The Rocks Didn't Go Anywhere. Go Figure

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Includes: BNO, DBO, DNO, DRIP, DTO, GUSH, IEO, NDP, OIL, OILK, OILX, OLEM, OLO, PXE, SCO, SOP, SZO, UCO, UOP, USL, USO, XOP
by: Craig Pirrong

The conventional wisdom during the oil price collapse that started in mid-2014 and which accelerated starting in November of that year when the Saudis decided not to cut output was that the Kingdom was engaged in a predatory pricing strategy intended to drive out US shale producers. I mocked this in real time. Nothing really special about that analysis: economists have known for a long time that predatory strategies are almost never rational. They are irrational because the predator has to incur losses to cause its competitors to reduce production, but the competitors' resources are unlikely to leave the industry permanently: they can come flooding back in when the predator attempts to restrict output to raise prices. Thus, the predator suffers all the pain at selling at low prices, but cannot recoup these losses by selling at higher prices later.

In the case of shale, the rocks weren't going anywhere. Obviously. When prices fell, companies just drilled fewer wells-a lot fewer wells-but the rocks remained. The knowledge of where the right rocks were remained too. The knowledge of how to drill the rocks didn't disappear. Idled rigs went into storage. Yes, some labor (including some skilled labor left), but this resource is pretty flexible and can come back quickly when demand goes up. E&P companies incurred financial losses, and some experienced financial distress and even bankruptcy, but this did not drive them out of the industry permanently, and did not drive out the human and physical capital that these firms employed. New capital required to drill new wells is available to E&P firms based on future prospects, not past failures. Indeed, one of the functions of bankruptcy and restructuring of distressed firms is to clean up balance sheets so that old debt doesn't impede the ability of firms to take on positive NPV projects.

In sum, even though drilling activity plummeted along with prices, the resources needed to ramp up production weren't destroyed or driven out of the industry. They were only waiting for more favorable prices. The industry went into hibernation: it didn't die.

OPEC's decision to cut output to raise prices-and the Saudis going beyond their share of output cuts to strengthen OPEC's effect-provided the opportunity the industry had been waiting for. It rapidly awoke from its slumbers. Rig counts did a U-turn, up 90 percent in 9 months. And so has output. John Kemp reports:

U.S. crude oil production appears to be rising strongly thanks to increased shale drilling as well as rising offshore output from the Gulf of Mexico.

Production averaged almost 9 million barrels per day (bpd) in the four weeks to Feb. 24, according to the latest weekly estimates published by the Energy Information Administration.

Production has been on an upward trend since hitting a cyclical low of 8.5 million bpd in September ("Weekly Petroleum Status Report", EIA, March 1).

Javier Blas chimes in:

"North American oil companies are going to increase their spending by 25 percent in 2017 compared to last year," said Daniel Yergin, the oil historian-cum-consultant who hosts the CERAWeek. "The increase reflects the magnetism of U.S. shale."

U.S. benchmark West Texas Intermediate traded at $52.79 a barrel on Friday. Futures bounced between $51.22 and $54.94 in February.

So far this year, U.S. energy companies have raised $10.5 billion in fresh equity, with shale and oil service groups drawing the most investment, the best start of the year since at least 1999 and equal to a third of what the sector raised in the whole of 2015. [A clear indication that "debt overhang" is not constraining the ability to access capital to fund drilling programs, which would have been the only way the Saudi strategy had a prayer of working.]

In Midland, the Texas city at the center of the Permian basin, the activity rush is palpable, as is the threat of higher costs for shale companies. The county's active-rig total ranks second in the U.S., behind only Reeves County further to the west.

"You could see the town's energy is back," said Alan Means, founder of Cambrian Management Ltd., a Midland-based firm that operates more than 200 oil wells in the Permian across Texas and New Mexico. "The rigs are up again, the fracking crews are busier and the highway traffic is increasing."

As activity rises, the man-camps in the town outskirts are flush again, with workers arriving from the Bakken in Montana and North Dakota, and from as far way as Canada. The 1,000-bed Permian Lodging camp is now 100 percent full, up from 65 percent in July, according to camp owner Ralph McIngvale. [See how quickly labor resources can return?]

Shale firms have also become more efficient.

In sum, the predatory strategy hasn't made shale go away. Now, the longer the Saudis and the rest of OPEC (and the non-OPEC countries that have joined in) hold down output, the larger the fraction of that output loss will be redeemed by resurgent shale production in the US.

In other words, shale makes the demand for OPEC (and non-OPEC cooperators') oil pretty elastic. This raises serious questions about the rationality of the output cuts from the perspective of the cutters, especially the big countries like Saudi Arabia (which has cut substantially-more than it promised) and Russia (whose cooperation is more equivocal). This, in turn, makes the durability of the cuts problematic.

The quick turnaround in US shale provides a new data point for the Saudis, Russians, et al. Their dreams that they could make rocks disappear-or that they could make it permanently unattractive to extract oil from their rocks-have proved chimerical. Persisting in output cuts will become progressively less profitable, and indeed, is likely to be downright unprofitable soon. What's the over-under on how long until they figure that rocks will outlast them, and give up the output cut game?

Teaser: I am currently slogging through oil well data (tens of thousands of wells in all the major basins) in a study of the sources of productivity gains in shale production. Hopefully I will be able to report some results soon. Initial results are particularly ominous for OPEC. I am finding evidence of learning-by-doing in both oil and gas. That is, drilling wells today generates knowledge that enhances future productivity and lowers future costs. This means that the increased shale output resulting from OPEC's current attempt to prop up prices will increase the US shale industry's future productivity, making it even harder for OPEC to keep prices high months or years from now.

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