EIA data release and some predictions for 2015

Data releases by EIA

Earlier this month the energy information agency released their year end 2013 reserve estimates for both liquids and natural gas.  I think that the past experience with gas reserves and production will be instructional for what is likely to happen in the world of crude oil.  When the price of US natural gas crashed in 2008, a number of interesting things happened: 

1. The number of rigs drilling for gas plummeted, and most of these were shifted over to oil drilling in the Permian, Bakken, and Eagleford.
2. Reserves in what turned out to be the higher cost shale basins (Barnett, Fayetteville, Haynesville, Woodford) continued to increase for another two or three years before leveling off, or even declining in the case of the Haynesville due to write-downs of uneconomic reserves.
3. Reserves and production continued to climb in the lowest cost basin, the Marcellus shale in Pennsylvania and West Virginia.
4. Despite the number of rigs going from 1500 to 350 or so, natural gas production has continued to increase due to continued improvements in performance and increasing infrastructure in the most cost-efficient area (Marcellus).

(I know I have said all this before on previous posts)

 The economics of the various shale oil plays remain something of an unknown in 2008, because the pell-mell pace of drilling, the lack of infrastructure, widely varying degrees of acreage quality and operator competence etc.  As of 2008 most of the drilling was for the purpose of holding acreage, and so was inherently inefficient.  It was also done in a boom atmosphere and a rush to claim huge tracts of acreage, and amidst very high prices.  At that time, there were plenty of analysts saying things like “you need $5.50 gas for shale drilling to make sense” and putting specific numbers for the so-called breakeven price in each of the shale areas.   Most of the drilling was not economic at the lower gas prices that we’ve had these past 5 years, but enough of it was to keep production growing.

How does this provide instruction for us on what is likely to happen with oil production in the USA?

Unless prices continue to decline, I think we are rather likely to see similar things happen: 

1. Number of oil rigs will decline dramatically.
2. Some areas, particularly newer-unproven oil regions such as the oil window of the Utica, Tuscaloosa Marine Shale, various of the smaller plays in the midcontinent region (Oklahoma, TX panhandle), and perhaps the DJ Basin/Niobrara area will see major declines in rig count, and perhaps also in production.
3. The big three regions will also see declines in rig-count, especially in exploratory peripheral regions, but production is likely to continue to grow, though perhaps more slowly.
4. The focus for the major operators will be how to streamline operations, cut costs, improve well economics, rather than finding new plays, adding acreage, or accelerating drilling schedules to bring forward returns.

but there may also be some big differences with 2008:  UNLIKE in the gas crash, operators will not have the ability to shift from one uneconomic resource (gas) to a profitable one (oil) as they had done in the years following the 2008 gas crash.  A number of smaller operators, and some larger ones, basically walked away from non-economic gas, bought some oil leases in Bakken/Permian/Eagleford, and were able to cover their interest payments and continue as a going concern.  Even the companies that carried on drilling gas tended to shift to "wet gas" since propane and butane prices are partly linked to oil prices.  Only a handful of companies including Southwestern and Cabot continued to drill almost exclusively dry gas (though both have more recently also shifted some capital to oil drilling).  The option of switching to a more profitable resource is not available at the moment because both oil and gas prices are low, so we are much more likely to see bankruptcies this time around should low prices in oil persist.   Unlike in the gas crash, the service companies will not be able to shift assets from the gas region to the oil region.  THIS MEANS THAT PRICES FOR SERVICES WILL PLUNGE.  Those declines in service costs will make break-even oil prices far lower than those often quoted today, and this will provide some relief for the E&Ps.

This last point is very important.  The companies most likely to go bankrupt are smaller E&Ps and smaller service companies with debt.  The smaller E&Ps that have no real economic drilling opportunities but don’t have a mountain of debt, may be able to sell-out to other operators.  If they have too much debt, they may be destined for bankruptcy.  Service companies may be even more vulnerable.  During the 1980s crash the number of rigs in use went from 4,500 in 1981 at the peak, down to 660 at the 1986 trough.  Rig rates went from $40k per day down to $7k per day.  Physical consumable items like drillbits declined in price by about 40% according to this very interesting article from the Economist from 1987.  http://www.economist.com/news/business-and-finance/21634592-looking-back-consolidation-swept-oilfield-services-industry-1980s-americas-oil

I think a similar spate of bankruptcies is highly likely, which is one reason why I chose to wait and not buy oil equities yet.  There is one important difference between then and now which should be highlighted.  Those 4500 rigs in 1981 were basically scraping the bottom of the barrel on US onshore conventional oil drilling opportunities.  They weren’t particularly spurred by any improvement in technology, only on a change in price.   This time around we are in the midst of a technological shift that makes drilling tight oil increasingly economic.  We are already hearing about acceptable rates of return in parts of the eagleford at sub-$40 oil from operators like EOG.  After massive service costs reductions combined with continued improvements in drilling practices, I wouldn’t be surprised if we see $20 breakeven prices in the Eagleford core when we look out two years from now (note that this prediction is totally predicated on continued low- say sub $60 prices). 

Besides waiting to see how the cost structure shakes out in the various plays, another reason to wait at the moment is to see which operators adopt a correctly conservative approach and cut costs aggressively.  E&P operators tend to be inherently optimistic people, and I want to see which companies scale back operations and go into survival mode, and which carry on spending recklessly.