Checking in

I haven’t posted in a loooong time, and I have not traded any energy stocks since then.  I’m still holding a bit of Whiting Petroleum (tragically).  And have not bought back into any of the other names I had owned at the start of last summer: Chevron, Chesapeake, Apache, Freeport Moran, and later briefly EOG.  

My sense is that we are not nearing the end of the troubles for oil companies.  These are my thoughts on US focused E&P companies a the moment:

1) Efficiency gains by drillers have been impressive

I would say that it was fairly obvious that the breakeven oil price would decline significantly as prices started to decline.  There was already a trajectory of improving economics even before the price declines, but the falling oil price caused costs to fall even more dramatically.  Improved economics (at a given price) have come from several different causes.  The most obvious is service cost declines.  When the rig count drops from 1800 to 800 there is more equipment and more people chasing an ever smaller amount of work.  The result is service cost deflation.  Secondly, more speculative efforts, like proving up new acreage, drilling outside of core areas, or drilling wildcat exploratory wells has declined.  The rigs that are working are drilling wells that the operator has plenty of confidence in.  As those more marginal areas are abandoned, the average amount of oil produced per well increases.  Finally, drilling was already improving prior to the start of price declines in 2014, as things like frac designs and better drilling accuracy were delivering ever improving results.  This process has continued.

Permian, Bakken, and Eagleford new-oil production per rig (from EIA drilling productivity report) are all up 40-50% yoy.  Bakken and Eagleford production have peaked for now because of the huge drop in rig count, but there is little doubt that production would come back strong if oil prices were to stabilize even at $70.  When the crash started, many analysts would talk about “break even” prices above that figure.  Now breakeven for single well economics is $40 or lower in the core areas of the big three oil regions. 

Source: Baker Hughes

2)      Better break-even cost on new wells cannot necessarily save highly levered companies. 

Their hedge books are much weaker than a year ago.  Many of these companies have made more on their hedge books than on actually producing oil as the price of oil has fallen.   In January of this year, most companies were somewhat protected because they had hedged a portion of their production at very high prices.  That will be much less true 6 months from now.

Their debt service costs are going to increase as they roll over debt.  For small E&P companies, they will have to issue new debt at much higher interest rates than they did a few years ago.

Price declines a year ago were somewhat offset by increasing production, this will be not be the case going forward.  There was a big backlog of uncompleted wells.  For a while they could cut capex but keep production strong by completing wells out of their inventory.  That will be less true going forward, so many companies are seeing declines in cashflow from lower prices, less hedged production, and now from lower volumes.

3) It is not clear that we need higher prices anytime soon to balance the market.

Many low cost OPEC countries have a strong incentive to try to increase production as prices decline.  If your full cycle cost is $10-15/bbl, and you need those oil dollars to fund your government, the natural thing to do when oil drops from $100 to $50 is to try to produce more.  

The US Rig count has declined from 1930 last september to 860 today.  But the middle east rig count has gone from a peak of 430 to 391 today.  There is hardly even a downward trend.  In fact, international rig counts (ex US and Canada) in general have only declined from a 2014 average of 1330, to about 1200 today.  These declines are very modest, and may not even offset increases in production from Iraq and Iran, where production has been artificially depressed by sanctions and instability.  (Source Bakerhughes.com)

IEA reports in August that Non-Opec supply will still grow 1.1 million barrels per day this year, down from 2.4 million barrels per day last year.  They predict .2 mbd decline in 2016 for non-opec supply.  OPEC supply has increased by 1.4 mbd since November’s decision to protect market share and not balance the market.  Initially that growth was driven by the Saudis but Iraq and Iran are likely to drive OPEC supply in the future.   Demand has grown at a fairly constant pace, and has not accelerated noticeably since price declined last year.  In Q2 2015 there was a record 3 mb/d of excess supply.  This is obviously not a sustainable situation.

Source: IEA.org

Conclusion: My instinct is to wait until we see some evidence that supply and demand are back in balance before buying oil stocks.  There is a possibility that many US E&P companies will be able to survive if price can recover even to $60.  But there is also a possibility that prices decline even further and we see a wave of bankruptcies.  And so I will continue to wait.