Capital Road: Oil Prices!

[originally written March 3, 2015]

Greetings!

We hope this finds you happy in a new year and doing work you’re proud of.

We’ve written a few versions of this edition over the last month or so, and have found the oil & gas market to move more quickly than we can write. It all seemed outdated a week after we started. So let’s first catch up with what’s happened over the last couple months:

The price of oil began its decent from a peak of over $100/barrel in June 2014. As we type this, WTI Crude is at $49 after a brief up and down rebound. Everyone — and that means everyone — has been surprised at the speed and magnitude of this decline.

Most of the articles you’ll read are centered around a couple main issues:

Rig Count

The number of active rigs is currently the most watched marker for predicting what the supply of oil will look like in the near future. As the thinking goes, the less exploration being done, the less oil coming out of the ground. Pretty straightforward, pretty logical. Here’s what the rig count has done over the last six months (declining 23% mostly since December):

Planned capital expenditures for E&P companies have more or less tracked the price of oil, often being reduced by ~50%. The cost for leasing one horizontal drilling rig costs between $20–30k per day — so it’s clear why they are not renewing these leases at $50 oil.

So if this is so straightforward and logical, why do we see predictions from very smart people — so-called experts in the same field — that range from $20 to $200 oil over the course of the next 1–2 years? We have the answer…remember, you heard it here first:

“Nobody has the faintest clue what is going to happen.”

The EIA projected a price near $100/barrel for 2015 less than a year ago. Now they have “revised” those projections to $55/barrel by the end of the year and just $71/barrel in 2016. Harold Hamm, CEO of Continental Resources and one of the pioneers of the fracking world (side note, he’s a main character in the excellent book The Frackers), said at the end of January that prices could rebound more quickly in 2015 than anyone expects, mostly due to the rapid decline in capital expenditures for exploration. On top of that, he says many operators will avoid completing wells until service costs come down further and simply stop producing until prices come back up. “It’s not going anywhere,” Hamm said. “It’s locked in a rock.”

Citi Group says we’ll see $20 oil before we see $100.

And to top it off, OPEC’s Secretary-General Abdulla al-Badri is saying we could see $200 oil in the next few years. Here’s why:

This graph shows the investment needed in exploration just to keep up with global demand for oil.

Al-Badri is warning that if we react too strongly (such as the 50% capital expenditure budget cuts mentioned earlier), along with the long-term nature of many offshore projects (Chevron began a $6 billion project in the Gulf of Mexico last year and we won’t see any of that oil until 2018), there will be a period of time where we can’t meet the demand. And then BOOM: $200/barrel.

Decline Curves & Delays

Let’s throw a couple more variables into the mix, just for fun.

We talked in the previous edition about conventional vs. unconventional drilling (fracking, horizontal). Onshore production still accounts for around 70% of total production, and roughly 60% of that production in the US is from horizontal wells. The point is that the amount of oil coming from unconventional wells is substantial, and that it is the primary driver of the supply glut we are currently experiencing. Without U.S. shale oil, we’d be looking at slightly declining amounts of global supply, as this chart shows clearly:

The reason this matters is because oil comes out of the ground very differently from a well that has been fracked than a conventional well. The main difference is that much of the oil is front-loaded in the first 1–2 years for unconventional wells (what they call “Tight-oil” in the graph below):

Consider this: thousands of unconventional wells that have been drilled over the past two years are still on the steep part of the decline curve you see above. Though technology is improving the efficiency in which we extract the oil out of each well, E&P companies are now investing half of what they did last year in replacing this decline with new wells.

Add to that the fact that many new wells are simply delaying their completion (which happens to make up two-thirds of the overall cost of an unconventional well), and you have a recipe for a “quicker than expected reduction in supply.”

The Flip Side

Let’s reiterate the fact that nobody has the faintest clue what is going to happen. So with that disclaimer out of the way, here’s what’s going to happen:

Oil prices will rebound further by the end of 2015 as supply levels off and demand continues its slow rise. Reserves that have been stored (some on rented oil tankers just out there waiting for prices to rebound) will begin to enter the market and deplete. The flip side of the quick response to the supply glut is that the industry will be equally quick to respond to a supply deficit. The delayed completions will be completed and those wells will be producing within a few months, and money will flow back into exploration to produce even more within a year. This new, short cycle will continue — up and down every 1–2 years — until something drastic happens in the world. Which could be tomorrow.

What is described above is a mild version of what they’re calling a “W-shaped Recovery,” which Citi Group has thrown out there has having $20/bl at the bottom of the W and $75 at the top (our view is a bit more optimistic, though still with some ups and downs). Meanwhile, Goldman Sachs is talking about an “L-shaped Recovery” in which prices go down and stay down for an extended period of time. And of course there are the optimists like Kepler in the Financial Times saying it’ll be “V-shaped.” Read this article for a great overview of these theories.

As always, don’t hesitate to reach out with questions, ideas, arguments, or lavish praise. We welcome it all!

Until next time, be well, do good work, and stay in touch.

Matt McPheely & the Capital Road Team
A division of Channel Capital