Shale productivity, oil prices, and marginal demand…

The quote above comes from the CFO of NOV Global, Clay Williams, in 2011. Clearly he understood the transformative nature of shale before many (as well as putting it as eloquently as anything I have ever read). The question for a long time for many was when will shale stop getting funded? But actually the shale revolution is beyond quetion now and the real question for offshore in a era of rising prices again is what proportion of new investment is directed to offshore versus onshore? Particularly for asset owners with high fixed running costs, and rates at below cash break-even on an annualised basis, what is likely in the short-term?

One of the reasons shale continued to be funded wasn’t just rising oil prices it is because capital markets in the US are efficient enough to support business models with high rates of productivity improvement even if the payoff is not immediate. This recent presentation from Helmerich & Payne, the largest US land based driller, shows why:

HP Well efficiency.png

H&P are targeting a 40% increase (as a stretch goal) in efficiency/productivity, an outcome that would further rapidly enhance the economics of shale. Not only that they are doing it with an assumption of pricing power for the drilling contractor where a 20% improvement in efficiency in operations for the customer leads to a 33% increase in their prices (15k-20k), and the next 20% increase brings them another 25% (20k-25k). With these sort of possible productivity improvements, and a much shorter payback time, it is hard to see a freeze in capital funding anytime soon, and in fact at current prices the investment boom is self sustaining anyway. This incremental learning-by-doing and constant improvement is a core part of manufacturing efficiency and has become part of the standard DNA of manufacturing companies (for a fascinating look at how this came to be in the car industry read The Machine that Changed the World). Deming would be proud.

Those sort of productivity improvements, on a per barrel delivered equivalent basis, are the competition for offshore production at the margin for project investment decisions. I continue to believe this will favour much larger, high volume, offshore fields over shallow water developments. Offshore faces the hurdle of clong lead times that were previously just assumed as an unavoidable part of the oil basis. A blog post for another day is the insights behavioural economics offers to this.

Pioneer Natural Resources also came out this week talking up their productivity:

Pioneer Improvement.JPG

This data point is interesting and is the crux of future demand across the offshore supply chain:

Shale rigs vs offshore.JPG

That index ratio is really what will drive the strength of any offshore recovery. Since May 16 up until January 18 rising oil prices (much slower than currently) were met with a massive increase in the shale rig count and continued decreasing demand of the offshore rig count. In May 16 the price of WTI was ~$44.00 and Jan 18 the price of WTI ~66.60 so a ~51% increase in the price of oil was followed by a 160% in US land rigs and a 22% reduction in offshore rigs. Any statistical model of industry demand that not have this relationship in the regression is to my mind invalid. Any statistical model without a period break from c. 2014-2016 should similarly be treated with exceptional caution. The future, statistically speaking, will not be like the past.

There are a host of reasons (many covered here previously) but the argument that increasing oil prices will be met at the margin first with an increase in demand for short cycle shale seems irrefutable. Any “offshore recovery” post the shale revolution is clearly going to be very different to recovery cycles prior to this enormous investment and capital deepening process that has taken place in the last 5-7 years.

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