Last year was incredibly volatile for the oil industry. As prices plummeted by 29.7% from $52.72 per barrel to $37.07, some companies entered into bankruptcy while others, like Linn Energy (NASDAQ:LINE) / LinnCo (NASDAQ:LNCO), Breitburn Energy Partners (NASDAQ:BBEP) and Approach Resources (NASDAQ:AREX) received a royal beatdown. This continued downturn prompted me to look deeper into production data associated with the domestic oil industry. In a previous piece, I looked at the problem of the rising production stemming from the Permian Basin but this only provides one piece of the puzzle. In what follows, I will take a look at the Eagle Ford Shale and discuss why investors should probably expect a continued massive decline in output moving forward if energy prices continue to be as low as they've been.
A look at the Eagle Ford
Of the seven major oil and natural gas drilling locations regularly covered by the EIA (Energy Information Administration), the Eagle Ford is the closest in terms of proximity to the Permian Basin, located along the Southern and Southeastern portions of Texas, but the economics of the site are much different than its neighbor. Whereas the Permian Basin has decline rates generally ranging from between 2% and 4% per month (or 24% to 48% per year), the decline rate in the Eagle Ford appears to hover between upper 6% and nearly 12% per month (72% to 144% per year), at least in recent years.
Because of this disparity, the Eagle Ford has actually reported a much larger decline in oil production over the past few months than not only the Permian Basin but also when stacked up against the other five locations the EIA examines. Using data from November, we can see that the region produced 1.66 million barrels of oil per day in November of 2014 but that number declined over the ensuing year by 385,730 barrels to 1.28 million per day. If you exclude data from the Permian and Utica, the only two regions that saw any uptick in output during this timeframe, the Eagle Ford accounted for a whopping 63.3% of the total drop in production across the five declining drilling regions. Even after reporting such a massive drawdown, however, the Eagle Ford still accounted for 25.7% of all oil produced, placing it only behind the Permian Basin in terms of output and slightly ahead of the Bakken.
Since October of 2014, when the energy industry really started taking a dive, the number of oil rigs in the region fell by 73.5% from 268 units in operation to just 71 in operation today. Much of this decline in rig count took place between December of 2014 and April of 2015. The decline did seem to moderate quite a bit after that but, as energy prices have taken another leg lower, the rig count has resumed its decline. Looking at periods of one month, two months, three months, four months, five months, and six months, the average monthly decline in rigs has been about 7.
As I've already mentioned, the decline rates of the Eagle Ford are quite significant. In the graph below, you can see what these monthly rates have been between January of 2007 (the furthest back the EIA's data goes) and what has been estimated for January of this year. What's interesting about this is that, while the decline rates hovered between around 6% and 8% or so for years, the number has since soared. My hypothesis regarding this is that the swift downturn in the energy environment forced companies to cut their rigs and to focus largely on sites that have high decline rates so that they could extract as much oil as possible in an attempt to avoid liquidity concerns.
What's the future look like for Eagle Ford?
Ultimately, I believe the future for oil looks bright absent a meaningful economic downturn at home or abroad but there's a difference between hoping and basing your stance off data. In what follows, I've looked at what I believe is likely to transpire for the Eagle Ford in terms of production but it's important to keep in mind that this is based on a variety of assumptions that could change depending on a number of unforeseeable factors. In my analysis, I figured that the low energy price environment will force rig counts down by 7 units per month in perpetuity and I assumed that decline rates average either 7% (the old decline rate before the crash), 12% (just a hair over the most recent estimates available) and 17%, what the picture could look like if the decline rates continue to grow.
I also had to look at the efficiency of oil rigs since that is a major determinant of oil output. In the graph above, you can see that the amount of oil generated per rig on a per day basis has continued to improve, with the month-over-month improvement being positive for each period over the past year. As a result of this, rig efficiency has pushed average production up from 612 barrels of oil per day to 795 barrels but, according to the EIA, that trend should be slowing. In fact, if their estimates are correct for January, the amount of oil produced for the month (on a per rig basis) will flatline. For my base case, I will use a 3% increase in rig efficiency but I'd be surprised if the rate is above 1% on average over the next year since most of the easy money from a cost-cutting perspective has likely been made already.
Using all of this data, I was able to conduct a sensitivity analysis that shows what the trend of oil production in the Eagle Ford should look like if my assumptions turn out to be accurate. Based on the data provided, a 7% decline rate in the region should result in oil production falling by 514,222 barrels per day throughout this year from the 1.28 million barrels per day that were estimated in November of last year to just 763,639 barrels by this next December. In a more liberal (but very realistic given the recent decline rates) scenario where decline rates average 12% moving forward, we should see production fall by up to 824,214 barrels per day to only 453,647 barrels daily by the end of this year. If decline rates continue to rise and eventually hit 17% per month (for an average for the year), we could see production drop by 1,008,924 barrels per day to a paltry 268,937 barrels. I would find this outcome quite unlikely unless energy prices fall further.
Right now, many investors seem to be bearish regarding oil but I have a hard time understanding why. Yes, we do have a large global oil glut (though it's small as a percent of overall inventories) but production should continue declining throughout most regions during 2016 if prices don't rise materially. The key player in determining how much we produce over the next 12 months is, undeniably, the Eagle Ford but even fairly conservative assumptions seem to indicate that production will likely drop much lower than where it is today. If that's not bullish, I don't know what is.
Disclosure: I am/we are long LINE, BBEP, AREX.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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