Production growth may slow, but total liquids production won't go down for years.
Low Price or High Price the Energy Revolution in America is here to Stay
The United States of America is the largest, most powerful hydrocarbon producer on the face of the Earth. Read that again. Ten short years ago you would be guffawing with laughter at such a statement. It would never, ever be possible. We are not used to this idea; it snuck up on us so quickly. Many people are still stuck on the outdated, silly Malthusian notion of Peak Oil. Remember that? As of last week we produced 9,422,000 barrels of oil. We also produced 5,214,000 barrels of other liquids: 3.1 Million barrels of natural gas plant liquids, 1 million barrels of renewable fuels and oxygenate and 1 million barrels of fuel ethanol. That is a total of 14.6 million barrels per day of total liquids production. We are also the world's largest natural gas producer. At the end of 2014 dry gas production was more than 74 Billion cubic feet per day.
This is OPEC's worst nightmare. We are effectively energy independent. We produce 9.4 million bbls per day and we import 3 million from Canada and 1 million from Mexico. They are our neighbors and friends. 13.5 million Bbls per day come from absolutely secure North American sources. We refine 15.5 or 16 million bbls per day. Thus 80-85% of our crude is our own. Not quite true energy independence, but darned close. Late last year, led by Saudi Arabia, OPEC began a price war in order to defend market share against the relentless North American onslaught.
OPEC has done the US energy industry a favor. Shale drilling is a technology that has produced a rebirth of the American energy business. All new technologies have a similar lifecycle. Explosive growth where everyone piles in and eventually silly money gets spent and some people get over leveraged. Then there is a period of consolidation where the weak get weeded out. Finally steady growth as a more mature business model takes hold. Look at the technology/internet business. The 1990's were the dot com bubble. After it burst there was a long period of consolidation as weak and poorly thought out businesses were taken over or went out of business. In 2015 the digital technology revolution is stronger than ever. Shale hydrofracking has gotten got out of hand. Many companies are overleveraged and have drilled anything whatsoever. A rationalization and consolidation is a good thing. It is a blessing that OPEC has induced this sooner rather than later. A few short years from now the US oil business will be stronger and better than ever.
OPEC has been losing market share slowly and steadily for a decade or more. This price war is too little too late. The best they can hope for is to slow the rate of production growth in America and stop the spread of the shale revolution around the world. Guess who has the second largest shale reserves on Earth? A gold star if you guessed China. OPEC has lost America as a customer, more or less. They cannot afford to lose China too.
Let us examine US oil production and how US producers think about capital deployment in order to better understand the consequences of lower prices. Current production is 9.4 million barrels per day. In January production was 9.1 million barrels per day. 100,000 barrels per month is still the growth rate. That's actually higher than the average over the last three to four years which has been around 80,000 bbls per month production growth rate. Analysts and economists expect this to slow in the second half of this year. The number of active drilling rigs has dropped enough that this is probably a safe bet. It won't drop as quickly as folks think and I do not believe it will go to zero or become negative. Maybe in 2017 you will see production actually drop, but that is a long time away.
Independent producers are called exploration and production companies for a reason. They are two different processes that are capitalized and thought of separately. All this talk of break even prices is largely irrelevant. The discussion is much more nuanced. Discussing break even prices of $60, $70 or $80 dollars is only relevant to an oil company at the very beginning of an exploration play; before land has been bought, before mineral rights acquired, before everything. The life cycle of an oil play is 10 - 30 years or more. The question that executives ask is will the price over the lifetime of this project justify the cost plus a suitable margin? It is not a black and white discussion since you are discussing long time frames and projects are capitalized in many small chunks along the way.
People confuse break even prices with shut in prices. It is vital to know the difference. Oil production is a cash flow business. Once you are at production stage (the pump jack nodding up and down) all other money has been spent. You have debt to service and the only thing that matters at this point is the actual cost of making the pump jack go up and down and getting the oil to the surface. This cost varies, but in most cases it is under $20 per barrel. You will not see significant shut-ins unless prices go below $20 for a long period of time.
It is important to understand the concepts of initial drilling, infill drilling, HBP and well completions. Initial drilling is always the most expensive. Roads and pads have to be built along with storage tanks and gathering systems. These systems have to be built whether you produce one barrel or one million. Once you have completed the initial drilling and build out has happened on a property or series of properties then everything else is infill drilling. The cost of the second, third fourth wells etc. go down. Once you have done the initial expensive work you will drill more wells even if the oil price is lower because your cost for those wells are lower AND you want the cash flow.
HBP stands for held by production. Most land being developed for oil is leased. Lease terms vary, but in all cases the lease holder has a limited time ( 3 - 5 years) to drill at least one producing well on the property ( generally every 640 acres, this varies). If you do not drill a producing well you lose the lease and the money you spent on it. Once you drill a producing well on a property you have the lease forever IE held by production. Millions of dollars are at stake, so in new oil fields like the Bakken, Eagle ford, Niobrara, and Marcellus/Utica every well necessary to hold the leases will be drilled almost regardless of price. The Eagle Ford, Bakken, Niobrara, Utica and Marcellus are big enough and young enough that HBP drilling is still going on.
Nationwide there is a backlog of thousands of wells that have been drilled and capped, but not completed and connected. The cost of completing a well is around $5 per barrel. No company will forgo the cash flow from production over $5 per barrel. It will take 12 months or more to relieve this back log. IE more production to come on stream whether or not there is new drilling.
According to a study by Ernst & Young the nationwide average reserve replacement cost is $20.30 per barrel. According to the Dept. of Mineral Resources in North Dakota the break even cost in the 4 core counties of the Bakken field is between $30 - $40 dollars per barrel. Recently spot prices have been in the $40's. It would seem marginal. Not so. Oilmen are a notoriously bullish bunch though and want to know what the price will be a year or two from now. The CME is helpful here. Oil for delivery in May of 2016 is $57.60. Oil for delivery in Jan of 17 is over $60. Plenty of potential profit margins there.
With those forward prices you will see lots of activity in the heart of all the major oil fields. This is called high-grading. Overall drilling activity will go down and capital budgets will be slashed, but overall capital will be redeployed to the very best areas with the lowest break evens and the best rate of return. This results in more production from fewer wells.
Finally two of the big fields are liquids rich. The Marcellus gas field is a wet gas field (IE the gas comes out with gas liquids such as ethane, propane and butane to name three). The Eagle Ford Shale is a liquids rich oil and natural gas field. The liquids are very high value and serve to drive revenues higher/costs down. Sub $3 natural gas has not slowed down the Marcellus and $50 oil will not affect the Eagle Ford.
The US oil business is going to undergo a much needed consolidation and rationalization phase, but the energy revolution is here to stay. There will be an enormous amount of merger and acquisition activity for the next few years. Follow the smart money. Several enormous PE funds exclusively for energy have been raised recently. The Moody's list of highly leveraged oil producers is a great place to start. Watch those companies. More than a few will seek shelter in the arms of better capitalized brethren. Drilling activity will slow down and the growth rate of oil production will slow from its torrid pace. Nevertheless the USA will produce 10 million barrels per day by the end of 2015. Write that one down in ink. All that oil and gas has to move to market. Mid stream assets available at bargain prices are a great risk reward investment right now as are well capitalized oil and gas producers.