Remember the shale gale and Saudi America? The scale of those outlandish delusions has now dwindled to plays in a few counties in West Texas and southeastern New Mexico. Saudi Permian.
It’s a race to the bottom as investors double down on the tight oil companies that can still tell a growth story. Permian-weighted E&P companies are the temporary darlings of Wall Street as other tight oil plays have lost their luster.
A Silly Price Rally: Catch-22
We are in the middle of a truly silly price rally. Other rallies of 2015 and 2016 took place despite substantial production surpluses and too much inventory. Then, there was some hope that higher prices might result if over-production could be brought under control. Now, the world’s production and consumption are near balance but oil prices remain mired in the $40 to $50 per barrel range.
This current rally will end badly because there is something more fundamental keeping prices low. Despite repeated assurances from IEA and EIA that demand growth is strong, it is not strong enough to draw down outsized global inventories.
Hope for an OPEC production freeze at next month’s meeting in Algiers is the main factor driving this rally. The problem is that the world liquids market is as close to balance as it ever gets—over-supply has been less than 0.5 million barrels per day for the last two months (Figure 1). Oil prices were more than $100 per barrel at similar or greater production surpluses in 2013 and 2014.
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Figure 1. World liquids production minus consumption shows that the present market is as close to balance as it ever gets. Source: EIA and Labyrinth Consulting Services, Inc.
In 2015, when the average production surplus was 2 million barrels per day, it was a different story. Over-production is not the problem now as it was then. If OPEC freezes production, it won’t make any difference.
Inventories exceed all historical levels. The world remains over-supplied because there is too much oil in inventory.
As long as oil prices are range-bound between about $40 and $50 per barrel, it makes more sense to store oil than to sell it. The carrying cost of storage is less than what can be made by rolling futures contracts over each month. Inventories will stay high until prices break out of their current range but outsized inventories make that impossible. Catch-22.
Four Oil-Price Cycles in 2015 and 2016
There have been four oil-price cycles in 2015 and 2016–the first three each lasted approximately 6 months (Figure 2). Each new cycle began with high price volatility that fell as price peaked. We are currently in the upward arc of Cycle 4.
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Figure 2. Oil-price and oil-price volatility cycles since 2014. Source: EIA, CBOE, Bloomberg and Labyrinth Consulting Services, Inc.
The oil-price volatility index has fallen to levels similar to when prices peaked during the last cycle suggesting that current WTI futures prices just above $48 per barrel may already be near the peak for this cycle. Prices may increase into the low-$50 per barrel range as they did in June before falling again.
The latest cycle began when NYMEX futures prices fell below $40 per barrel in early August. In the succeeding two weeks, they have climbed to more than $48 (Figure 3).
A factor beyond a possible OPEC freeze is the weakened U.S. dollar because of expectations that the Federal Reserve Bank will not raise interest rates at least until December. The value of the dollar against other major currencies has fallen 3 percent over the last month (36 percent annualized). WTI futures prices have increased 22 percent since August 1.
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Figure 3. 2016 U.S. dollar index and WTI NYMEX futures prices. Source: EIA, Wall Street Journal and Labyrinth Consulting Services, Inc.
A third factor driving the current price rally is long-term concern about supply because of under-investment in oil development projects and exploration since the oil-price collapse. Recent statements by the International Energy Agency that demand may outpace supply in the next few years underscored that anxiety.
Figure 3 shows that oil prices appear to be range-bound between about $40 support and $51 per barrel resistance levels. The upper boundary is largely controlled by record-breaking volumes of U.S. and world crude oil inventories and the fact that producers add rigs and production with each upward swing in oil prices.
The 200-day moving average of NYMEX futures prices suggests similar range boundaries of about $38 and $52 per barrel (Figure 4).
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Figure 4. Two-hundred day moving average of WTI NYMEX futures prices. Source: EIA, Bloomberg and Labyrinth Consulting Services, Inc.
Staggering Inventories
This market looks for any excuse to raise prices. Every price upswing is seen by some as the beginning of a return to oil prices above $70 per barrel. We seem to selectively forget that the staggering inventory levels of crude oil make this impossible until those volumes are drawn down substantially. Oops.
U.S. crude oil inventories fell 2.5 million barrels this week but have increased a net 1.6 million barrels over the last month during what is supposed to be de-stocking season (Figure 5).
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Figure 5. U.S. crude oil inventories and comparison with 2015 levels and the four years preceding. Source: EIA and Labyrinth Consulting Services, Inc.
Storage volumes are 57 million barrels more than at this time in 2015 and are 143 million barrels higher than the 5-year average. This is definitely not a basis for a sustainable oil-price rally. Until inventories are drawn down by at least another 125 million barrels, a recovery to somewhere approaching mid-cycle 2014 levels of about $80 per barrel is technically impossible.
The Permian Basin Dominates Rig Count Increases
Five new horizontal rigs were added last week to drill tight oil objectives in the Permian basin and 12 rigs were added the previous week. Only 1 rig was added in the Bakken play after losing 2 rigs a week ago. No rigs were added in the Eagle Ford after losing 1 rig the previous week. More capital is being spent in the Permian basin than in all the other plays put together.
Overall, 67 tight oil rigs have been added since early June. Forty eight of those are in the Permian basin, 5 in the Bakken and 6 in the Eagle Ford play (Figure 6). Four rigs were added in the Niobrara, 3 in the Granite Wash and 1 in “Other.” Rig count increases began as oil prices peaked above $50 per barrel in early June and continued through the slump toward $40 prices before the latest upward swing to $48 per barrel.
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Figure 6. Permian basin, Bakken and Eagle Ford tight oil horizontal rig count, NYMEX WTI prices and oil-price volatility index. Source: Baker Hughes, EIA, Bloomberg and Labyrinth Consulting Services, Inc.
Related: How Artificial Intelligence Could Help Transform The Oil Industry
Weekly changes in the Permian basin rig count are the leading indicator of capital flows and expenditures. Permian rig count is more responsive to capital flows than the other tight oil plays because there is more money available for Permian-weighted companies.
In late July, I wrote, “When prices fall and oil-price volatility increases, the floodgates of capital open. Every genius-investor wants to buy low and sell high. Rig count rises with fresh capital, production increases and oil prices fall.”
In fact, the Permian basin accounts for 64 percent of the total U.S. horizontal tight oil rig count (Figure 7).
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Figure 7. The Permian basin rig count represents more than 60 percent of the U.S. horizontal tight oil rig count. Source: Baker Hughes and Labyrinth Consulting Services, Inc.
This is curious because Permian production from the Bone Spring, Wolfcamp and Trend-Spraberry horizontal plays represents only 21 percent of total tight oil production (Figure 8).
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Figure 8. Permian basin daily production from the Bone Spring, Wolfcamp and Trend Area-Spraberry plays is only 21 percent of total U.S. horizontal oil production. Source: EIA, Drilling Info, North Dakota Department of Natural Resources and Labyrinth Consulting Services, Inc.
It is even more curious because Permian basin tight oil proven reserves rank 42nd in the world just behind Denmark and Trinidad and Tobago based on the latest EIA data (Figure 9).
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Figure 9. Permian basin tight oil proven reserves compared with world crude oil reserves. Source: EIA and Labyrinth Consulting Services, Inc.
Some will argue about potential and possible Permian resources and reserves preferring Pioneer CEO Scott Sheffield’s view of things to reality. I won’t debate them but the point is that Saudi Permian is a stretch based on any reality-based interpretation of existing data.
It’s A Stock Play, Not An Oil Play
Eleven companies now operate 3 or more rigs in the Permian basin (Figure 10). These represent a mix of independents and major oil companies. Concho operates the most rigs with 15 and Pioneer is second with 13. Energen, Anadarko, Chevron and Apache all operate 5 rigs or more. Companies that operate at least 3 rigs include Cimarex, Diamondback, Oxy, Parsley and Callon.
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Figure 10. Companies that operate three or more rigs in the Permian basin. Source: Drilling Info and Labyrinth Consulting Services, Inc.
The stock performance of all oil companies correlates strongly with oil prices but many Permian basin-weighted stocks have significantly out-performed ETFs (exchange-traded funds) by 2-to-1 to as much as 4-to-1 since the current price rally began in early August (Figure 11).
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Figure 11. Stock performance of many Permian-weighted independent stocks out-perform ETFs by 2:1 to 4:1 since the current oil-price rally began. Source: Source: Google Finance, EIA, Bloomberg & Labyrinth Consulting Services, Inc.
Callon’s stock price has increased 34 percent since August 1, 2016. Parsley’s and Energen’s have increased 22 percent, Pioneer’s has risen 18 percent and EOG’s, 17 percent. These companies have all beaten the 16 percent increase in WTI futures prices over the same period and have substantially out-performed oil ETFs (Energy Select XLE and Vanguard Energy VDE) whose returns averaged only 8 percent in August. Related: Why Investors Shouldn’t Believe The OPEC Rumors
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Most of the Permian companies with strong stock performance also have sizable debt loads and high debt-to-cash from operations (EBITDA) ratios. The average debt-to-cash flow ratio is 5.4:1, and 4:1 is considered the current threshold for bank loan risk (Figure 12). Among the independent companies with high stock performance, only Diamondback and Energen have ratios less than 4:1. Parsley, Cimarex and Concho all exceed 7:1.
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Figure 12. Most Permian operators have debt-to-cash flow (EBITDA) ratios that exceed bank-risk threshold of 4:1. Source: Google Finance and Labyrinth Consulting Services, Inc.
Another reason for the highly volatile stock prices of most Permian companies is in their stock valuations. On average, the ratio of current to mid-2014 stock valuations is double the ratio of first half 2014-first half 2016 NYMEX WTI oil prices (Figure 13).
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Figure 13. The average ratio of 2016-2014 stock valuations is double the ratio of 2016-2014 WTI futures prices for Permian-weighted companies. Source Google Finance, EIA and Labyrinth Consulting Services, Inc.
Stock prices of shale companies with good positions in the Bakken and Eagle Ford have also increased but those companies have a harder growth story to tell. Average well density in the Permian horizontal plays is about 1 well per 860 acres. That is less than half of the 1 well per 382 acres per well in the Bakken and one-fifth of the 1 well per 172 acres per well in the Eagle Ford play (Table 1).
Table 1. Current well densities for the Bakken, Eagle Ford and Permian horizontal plays. Source: Drilling Info and Labyinth Consulting Services, Inc.
Among the high stock performers, both EOG and Pioneer also have positions in the Eagle Ford and EOG is also represented in the Bakken play.
A Race To The Bottom
The main cause of the collapse of global oil prices in 2014 was a production surplus. That continued to be the key factor throughout 2015. Now, over-production is still a concern but the market has been close to balance for the last 6 months.
For most of 2016, however, liquids consumption growth has declined. It increased with falling oil prices and peaked at the end of 2015 when monthly average oil prices were near $30 per barrel (Figure 14). As prices recovered into the $40 to $50 range, consumption growth dropped. The global economy is apparently too weak for prices in this range.
Figure 14. World liquids consumption growth is decreasing with increasing oil prices. Source: EIA and Labyrinth Consulting Services, Inc.
Growth occurred only when oil prices were below disturbingly low thresholds. Declining consumption growth is the likely cause of persistent high inventory levels and range-bounded prices.
The dream of Saudi America has fallen on hard times since oil prices collapsed. Persistent and often misleading claims about technology, efficiency and lower cost have kept hope alive for true believers. The truth is that production costs are more than oil prices. The present situation cannot be sustained without even more carnage in the oil industry.
Investors have identified the plays and companies that are in the best position to survive and they are in the Permian basin. As the field of attractive companies dwindles, more short-term investment is directed toward the perceived winners. These favored companies can go to the capital markets more or less at will with new stock or bond offerings and easily raise hundreds of millions to billions of dollars. This allows them to continue drilling and spending, and accounts for the upsurge in Permian rig counts at the beginning of every new price cycle.
Those who bought stock in Permian-weighted companies made a good profit this month. Those companies are attractive to investors not because of their underlying financial strength. It is because they satisfy the reach for yield that is no longer met by Treasury bonds or other conventional investments in a low-interest rate and low-growth economy.
Like the companies, the Permian plays are attractive mostly because they don’t lose as much money as the other tight oil plays and have a better growth story. They are the best of a bad lot. But they still lose money at oil prices less than $50 to $60 dollars per barrel at the wellhead. There is about a $5 differential between Permian wellhead and benchmark price so $55 to $65 per barrel WTI prices are needed for Permian tight oil plays to break even.
Permian basin tight oil production will peak around 1 million barrels per day and begin to decline in the mid-2020s based on our models. Those models assume a return to $75 to $80 oil prices in the next 3 to 5 years and that capital will be readily available to fund ongoing drilling. If either assumption is too optimistic, the plays will peak later but will not produce any more oil. The Permian basin has good, prolific plays but it is no Saudi Arabia.
The Bakken and the Eagle Ford were all the rage for investors until lower-for-longer oil prices were accepted as the new reality during the second half of 2015. Now, investors believe that the Permian basin is the only place with profitable plays at low oil prices. Eventually, they will tire of the Permian also and may be lured back to the Eagle Ford or Bakken by some new tall tale about technology or efficiency.
Investors will provide capital as long as the stock plays earn them the yield that they need. Companies will dress themselves and their plays up in order to compete for the capital offered.
Meanwhile companies continue to produce about 3.5 million barrels per day of tight oil that loses money on each barrel.
With every new price rally, investors and companies think that this time oil prices will finally recover to a level where the companies can make money again. But with every price rally, rig counts and production increase, demand falters, inventory rises and prices fall back.
It is Einstein’s definition of insanity–doing the same thing over and over again and expecting a different result.
It is race to the bottom.
By Art Berman for Oilprice.com
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