty steady to recent levels and with US production rolling over, I think we'll get closer to a balance in 2016. But if you look at previous industry downturns, what we really need is a meaningful production cut from OPEC. I think we're going to continue to see Saudi Arabia put pressure on Venezuela, Iraq and Nigeria to bear their share of production cuts. Relying on natural declines to take care of an oversupply that's between 1.2 and 1.6 million barrels a day will be a prolonged process. So, we're going to need help on the demand side and we're going to need more US declines in production, but what we're really going to need is a cut from OPEC. I don't see a really dramatic price increase absent some major geopolitical event.

OGFJ: But aren't things moving in the opposite direction? Iran is an OPEC country, and with the lifting of sanctions, that likely means that more OPEC production will be added to the global oil market - not less.

WHITE: Yes, and that is motivation for the Saudi strategy. Consensus opinion seems to be expecting increases from Iran in the range of 250,000 to 400,000 barrels a day during the first two quarters of 2016. A lot of people in the industry expect that will be offset by the declines in US onshore production. So that should roughly be a wash.

OGFJ: Let's talk about bankruptcies in the industry. We have seen quite a few overleveraged companies file for bankruptcy in 2015, and some bankruptcy attorneys I've spoken with expect this will increase next year. The longer the downturn lasts, the harder it will be for companies to avoid bankruptcy. What will be the significance of this? Will we see a lot more industry consolidation?

WHITE: During the second half of 2015, we had a second crash in oil prices from when prices reached around $60 a barrel in June. Prices actually fell to about $38 for a couple of days in August. When we look back at the second half of 2015, I think we'll characterize it as the "year of restructuring." A lot of these highly levered E&P companies saw the low prices in the second half of 2015 and moved proactively to restructure their balance sheets, mainly addressing the senior unsecured notes. You've seen these companies work proactively with bond-holders to restructure the notes. There have been all kinds of swaps and exchanges taking place to the goal of extending maturities, reducing the actual amount of debt, and providing the oil companies more flexibility to continue to operate, and the bond-holders are cooperating. So this allows the company to avoid bankruptcy and buy some time for, hopefully, an eventual increase in crude oil prices. Some of these exchanges have involved a reduction in the principal amount of the notes in exchange for some warrants or some common stock or some other sweeteners - higher coupons and the like so that both parties are happy with the trade.

In my view, no company has been more proactive in managing its balance sheet than Halcón. Halcón has a very experienced management team, and they have pulled every lever available to improve the balance sheet. They have swapped common stock for senior unsecured notes, and they've done a second lien note deal. And, I haven't seen this in previous downturns, but we've seen the advent of third-lien notes. Halcón has swapped third-lien notes for a big chunk of its senior unsecured notes, and that's taken about a net $500 million of debt off the balance sheet.

Also, during the yield-happy days of 2011, 2012, and 2013, we saw a number of companies issue preferred stock. A lot of the smaller companies have had to suspend dividends on their preferred stock because of the financial stress they're under.

OGFJ: How big an impact will LNG exports have on the US natural gas industry? Will this be a game-changer?

WHITE: I would term this as slightly favorable for the natural gas industry, but I wouldn't call it a game-changer. Cheniere will make the first LNG shipment in January. However, the volumes of US natural gas planned to be shipped overseas as LNG just aren't going to have a major impact on the industry in the near term.

OGFJ: There have been efforts on the federal, state, and local levels to regulate hydraulic fracturing. Where do you think this is headed? Will we see more regulation next year and in coming years?

WHITE: I think dealing with potential regulatory threats will be a bothersome issue for E&P companies, but I don't see a long-term draconian setback. Federal authorities will continue to regulate drilling activity on federal lands. However, states traditionally regulate such activities on non-federal lands. As long as the states get the lion's share of taxes from this activity, they will not allow local municipalities to take over this function. There is a mountain of legal precedent for the states to control drilling activities, and they are incentivized to support more oil and gas production.

OGFJ: Were oil prices too high at $100 a barrel, and were they too low at $40 a barrel? Is there a price range that is best for both producers and consumers, and how do we reach that equilibrium?

WHITE: We had three years of $100 oil, and that was sort of the result of a perfect storm where we had the Arab Spring, Libya went off-line, and we also had the Fukushima nuclear incident in Japan that resulted in the shutdown of all that country's nuclear power plants. The Iranian sanctions also went into effect during that period. So these events on both the supply and demand sides came together at about the same time. During this time, the US oil industry got very innovative and productive and increased oil production by 3 million barrels a day, so that served as a catalyst to an oversupplied market.

We're running a $62.50 case for 2016, and I think a lot of US onshore oil and gas companies that have acreage in the sweet spots of the shale plays can have very attractive returns in this price range. While that looks optimistic with today's spot prices, the market can turn fast.