More Short-Term Pain In The Oil Patch

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Includes: BNO, DBO, DNO, DTO, DWTI, OIL, OLEM, OLO, SCO, SZO, UCO, USL, USO, UWTI
by: Daniel Jones

Summary

Despite seeing a massive drop in rig count across the country, some regions are due to post a smaller-than-expected decline in oil production this year than was expected last month.

One of these locations is the Niobrara, which is being hurt by revisions to government data.

Despite this, though, signs point to a very bullish long-term scenario if current trends persist, a positive for long-term investors moving forward.

Last month, I published an article covering oil production in the Niobrara, one of the largest oil and natural gas producing regions in the U.S. In that piece, I used data provided by the EIA (Energy Information Administration) in its Drilling Productivity Report to show that investors should expect a major decline in output for oil this year if current trends persist. Now, using newer data provided by the organization, I've decided to look back at my old analysis and make some adjustments to reflect the picture today. While I still expect production to take a nice beating this year, which should prove bullish for investors in the United States Oil ETF (NYSEARCA:USO) as well as for investors in companies like Linn Energy (LINE)/LinnCo (LNCO), BreitBurn Energy Partners (BBEP), Approach Resources (NASDAQ:AREX) and Memorial Production Partners (NASDAQ:MEMP), the situation is a little less favorable than I expected it to be last month.

Making some much-needed revisions

In my last article on the Niobrara, I had to look at three core assumptions regarding production that should, in theory, allow me to chart out the future of oil production not only in that region but in other regions as well; rig counts, decline rates, and rig productivity improvements. In my article on the Niobrara, I used historical data to suggest that we should expect rig counts to fall by about 4 units each month under current conditions. Unfortunately, February saw a slower decline of 3 units but the historical data still, in my opinion, supports a month-to-month decline of 4 units moving forward for the time being.

In addition to looking at the rig count, I had to analyze what makes sense from a decline rate perspective. In the graph below, you can see the historical trend that decline rates have taken each month since January of 2007 and recent data shows that a good expectation might be for wells to decline by about 8.25% per month. However, I generally like to have a range here so I will be adopting that as a moderate estimate while also having a conservative scenario where decline rates average 7% each month and a liberal scenario where they average 9.5% each month. This represents a downward revision from the 9% decline rate for the moderate scenario and a revision from the 11% for the liberal one, but it keeps the conservative scenario's estimate unchanged.

Click to enlarge

*Source: Created by author with data from the EIA's Drilling Productivity Report

On top of this, I had to look at the changes in rig productivity rates on a month-to-month basis. In my last analysis on the Niobrara, I used data to imply that we should expect rigs to become 2.5% more productive each month. However, as you can see in the graph below, that too has changed according to the EIA. Now, rig productivity rates have been revised up by the organization, which has led me to revise my estimate up to a month-to-month improvement of 3.25%. This is extremely painful for me since it, combined with the change in decline rates, hurts my outlook for oil production contraction, but I have to be realistic and implement the most up-to-date information or else all of my work is meaningless.

Click to enlarge

*Source: Created by author with data from the EIA's Drilling Productivity Report

Using the old data from last month, I constructed the following table below. What you can see from this is that I expected oil production to fall by a great deal throughout the year. Under the conservative forecast, for instance, output should have dropped to about 234,530 barrels per day by December of 2016. This compares very favorably to the new 2015 estimated data for December of 462,617 barrels per day. Meanwhile, under the moderate and liberal forecasts, output would be 194,435 barrels per day and 160,615 barrels per day, respectively.

Click to enlarge

*Source: Created by author with data from the EIA's Drilling Productivity Report

The picture looks bullish but less so

After incorporating these much-needed changes into my work, I was able to generate the following table below. What you can see by looking at it is that production is still expected to fall but nowhere near as much. Under the conservative forecast, for instance, we should now see output hit 259,620 barrels per day by the end of 2016. Under the moderate (and most likely) forecast, we're looking at 233,935 barrels per day, while the liberal forecast suggests output of 219,628 barrels per day. No matter how you look at this, it's much, much lower (by between 202,997 and 242,989 barrels per day) than what was seen in December of last year, but the situation looked better a month ago.

Click to enlarge

*Source: Created by author with data from the EIA's Drilling Productivity Report

To put things in perspective, I created the following table below, which compares my work from last month to my fresh analysis. This helps me to hold myself accountable for my work since an analysts' results are only as good as his/her assumptions. What we can see from all of this is that, while the picture still looks very bullish for investors, it's not as bullish as last month, with the region expected to produce between 25,090 barrels per day and 59,013 barrels per day more by the end of this year than I hoped it would in February.

Click to enlarge

*Source: Created by author with data from the EIA's Drilling Productivity Report

Takeaway

At this moment, things are very much looking up for long-term oil investors (though risks remain). With oil prices moving higher on the back of positive news and speculation regarding OPEC activity, investors should be very happy, but what ultimately needs to happen is that oil production in the U.S. needs to take a tumble. Although the drop projected by me right now is not as large as it was last month, it appears as though the Niobrara will likely help out the situation on the supply side by quite a bit unless oil prices happen to turn a corner even further, driving rig activity higher.

Disclosure: I am/we are long BBEP, AREX, MEMP.

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.