Oil prices are every energy investor’s favorite topic, and we are no exception. In my post from last week, I discussed our view on crude prices, and noted how wrong oil price forecasters usually are. But, we still find a need to focus on them when we see conditions for directional changes begin to manifest. Now is one of those times.
Since the middle of September, West Texas Intermediate has found support at $50 per barrel. Several bullish signs have begun to emerge, giving traders indications that market fundamentals are moving in the right direction to correct the current oversupply. For example, recent drawdowns in crude oil inventories appear to indicate that demand is beginning to rise. That’s a good thing, but anyone savvy to the ways of American oil shale developers, there’s a mitigating factor.
We anticipate that many operators are taking advantage of WTI cresting above $50 and placing new hedges on future production
Recall that fundamentals include both demand and supply.
We anticipate that many operators are taking advantage of WTI cresting above $50 to place new hedges on future production. That locks-in net cash flows during the first year of a new well’s production, when Internal Rates of Return are at most risk.
More hedging about $50 per barrel means U.S. shale players will keep on drilling, and even add to the rig count in the coming quarters.
…operators in the Permian Basin are looking to increase rig count in 2018, and are shopping for service providers who can help them ramp-up activity.
A recent anecdote provides some insight into the magnitude of this trend. I met a long-time oil business acquaintance and former colleague for Happy Hour last Friday evening, and together we have seen more than a few energy business cycles over the past 25 years. Today, he is running sales and marketing for an oilfield services company, and had just returned from business trip to Midland. From his perspective, operators in the Permian Basin are looking to increase rig count in 2018 in a significant way, and are shopping for service providers who can help them ramp-up. Among other things, we talked about what operators are looking for from service providers and how fast they plan to increase activity.
Based on our discussion, big E&P companies are poised to stand-up more rigs in the Permian and if we take into consideration the planned increases from only the companies my friend mentioned, the region could see an increase of 30+ rigs in the first quarter of 2018. He obviously did not talk to every Permian Basin driller, but the companies he mentioned were big enough to generate a meaningful bump in the Baker Hughes rig count, which stood at 378 rigs last Friday, on their own. In other words, his view may be conservative.
Thirty more rigs could result in an additional 720,000 barrels of oil per day from the Permian Basin alone in 2018, an increase of 50% from the approximately 1.6 million barrels of oil per day the region produced in the first six months of 2017.
Let’s apply some back-of-the-napkin math to that equation. If operators stand-up 30 rigs in the Permian, and each one of them can drill 12 wells per year, then that conservatively translates into 360 new wells. The increase is coming from operators developing acreage in the most prolific parts of the Delaware Basin region of the Permian, so these aren’t just any wells. The new wells will be horizontal, multi-stage shale oil wells drilled in some of the most prolific areas of the U.S., quite capable of producing 2,000 barrels per day on average during their first year of production. Thirty more rigs could result in an additional 720,000 barrels of oil per day from the Permian Basin in 2018, an increase of 50% from the approximately 1.6 million barrels of oil per day the region produced in the first six months of 2017, according to the Texas Railroad Commission. We know our analysis is simplistic, however, it is indicative of rising future supply at a time when support at $50 looks tenuous to some.
At this point in the cycle, Permian Basin operators are the noise in the long-term signal of improving fundamentals. The ability of the U.S. industry to stand-up and lay-down rigs on short notice is astonishing, and oil shale operators will continue to ride the oil price bubble until global fundamentals improve and demand outstrips the Permian Basin’s ability to meet it, requiring a higher price signal to encourage Big Oil to invest billions in long-lead projects.
Even if OPEC holds the line on maintaining production quotas, we could see production growth exceed demand increases well into 2018. As we noted last week, because oil price forecasts are notoriously inaccurate, it probably makes sense to have a position in oil and gas stocks today. If we see weakness in WTI between now and next spring, then it could be a compelling opportunity for energy investors to make, or even increase, their positions in mis-priced, Deep Value oil and gas equities.