“Short-cycle production” could be about to get an economic test…

The dots clearly show that oil prices and oil production are uncorrelated…

Caldara, Dario, Michele Cavallo, and Matteo Iacoviello

Board of Governers of the Federal Reserve System, 2016

The number of US oil rigs went down by 5 last week to 744 rigs, while the number of US gas rigs increased by 4 to 190 rigs. In terms of the large basins, the Permian rig count increased by 6 to 386 rigs, while both the Eagle Ford and Bakken rig counts declined by 3 each to 68 and 49 rigs respectively. 

Baker Hughes Rig Count, Sep 25, 2017

 

The multi-billion dollar question is: Can shale handle an increse in demand? Closely related: Is shale in a boom that is unsustainable and not generating sufficient cash to reward investors for the massive risk they have taken? Because if the latter is correct the former must be answered in the negative. The above quote is slightly mischevious and merely highlights economic research that supply factors have historically had a far bigger impact on the oil market than demand factors  (whether this is true going forward is not for today).

The NY Fed today reports that it is supply shortages now that are driving the price (and I have no idea about the construction of the model but the reduction in the residual leads me to believe it is broadly accurate), so this is a supply driven event not a demand driven event:

Oil Price Decomp 25 Sep 2017.png

If, as Spencer Dale argues (speech here), we are in the midst of a technical revolution then this is what we would expect. Hostoric levels of inventories should come down because supply is more flexible, these short-term kinks in demand caused by natural or geopolitical events should merely spur an increase in the rig count or a change in OPEC quotas. Other senior BP staff today were on message:

“Rebalancing is already on the way,” Janet Kong, Eastern Hemisphere Chief Executive Officer of integrated supply and trading at BP, said in an interview in Singapore. But OPEC needs “definitely to cut beyond the first quarter [2018]” to bring inventories down and back to historically normal levels, she said…

“If they extend the cuts, yes it’s possible” to achieve $60 a barrel next year, she said. “But it’s hard for me to see that prices will be sustainably higher,” she added.

Or is Permania simply the result of the Federal Reserve flooding the market with liquidity that is allowing an unsustainable production methodology to continue unabated storing up yet another boom and bust cycle? Bloomberg this week published this article on Permania, where the incipient signs of a bubble are showing in labour and infrastructure shortages and the outrageous cost overruns:

Experienced workers are harder and harder to find, and training newbies adds to expenses. The quality of work can suffer, too, erasing efficiency gains. Pruett said Elevation Resources recently had a fracking job that was supposed to take seven days but lasted nine because unschooled roughnecks caused some equipment malfunctions.

By this point, “we’ve given up all of our profit margin,” he said, referring to the industry. “We’re over-capitalized, we’re over-drilling and, if prices don’t rise, we might be facing a double dip in drilling.”

If I was being cynical about offshore production I would note that he was two days over with a rig crew while in the same calender week Seadrill and Oceanrig had collectively disposed of billions of investment capital and will still have the inventory for years. This guy is literally two days out of forecast and he is worried about being over-capitalized (and also that wiped his profit margin? Hardly redolent of a boom?) Offshore drilling companies are like 10 years and 100 rigs out of kilter… Anyway moving swiftly on…

Bloomberg also published this opinion on Anadarko noting:

Late on Wednesday, Anadarko Petroleum Corp., which closed at $44.81 a share, announced plans to buy back up to $2.5 billion of its stock; which is interesting, because almost exactly a year ago, it sold about $2 billion of new stock — at $54.50 apiece.

(That’s pretty clever, they sold stock at $54.5 and are buying it back at $44.8, like Glencore never buy off these people when they are selling, at heart they are traders. More importantly most research suggest companies nearly always overpay when buying stock back so if the oil price keeps creeping up they are going to look very smart indeed.)

But the real point of the story is that capital is slowing up to the E&P sector, well equity anyway no mention of high-yield:

Equity US E&P Sep 2017

Meaning that maybe people are getting sick of being promised “jam tomorrow”. However I can’t help contrasting this with productivity data, Rystad on Friday produced this:

Rystad Shale Improvement Sep 17

So despite the anecdotal evidence on cost increases in the first Bloomberg article the productivity trend is all one way.  And the stats seem clear that a large part of deepwater is at a structural cost disadvantage to shale:

ANZ cost structure 2017

Frac sand used to be c.50% of the consummables of shale, but surprise:

Average sand volumes for each foot of a well drilled fell slightly last quarter for the first time in a year, said exploration and production consultancy Rystad Energy. Volumes are expected to drop a further 2.5 percent per foot in the current quarter over last, Rystad forecast…

Companies including Unimin Corp, U.S. Silica Holdings Inc (SLCA.N), and Hi Crush Partners LP (HCLP.N) are spending hundreds of millions of dollars on new mines to address an expected increase in demand.

On Thursday, supplier Smart Sand SND.O reported it shipped less frack sand in the second quarter than it did in the first. Rival Fairmount Santrol Holdings Inc (FMSA.N) forecast flat to slightly higher volumes this quarter over last.

In the last six weeks, shares of U.S. Silica and Hi Crush are both off about 30 percent. Smart Sand is off about 43 percent since June 30…

Some shale producers add chemical diverters, compounds that spread the slurry evenly in a well, and can reduce the amount of sand required. Anadarko Petroleum Corp (APC.N) and Continental Resources Inc (CLR.N) are reducing the distance between fractures to boost oil production. The tighter spacing allows them to extract more crude with less sand.

Technological innovation and scale: Less sand used and increased investment going on that will reduce the unit costs of sand for E&P producers. This is the sort of production that brought you the Model T in the first place and the American economy excels at. Bet against if you want: just remember the widowmaker trade.

Shale is a mass production technique: eventually it will push the cost of production down as it refines the processes associated with it. To be competitive offshore must emulate these constantly increasing cost efficiencies. I have said before that shale won’t be the death of offshore but it will make a new offshore: a bifurcation between more efficient fields, low lift costs, and economies of scale in production that make the “one-off” nature of the infratsructure cost efficient, and smaller, short-cycle E&P of shale (and some onshore conventional).

Offshore is going to be here for a long time, it is simply too important in volume terms not to be. But what a price increase is not going to see is a vast increase in the sanctioning of new offshore projects in the short-term. These will be gradual and provide a strong base of supply, as there longer investment cycle represents, while kinks in short-term demand will be pushed towards short cycle production. Backlog, or lack thereof, remains the single biggest threat to all offshore contractors.

Or this thesis is wrong and I, and to be fair people far cleverer (and more credible) than me, are spectacularly wrong, and a new boom for offshore awaits in the not too distant future…

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