The signs are emerging that the era of cheap and widely available energy is drawing to a close. Around the world, people are discovering that oil and gas are necessary if the energy supply is to be uninterrupted. Shortages in Europe have made the news frequently over the past few months. What’s news is it’s catching a lot of folk off-guard. I have been discussing this possibility for a couple of years in Oilprice articles and I’ll link a couple below if you would like to go back and examine my original thesis in light of current events. In this article, we will discuss why we feel that shale production, now on the rise, could plateau and even decline as the year progresses.
It's no great secret as to how we got to this point. Stockpiles of crude are below 5-year historical averages. Thanks to some cold weather and the burgeoning LNG trade eastward supplies of natural gas are 6.2% below year-ago levels and just above the 5-year average. There are myriad reasons - and we'll just list what we feel are the key drivers - that oil prices have reached today’s levels. These reasons range from the government's messaging to oil and gas companies to OPEC+'s fairly stoic restoration of the 9.5 mm BOPD they cut in 2020 and, of course, the amazing recovery of the global economy, particularly here in the U.S.
I’ve authored a number of Oilprice articles on shale and the broader energy market over the past couple of years. In those articles, there was deep value in U.S. domestic shale companies that was not yet reflected in the market. I have also discussed the likely impact of nearly a decade of under-investment in new upstream supplies by hard-pressed oil companies struggling to survive in a lower for longer energy reality. There are a couple that I would recommend reviewing after reading this article.
The response from the drillers to higher prices has been restrained but nonetheless gratifying as just this week we poked through the 600 rig level, not seen since 2020. We even put 10 frac spreads back to work with the total coming to 254. Something about $80.00 oil perhaps? Of course it is. The rig count is probably 50-75 rigs above where it would likely be with oil under $70.00.
PrimaryVision, Chart by Author
The increase in drilling has led to shale production approaching its early 2020 levels of 9.3 mm BOPD, along with the DUCs activation that we have discussed many times. Most recently in an Oilprice article earlier this month. The DUC count continued to decline through December, with another 214 wells being brought online as per today’s issue of the EIA Drilling Productivity Report. This increase in production has led the Energy Information Agency (EIA), to project a continued increase in production this year as we noted previously, with production eclipsing demand for most of 2022, and 2023. If we were to add the 800K BOPD the agency expects us to add it would require another +/- 200 rigs, and another 50 frac spreads, to land out at around 9.7 mm BOPD. It would also require something else.
That brings us to the core of our thesis that continued gains in shale production are problematic due to the age of the currently producing inventory, and the remaining Tier I drilling sites.
If you've read many of my articles on shale producers you run across the term- rock quality. It refers to a number of features of a producing interval that can include but are not limited to interval depth and thickness, the natural permeability, the crude quality, the gas-oil ratio, formation pressure, and temperature. All of these will have a bearing on what it costs to drill a well and how much production per day, and over the economic life of the well it can be expected to make. It will also have an impact on the decline rate-the rate at which oil production declines as water rushes in to replace it. But, let's not stray too far from our central thesis.
A two-part central thesis
First, the producing wells in shale land are aging, and an increasing number of wells will water-out each month as we go. The takeaway from the graph below is that 8-10 months online and a shale well has produced about 2/3 of the oil it will ever produce. The water cut is rising - let's understand something, nature abhors a vacuum, right? Yes, it does. So as oil is extracted water begins to form an increasing amount of daily production. Somewhere between 18 and 20 months we hit 90% of the potential ultimate recovery, and...it is time to call the cement truck. Ignore the amounts here, the point is wells that have been online for over a year are headed toward P&A town. Let's also agree that we are over-simplifying here to make a point, as rock quality - there it is again - will play a big role in the decline curve for a particular well or field.
For the sake of simplicity let's agree that a horizontal well and a shale well mean the same thing. That's a bit of an over-simplification, but is probably 98% true. Let's not quibble.
Every year we typically add about 20K wells in the U.S. This tracks with the number of active wells in the Permian and Eagle Ford basins, 66530, the two basins which account for about half the daily output of shale.
If you just average the number of wells with shale production at 8.5 mm BOPD it comes out to 52 BOPD, meaning the bulk of these wells are long past their peak and headed for extinction.
The takeaway here is that current drilling is barely replacing the 20K odd wells that hit terminal decline every year, having produced 90% of everything they are likely to do. It is going to take substantially more drilling to impact this figure with new wells alone.
Another well-kept little secret
Let's say you're an oil producer in 2019. Oil prices are in the tank, not as low as they will go, but your company is just keeping its head above water. You bring your executive operations team into your office and direct them to spend their capex money on the very best prospects.
And, that's just what companies have done. A Rystad article noted that in 2020, companies put their emphasis on Tier I locations.
“Five months into 2020 and three months into the downturn and the resulting drilling-activity collapse, we see that operators are increasingly focusing on sweet spots. This is likely to result in Tier 1 acreage making up a record 47% share of this year’s total drilling activity, up from between 36% and 40% in the 2016 to 2019 period.”
Now, the same article notes that while the Midland and Delaware basins likely contain another 15-19K, Tier I locations, using the same logic we applied above, the emphasis may shift toward Tier II and III zones. The rationale being that with the higher breakevens for these lower tiers, it makes sense to develop them with high prices currently being received.
Some of the distinctions between Tiers can be overcome by technology, on a case-by-case basis. This will depend, for example, if a well is Tier II because of depth, or distance from sales lines, or perhaps if it’s lower quality rock, with lower natural pressure and porosity and permeability, or the GOR is tilted more toward gas than oil. As I've said there are many variables distinguishing the Tiers.
Energy stocks continue to be undervalued relative to the demand that is being seen for oil and gas at present. If indeed we see shortages of critical crude, gas, and refined fuels, I think the present upward trend will deflect sharply higher. The world is still addicted to fossil fuels, whether it likes it or not.
Companies that have been top performers in 2021, will likely continue this outperformance in 2022. Moves that many of them made to secure top-quality Tier I drilling locations, with M&A activity of the last couple of years to ensure their long-term survival comes sharply into focus. The moves made by Occidental Petroleum, (NYSE:OXY), ConocoPhillips, (NYSE:COP) Pioneer Natural Resources, (NYSE:PXD), Devon Energy, (NYSE:DVN), and others viewed in the context of this new era should begin to add further value to these companies.
It is not too late to buy these companies, subject to your own investor risk tolerance for growth and income.
By David Messler for Oilprice.com
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