The Bullish Case For Oil In The Eagle Ford Just Got Weaker

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

Summary

Oil prices have continued to rise and I am personally very bullish regarding the space, but it's important to keep up-to-date with the data.

According to the EIA's results, which allow for an analysis of the region, oil production this year is slated to be higher than originally anticipated by a hefty margin.

Having said that, though, production is still set to fall by a nice amount, which should be bullish for investors but just not as bullish as a month ago.

A little over a month ago, I published an article on the Eagle Ford, one of the seven largest onshore oil and natural gas producing regions in the U.S. Every month, the EIA (Energy Information Administration) publishes its Drilling Productivity Report, which aims to use the most up-to-date data possible in an attempt to show what the overall oil (and natural gas) production situation has been like throughout different parts of the country. Now, with new data out from the organization, I've decided to look back at my prior analysis and see how the picture has changed and what it means for investors in the United States Oil ETF (NYSEARCA:USO), other oil-related ETFs, and energy-producing companies like Memorial Production Partners (NASDAQ:MEMP), Approach Resources (NASDAQ:AREX), and Legacy Reserves (NASDAQ:LGCY).

Revising data's a must

In order to provide a good outlook for the U.S. in terms of oil production, it's imperative to have a firm understanding of what makes the market work. In the past, I had to rely on three core assumptions regarding production. The first of these was what the rig count change would be over time. Previously, I had forecasted a drop in the rig count totaling 9 units per month. However, over the past month, the number dropped by just 5 units but with the falloff in May already reaching 9 units, according to Baker Hughes (NYSE:BHI), I feel confident keeping this unchanged for the meantime.

The second assumption I had to make relates to changes in the month-to-month rig productivity improvement rate. In the past, I had forecasted that the productivity rate would be about 1.5% per month, which is actually lower than in other regions such as the Permian. However, in the graph below, you can see the most recently-revised data reported by the EIA on the issue, dating all the way back to January of 2007. Based on this data, it now appears that the productivity improvement rate looked at by the EIA is closer to 2.5% than it is 1.5%. Because of this shift higher, the oil output trend will look more bearish than it did last month, but it's necessary to stay true to the numbers.

Click to enlarge

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

The last indicator I had to analyze was the decline rate in the Eagle Ford. Last month, I used three different scenarios; a conservative one where the decline rate would be 7.5% per month, a moderate one with a rate of 8.5% per month, and a liberal one whereby the decline rate would be 9.5% per month. Now, however, the newest revisions by the EIA (shown in the graph below) suggest that the picture isn't quite as positive as it was in April. If the EIA is accurate in its assessment of the situation in the Eagle Ford, we're looking at a decline rate of about 8.25% moving forward. Because of this, I will be making the moderate scenario's decline rate 8.25% and lowering the liberal scenario's decline rate to 9%. The conservative one, however, will remain unchanged moving forward.

Click to enlarge

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

Using the older data provided above, I was able to create the following table below. In it, you can see that investors would be right to anticipate a major drop in oil production from the Eagle Ford throughout the year. In the conservative scenario, production would fall to just 746,114 barrels per day by the end of this year from the now-revised number in December of 2015 of 1,508,501 barrels per day. Meanwhile, the moderate and liberal scenarios would call for production dropping to 692,815 barrels per day and 642,838 barrels per day, respectively. No matter how you stack it, these are material in nature and would be a boon for long-oriented oil investors, ceteris paribus.

Click to enlarge

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

But the picture has deteriorated a bit

It's almost impossible to make the trend in the Eagle Ford look anything but bullish but one argument that oil bears can make is that fresh data is suggesting a smaller drop than I thought just a month ago. You see, by incorporating the changes looked at above, I was able to create the table below, which shows that production at the end of this year, under the conservative forecast, is slated to be about 818,776 barrels per day. The moderate (which is the most likely scenario) and the liberal (which is the least likely) scenarios are calling for production of 780,683 barrels per day and 744,089 barrels per day, respectively, by the end of 2016.

Click to enlarge

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

To put these revisions into perspective, I was able to create the following table below. In it, you can see that the conservative scenario is now calling for output to be about 72,662 barrels per day higher than the data indicated just last month. In the moderate scenario, this changes rises to 87,868 barrels per day, and the liberal scenario is now calling for output to be 101,251 barrels per day greater than I anticipated. Overall, this is disheartening because it shows a bearish streak amidst a recent wave of bullishness in the market, but the overall decline should still be very attractive.

Click to enlarge

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

Takeaway

Based on the data provided, it seems as though investors can still expect the Eagle Ford to see a massive drop in oil output unless something changes for the worse. This is certainly great news and investors should look forward to it, but they should also be cognizant of how the data has changed and what it means for the broader market as a whole. Personally, I am still very bullish regarding crude, but I am going to keep a close eye for further revisions in the Eagle Ford so that I understand what the situation should look like in the months to come.

Disclosure: I am/we are long MEMP, 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.

Additional disclosure: I may end up buying shares of LGCY or its preferred units at some point in time