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The oil market's rally has been spectacular: from the apocalypse in mid-February to today, the change in sentiment was very quick. Indeed, the market is focusing on shale oil production instead of oil inventory, and bad news is hard to find when looking at production.
With shale oil production so important in this market it would be wise for oil investors to know when shale oil production will flatten or worse, grow.
Let the shale oil executives speak for themselves: I read the transcripts of Devon Energy (NYSE:DVN), Continental Resources (NYSE:CLR), EOG Resources (NYSE:EOG), Encana (NYSE:ECA) and ConocoPhillips (NYSE:COP), both from Q4 2015 and Q1 2016.
Let me share with you the insights I gained.
Change in sentiment: prudence
The industry isn't focused on growing production anymore if we take a detailed look at the executive of the major shale drillers. It makes no sense to grow production or to outspend cash flow in the current environment. Some simply lack the capital to do so.
Our primary emphasis, first of all, would be balance sheet, paying down debt, next would be DUCs and then maybe ramping up the completion of those DUCs before we ever considering bringing on rigs back. So we're probably at the $60 range, and that can happen prior to year-end.
-Harold Hamm, CEO, Continental Resources
Our number one priority is not just flattening the production. We're much more interested in, first, the financial strength of the balance sheet.
David Hager, CEO, Devon Energy (DVN)
Only positive fundamentals will change the sentiment in the shale oil industry and bring back the focus in growing production.
This is understandable, as investors and oil executives know that oil will be lower for longer. The current downturn isn't a temporary bump in the road anymore. Some are wounded, some are still bleeding and some are giving up like LINN Energy (NASDAQ:LINE) recently. Hence why shale oil are cautious and prudent for their own sake.
When the oil prices begin to recover, we're going to be disciplined going forward. We don't want to be fooled again, like last year.
-William Thomas, CEO, EOG Resources
The drilled but uncompleted ((NYSE:DUC)) wells inventory
The first thing shale drillers will do is start completing their drilled but uncompleted (DUC) wells. But at what price, and when do they accelerate completions?
For example, Harold Hamm, CEO of Continental Resources, is looking for WTI oil to trade at $50 before ramping up completion rate. This could lead some investors to think shale oil will flood the market very soon: WTI oil is almost at $50 and DUC wells inventory is high.
While we could see part of the DUC wells inventory being completed, it will take time; it isn't a spigot.
When you just start with the completion and bringing on, you can see a pretty substantial increase in volumes within three to four months.
-Gary Thomas, COO, EOG Resources
Production can't grow back quickly
Ramping up shale oil production back to growth mode is another story. It takes capital, time, equipment and a competent workforce.
The shale oil industry's capacity, meaning the rigs, the equipment and the competent workforce could take years to bring back to the oil boom that lead to the crisis in 2014.
I don't think U.S. unconventional production could go back up as fast as it came down, or is coming down still.
-Al Hirshberg, Executive VP, ConocoPhillips
EOG Resources did take measure to mitigate this risk by keeping their best crews under contract. The company prefers to keep the rigs and keep the DUC wells inventory growing than see those crews vanish or worst, signed for work by a competitor.
Still: $50 WTI is enough for shale oil
There is no denying returns are interesting even at $40 WTI on premium shale locations ($50 WTI is enough for average drills). Therefore, while the industry seems to be more prudent, there is still money to be made.
Another potential downside is potential hedging programs implemented by oil producers, especially shale oil. Given the returns obtained, hedging at $50 makes sense. However, it would be more interesting to hedge higher, maybe at $60 WTI, as this could give shale oil cash to manage their balance sheet and ramp up drilling with no downside risks for shareholders.
I am not adding more to my energy holding. For now, I am holding my positions.
The possible absence of capacity for ramping shale oil production is definitely a concern for oil executives, and therefore should be a bigger concern for oil bears. This puts in jeopardy the new role of swing producer attributed by some to the shale oil industry as oil demand grows.
Shale oil will ramp up their DUC wells in the short-term as we approach $50 WTI. However, this won't flood the oil market as said earlier.
Importantly, I don't believe shale oil still have the fighting attitude they had back in late 2014. They have been put in order by $25 oil price.
The wounds made to the shale oil industry by the OPEC's policy will take a lot of time to heal, and will be apparent in the medium to long-term. Healing these wounds won't happen fast enough for the industry to become the new swing producer. The capacity (rigs, equipment and workforce) will simply be absent.
My biggest concern for oil price is for oil producers to hedge at $60 WTI. With a hedging program in place, some could ramp up production again with no downside for shareholders. This price seems far. However, the oil surplus is beginning to shrink dramatically, and we are a black swan event away from market equilibrium. And we know that unexpected, game-changer events happen.
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