U.S. crude oil production peaked earlier in 2015 at 9.6M BBL/d and is now on a steepening decline curve.
World oil over-supply is estimated at 1.5M BBL/d, and Saudi Arabia is said to be increasing production as oil prices decline to regain market share.
As U.S. shale oil drillers struggle to survive in this low priced environment, the question arises “How long will oil prices remain low?”.
The business media is currently full of year end predictions, and many concern the future price of oil.
Goldman Sachs led the charge in predicting low the prices of oil might go back in September of 2015 when analysts for the firm published a report saying prices could drop as low as $20 per barrel.
And now that oil spot market prices have dropped to the $35 range in mid-December, the market is now set-up for an epic battle for the game of “who is going to be right?” Ron Insana injected his view on 12/8/2015 that an Oil recovery by 2017? Not likely. He foresees price levels approaching $20 per barrel and shale oil drillers surviving through higher productivity. Alternatively, on 12/4/2015 Daniel Yergin, Vice Chairman of IHS, explained his view on Why oil prices cannot stay this low. He sees a range bound trade of $40-$60 for oil over the intermediate future.
Not one to be satisfied with just following the news cycle to assess the probable direction of the market, I gathered some useful facts about the current oil market. I share them in this article so as to help investors make their own informed decision about their energy market positions and investment strategy.
U.S. oil market prices on a roller coaster ride since 2008
Oil prices hit an all-time high over $147 per barrel in the summer of 2008, and 6 months later were below $40 per barrel as the U.S. financial crisis left no asset class unscathed, with the exception of sovereign government bonds like U.S. Treasuries. The price of oil experienced a similar downward juggernaut from June of 2014 into early 2015, dropping from over $100 per barrel in June 2014 to below $40 per barrel by the winter of 2015. The price of oil has since stayed stubbornly on average below $50, and now seems to be making $40 the over / under zone.
But there is a big difference in the oil market in 2014-15 versus 2008-09. In 2008 U.S. oil production was still in a multi-decade decline trend. Since the end of 1985 when production was at 9M barrels a day, U.S. production dropped steadily to 5M barrels a day on average by 2005 – a low level for production not witnessed since the mid-1940s. The low oil production level meant the U.S. was heavily dependent on imported oil leading up to the 2008 financial crisis.
U.S. oil production increased only slightly post-crisis from 2009 to 2012. Because on the margin the world was still under-supplied with oil, prices recovered quickly from the 2008 crisis toward highs reached before the financial crisis.
The price rise abated at the end of 2011 as new supply came onto the market, but held steady in the $80 to $120 range for the next 3 years. The above chart shows the primary driver that eventually broke the back of oil prices beginning in 2014. U.S. oil production, driven by the exponential growth U.S. shale output, had risen from 5.5M BBL/d in mid 2011 to over 8.5M BBL/d by the summer of 2014, a 3M BBL/d increase in a very short span of time. And, U.S. oil production continued to grow to a peak of 9.6M BBL a day in June of 2015. In the second half of 2015 the upward trend has reversed.
What caused the recent downturn in U.S. production? Lower oil prices are the culprit. Saudi Arabia is the price leader in the market, and they have dropped the price level of oil to the point where it is expected that the market will clear excess world supply which has come about with the U.S. “Shale Boom”. In a “free market” the price drop will exert the most pain on the high marginal cost producers.
The very rapid reduction in shale oil production from mid 2015 though the end of the year provides a good indication that the Shale Boom is very vulnerable with oil prices at $50 per barrel or below (probably not news to many at this point). The real question is, when does the marginal supply from U.S. shale, and other marginal producers in the world, drop to a point that the market clears? And secondly, once the market has cleared, at what price point will capital race back into the marginal suppliers to pump production up to unsustainable highs again?
First, take a look at the U.S. production in a broader context.
U.S. Supply Increase in a World Context
In the third quarter of 2015 the world oil supply was 96.9M barrels per day. The U.S. supplied about 10% of this total.
But the bigger irrational fact is that on the margin over the last 2 years, the U.S. supplied 42% of the new oil which came on the market.
Meanwhile, world demand for oil has increased steadily as supply has risen over the last 2 years. In 3Q2015, world oil demand was 95.4M barrels a day, of which the U.S. consumed much more than the 10% it produced (see import section below).
The one fact which stands out in the data to me is that the U.S. pushed 4M BBL/ day in new supply onto the market between 2012 and mid-2014, and yet the marginal over-supply in the world is only 1.5M barrels a day. Purely from an economic standpoint, it appears some portion of the U.S. new supply is critical to the world supply equation. If this is true, the question becomes how much, and what price point is needed to profitably support the marginal production?
OPEC exports hurt most by U.S. shale boom
When I hear news media reports referring to Saudi Arabia “letting the price of oil collapse in order to garner market share”, the first question I have is “how much is enough?” To answer this question, I took a look at the net import data of crude oil into the U.S., concentrating on the 2007 to 2015 time period.
The data reveals that the U.S., by generating 42% of the new world oil production since 2012 has been able to lower its dependency level on foreign oil imports by 1.5M to 2M BBL/Day. The quest for “U.S. Energy Independence” touted as a goal in the 2012 Presidential race has actually succeeded to some extent. Drilling deeper into the statistics, the reason the Saudis have been able to garner OPEC co-operation in support of the current price dropping strategy becomes a little clearer. Since 2010, OPEC and Persian Gulf countries have lost over 1.5M BBLs per day in U.S. bound export volume. And, dating back to 2008, the decline reaches 3.0M BBLs per day. The primary reason for the added decline going back to 2008 has been increased imports from Canada into the United Sates.
Why is this important? My assessment is that re-gaining U.S. dependency is a key market share objective of the Saudis and by extension OPEC. As the U.S. became more energy independent over the past several years, the influence level of Saudi Arabia and OPEC over Washington policies and the U.S. financial system has waned. Yet, oil is priced in U.S. dollars for world trade. The unconventional policy of massive Fed QE which found its way into the oil patch was creating an unconventional monster. As painful and irrational as a shift from $100 per barrel oil may seem, the unconventional policy of destroying their revenue stream to flood the market with oil currency has been the chosen path by the Saudis.
I have coined the term “Oil QE” to describe the Saudi strategy. The near-term effect of lower oil prices in world market is to strengthen the USD. But it also strangles marginal producers, particularly those in the U.S. who cannot compete at the lower price level. The eventual impact will be that the U.S. will once again have to increase oil imports dramatically and begin running larger current account deficits. When that process begins, the U.S. Fed will be faced with a declining dollar and rising inflation as oil prices will rise if only because the dollar declines (opposite of today). Voila, oil QE counter-balances Fed QE, and Treasury rates must rise or inflation will become even worse.
The primary question is, when does the decline in U.S. supply become evident to the market, marking the beginning of the reversal expected?
EIA U.S. oil supply estimate shows rapid decline upcoming
In early December the EIA published a 2016 forecast for U.S. oil production. The forecast expects an average of 8.8M BBLs / day in production. If you extrapolate the production trend from this estimate you find that U.S. oil production is about to enter a period of substantial decline over a very short period of time.
When U.S. oil production peaked in June 2015 at 9.6M BBLs / day, the news media was filled with stories about how the industry had magically become more productive per capital dollar invested. If only the analyst doing the story actually did their homework and realized there is a lag time between when capital is spent and peak new production comes on line. That lag time is about 2 to 3 quarters. I am still hearing the argument, but it is not as strong after U.S. production has gone down 400,000 BBLs / day from July to November, and is definitely trending downward now.
Shale oil decline rates – Achilles’ heel of horizontal drilling
The rapid decline in production which is just beginning to show up in the U.S. oil production figures is a function of the rapid decline rates in shale well performance. Take a look at the typical life-cycle well performance for a shale oil well drilled in the Bakken.
After the first year, 72% of the expected oil output over the life of a newly drilled well is recovered. Within 3 years, 85% of the lifetime expected output is gone. With such a rapid rate of decline, the only way an investment in this type of well becomes profitable is for the business to have a very high price relative to the drilling cost, as a perpetual turn-over in capital is required to sustain the business model. If the price of oil drops below a sustainable threshold, capital formation becomes untenable as investors quickly realize that they are throwing money “down a proverbial hole”.
The marginal price threshold to sustain shale drilling in my analysis, where producers can provide a decent return on capital to shareholders, is $80 to $100 per barrel, depending on the field quality. I am currently following the “breakeven” level for many shale oil operations (see here and here for some published information), and currently the 0% return levels are reflecting marginal cost levels of $30 to $40 for many firms. These figures reflect short-run survival cost only. At these prices, the firm has an implied negative shareholder return because debt-holders expect to get paid. In order to get a real return on capital, oil prices must be higher, and you have to assume that production can be maintained, which requires perpetually more capital!
Why U.S. increased oil production is in serious trouble at prices below $50 per barrel
I have been tracking horizontal drilling firms since the phenomenon really picked up investment community momentum in 2012. The data suggest that the highest correlation of oil production rates and capital spending levels occur with a 2 to 3 quarter lag between spending and production. And, since capital spending in the industry increased upward at an exponential rate from 2012 through the end of 2014, the rapid decline in well output was masked until after mid-year 2015, since capital spending peaked 4Q 2014, and then fell dramatically.
Based on the major reduction in shale drilling capital budgets which have been implemented in the 9 months since the end of 2014, and the announced continued declines going into 2016, I expect U.S. drilling capital spending to drop below levels experienced in 2009. At this low level of capital spending, there is a growing chance that the EIA forecast for U.S. oil production by the end of 2016 and into 2017 will be far worse than the 8.4M BBL/d the currently projected. This assessment is based on regression analysis of shale drilling results relative to capital investment over the past 5 years.
Continental Resources: A reality check on shale oil productivity
To back up the assessment that investors are very likely under estimating how quickly U.S. oil production will decline, I suggest an in-depth review and tracking of how Continental Resources (NYSE:CLR) production changes in the next year as they dramatically curtail capital spending. Continental Resources, with its push into the Bakken with massive capital expenditures from 2011 through 2014 will be a good business case to track the reality behind shale oil drilling “productivity”. As the chart below shows , the CLR capital budget reversed dramatically after year end 2014. As expected, within 9 months oil production began to decline.
Continental Resources has provided 4Q 2015 guidance that total production will decline to between 200,000 and 215,000 boe/d in 4Q 2015. The total guidance includes gas production which is 35% of CLR output, and growing as percentage of output. If the production mix remains constant at 3Q levels, oil output in Q4 will drop to as low as 130,000 bbl/d, down from 148,000 bbl/d in Q3, a 12% decline in one quarter. The company also expects its capital spending rate to be at $400M-$500M as it exits 2015, a level last experienced at the end of 2010.
Continental Resources currently provides 1.6% of U.S. oil production, but has contributed 2.6% of the over 4MM per day increase in U.S. production since the beginning of 2011.
What goes up exponentially typically goes down at an equal pace unless the force being applied to produce the change is sustained. If this turns out to be true for the shale oil industry, you can expect CLR oil production to trend below 100,000 bbl / day by early 2017 if capital expenditures remain at $500M or below. By extrapolation, if the shale oil industry cuts spending in relative fashion, U.S. oil production will be below the EIA estimated 8.8M BBL/d average for the U.S. production in 2016.
Bottom Line: Oil QE Trumps Fed QE, and the carnage in the shale industry will be high
Some market “experts” have the opinion that oil will be lower longer, much longer, with $20 per barrel not considered unreasonable. The fundamental market metrics which need to stay in place for this scenario to materialize are stable (not drastically falling) U.S. oil production and a continually strong U.S. dollar. Alternative opinions are materializing that oil prices will stabilize in the $40-$60 per barrel range for some time period, probably through 2016, and then gradually rise as the world supply and demand imbalance disappears. This scenario seems to assume that shale oil producers can reasonably maintain production with low capital budgets in the face of the dramatic price decline.
Here is my opinion. Oil QE will bring the grand Fed QE experiment to its knees before oil goes back up.
The oil market is going to stay at or below $40 most likely right into the 2016 election. This low price level is going to result in at least one high profile bankruptcy announcement, combined with multiple others of smaller firms like Swift Energy (NYSE:SFY) and Sandridge Energy (NYSE:SD) which have already entered the re-structuring process. And there are currently plenty of other marginal firms in need of re-structuring of their high yield debt, see (NYSE:PQ) (NYSE:XCO) (NYSE:REN) to name a few.
One larger E&P firm that I have written about recently that fits this profile is Chesapeake Energy (NYSE:CHK). (see report here). If Chesapeake Energy were to enter bankruptcy it would be a blow to the industry as Aubrey McClendon was a pioneer in horizontal drilling. I have been told that he touted the technology as far back as a student at Duke University in the 1970s.
Continental Resources is at some risk if the low price pain extends too long, but currently is only on my watch list. However, I warn investors to be very careful with taking any long positions in high profile shale drillers like (NYSE:PXD) (NYSE:HES) (NYSE:AR) (NYSE:RRC) (NYSE:NBL) (NYSE:APA) (NYSE:CXO) at this time because the shake-out is only beginning. Many have already had high share price declines, but more pain is coming in my opinion.
Once the “sub-prime oil” panic level I expect is finally reached, the U.S. oversupply which the Saudis and OPEC are targeting to exterminate will be put on a trajectory to fall even more quickly as production shut-ins usually accompany bankruptcies. Although this scenario is a tumultuous financial market result, I do not think it will harm U.S. GDP, short-term, because Main Street loves cheap oil. This sequence of events will set the stage for the market reversal in Treasury rates and stock over-valuations that have benefited so heavily from the grand Fed QE / ZIRP experiment. A higher trade deficit, increasing consumer consumption, increasing inflation and a weaker dollar would leave the Fed few choices but to change course, particularly if the government starts to spend more to “keep America safe” from ISIS.
Now that oil is relatively very cheap, (in inflation adjusted dollars it is at pre-1974 Arab oil embargo levels), ironically the U.S. is on a path to return to dependency on Middle East oil. How much market share will be enough for Saudi Arabia? I think U.S. production will have to return to the pre-Shale Boom level of 6-7M BBL/d. At a minimum this means that at least 2M BBL per day in U.S. production needs to disappear. For many U.S. shale drillers this lower production number will not come soon enough…
Daniel Moore is the author of the book Theory of Financial Relativity:Unlocking Market Mysteries that will Make You a Better Investor. All opinions and analyses shared in this article are expressly his own, and intended for information purposes only and not advice to buy or sell.
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