A Very Ugly Oil Revision

| About: The United (USO)

Summary

Oil prices have been pretty volatile, but are still fairly high despite the rig count rising in 3 of the past 4 weeks.

This move in the rig count has caused a great deal of uncertainty, especially in the Permian, in which investors could have anticipated production declines this year.

Now, however, the picture in the Permian by itself looks pretty ugly compared to where it did a month ago.

This does not show what the overall picture should look like, but investors should keep an eye here.

In the month of May, I published an article here on Seeking Alpha about the Permian Basin and the future (looking out through the rest of this year alone) of oil output in the region. In it, I concluded that oil output was almost guaranteed to fall this year, but a lot can happen in the course of a month. After seeing oil prices continue climbing, and after seeing the rig count in the Permian rise, according to Baker Hughes (NYSE:BHI), I've decided to dig back into the data and figure out what it means for companies like Memorial Production Partners (NASDAQ:MEMP), Approach Resources (NASDAQ:AREX), and Legacy Reserves (NASDAQ:LGCY), as well as for those in the United States Oil ETF (NYSEARCA:USO) and other oil-related ETFs.

A look at past data

Before I look into the fresh data regarding oil production in the Permian, it's imperative to dig into the old data I used and revise it accordingly. The biggest revision here relates to the change in the oil rig count. As oil prices have risen in recent weeks, I decided that it would be a good idea to make some adjustments. After hitting 137 units on average for the month of May, recent rig counts suggest that the number of units in operation there for oil amount to 142. In the past, I had estimated a 10-rig per month drop in the rig count, but because of this increase and because of the recent decline in oil prices once again, I've elected to use 142 rigs for this month, but to then assume a 5-rig per month drop moving forward. However, if I continue to see the rig count increase, I will adjust accordingly in the future.

In addition to looking over the rig count, I had to assess rig productivity improvement rates on a month-to-month basis. In last month's report, I made the assumption that the rig productivity improvement rate during each period would be 3%. In the graph below, you can see the revised numbers provided by the EIA (Energy Information Administration) in its Drilling Productivity Report. Overall, this number is also approximately 3% each month so, for the time being, I've elected to keep this metric unchanged.

Click to enlarge

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

The last indicator I had to look at in order to revise my analysis was the decline rate in the region. In my last report on the Permian, I had concluded that we should look at a conservative scenario whereby the decline rate in the region would be about 3% each month, a moderate one where it would be 4% each month, and a liberal one where it would be 5% each month. Now, however, as you can see in the graph below, the number is at 3.79% and seems to be trending down slightly. Because of this, I've decided to keep my conservative forecast unchanged, to decrease my moderate one to 3.75%, and to drop my liberal one to 4.5%.

Click to enlarge

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

After incorporating the prior numbers into the equation, I was able to create the following table. In it, you can see that, if my estimates turned out to be accurate, oil output this December would drop to at least 1,990,387 barrels per day in the Permian, a modest decrease from the now-revised 1,992,162 barrels per day seen in December of 2015. Under the likely moderate forecast, output would drop to around 1,897,374 barrels per day, while the liberal forecast would call for output to be about 1,808,049 barrels per day by December of this year, a pretty sizable decline in production compared to last year.

Click to enlarge

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

The picture got worse... a lot worse

For now, I am treating the increase in the rig count in the Permian as a one-time event, but I've permanently impaired the month-to-month drop (assuming data doesn't change again) in the rig count. After incorporating the change in the rig count assumptions, as well as the other changes highlighted above, the picture looks materially worse than it did a month ago. As you can see in the table below, the conservative forecast now calls for production in the Permian to actually increase to 2,072,996 barrels per day, while the moderate scenario is calling for a modest uptick of 2,002,022 barrels per day. Only in the liberal forecast does output fall but the decline is only to 1,933,147 barrels per day.

Click to enlarge

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

In the table below, you can see my old analysis compared to my current analysis. Based on the findings, the conservative forecast is calling for oil production in the Permian to be a whopping 82,610 barrels per day greater than it was in last month's report. Under the conservative scenario, that number rises to 104,648 barrels, while the liberal forecast calls for production to be about 125,098 barrels greater than my prior estimates. Overall, this is a bearish indicator, but we will still have to see in future articles, what the impact should be for other regions in the U.S.

Click to enlarge

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

Takeaway

By itself, the Permian data appears to be very ugly. If the situation does not show signs of improving or, even, if it were to worsen, investors will not be too happy (not taking into consideration what happens elsewhere in the U.S. from a production standpoint). All in all, I am still very bullish on oil moving forward, and I believe additional upside is warranted down the road, but investors should be cognizant of the working pieces that make up the whole. Should we see additional revisions like this, I may change my mind, but for now, I am treating this as a rather bad anomaly.

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

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: My LGCY units are preferred, not common.