Seeking Alpha

Oil - The Slowdown In U.S. Shale Is For Real This Time

|
Includes: AOIL, BNO, DBO, DTO, DWT, NRGD, NRGO, NRGU, NRGZ, OIL, OILD, OILK, OILU, OILX, OLEM, OLO, SCO, SZO, UCO, USAI, USL, USO, USOD, USOI, USOU, UWT, WTID, WTIU, YGRN
by: HFIR
HFIR
Contrarian, value, long-term horizon, long/short equity
Summary

Like the story where the boy who cried wolf one too many times, the shale doubters have been proven wrong twice already.

But we have materially improved our methods since 2017 and our tracking models are better than ever.

We are now starting to see concrete signs of a slowdown in US shale growth. Rystad estimates that growth rates could be negative to just +235k b/d per year to-2022.

The slowdown in US shale comes at a time when long-lead conventional oil projects are set to fall off a cliff after 2020.

This will pave the path to high oil prices for many years to come.

Welcome to the For Real Edition of Oil Markets Daily!

Like the story where the boy who cried wolf one too many times, the shale doubters have been proven wrong twice already. Since our failed attempt in 2017 to cast a dark cloud hanging over US shale due to 1) lack of frac crews, 2) capital discipline (in 2017), and 3) lower productivity, we have been reluctant since to underestimate US shale. Because for starters, US shale has proven us wrong not only in 2017 but also in 2018.

At the end of October 2018, the EIA 914 report came out with US oil production surpassing ~11.3 mb/d or ~400k b/d higher than the weekly estimate and 200k b/d higher than our trued-up method at the time (weekly + adjustment). This stunning production figure ended up foreshadowing much larger growth into year-end where US oil production finished 2018 at ~12 mb/d or ~700k b/d higher than we initially predicted at the start of 2018. That was quite a large miss on our behalf.

So since then, we have made massive improvements to our method. One key area we made a major improvement on was our tracking method which now encompasses different data points to verify the figure. For example, we use natural gas production as a leading indicator for our US oil production proxy. The correlation is near perfect and was a perfect tool to have predicted higher oil production last year.

Source: EIA, HFI Research

In addition, our methodology improvement also made the old method of verification obsolete. The old "trued-up" method no longer forecasts US oil production as EIA has "unexplainable adjustment" factors now in the weekly oil storage reports. Our analysis indicates that it is crude-by-rail + plant condensate, but others will argue otherwise. Nonetheless, you can see in the chart below how the trued-up method became useless since October 2018.

Source: EIA, HFI Research

With all that being said then, why is it different this time? Why is the US shale slowdown for real and not just another headfake?

One of the key headwinds against US shale has always been the parabolic decline curve profile. In year 1, most US shale basins lose up to ~70% of initial oil production followed by another ~35% decline in year 2. That means the faster US shale grows, the faster the decline. An analogy we've used in the past is to imagine running on a treadmill. The treadmill gets faster the faster you run, resulting in a higher intensity just to stay in the same place.

Source: Goldman Sachs

Goldman estimates that in order to keep production flat in 2019, US shale needed to produce 2.7 mb/d or more than 3x the amount needed in 2017. By 2022, the figure increases to 3 mb/d.

To further verify this data, Rystad Energy calculates that the base decline for the top 4 US shale basins will accelerate starting in Q1 2020.

Source: Rystad Energy

So as the treadmill speed increases, there are two ways US shale producers can combat the higher decline rates.

Producers can either:

  1. Drill/complete more wells or;
  2. The wells that they drill/complete have higher well productivity.

But point number 2 is very unlikely to happen as producers were barely able to see any productivity gains this year while historical basin decline rates eat up the productivity increases:

Source: Rystad Energy

As a result, this means that the only way to combat accelerating decline rates is to drill/complete more wells.

But once again, we run into an obstacle. For starters, rig counts in the US are nosediving.

Source: Ninepoint Partners

The declining rig count is already resulting in shale producers to take down DUCs as completion activity now outweigh drilling activity. But how much longer can this persist?

Source: Rystad Energy

According to Rystad's figure above, it does not look like the trend can continue for long.

As a result, there are a few scenarios to contemplate here.

Source: Rystad Energy

According to Rystad Energy, if US shale producers keep completion activity flat, US shale will see growth rates of +470k b/d per year from Q4 2019 to Q4 2022.

Keep in mind that this is following growth rates of closer to +900k b/d in 2019. Because of the accelerating treadmill, a flat completion activity is expected to cut this in half.

Now, what happens if the completion activity falls to match the current rig count?

Rystad estimates that US shale production would decline 700k b/d total between Q4 2019 and Q4 2021. This would basically push US oil production back down to ~12.2 mb/d from our expected ~12.9 mb/d exit.

Let's take a step back and consider a more conservative scenario, which Rystad is saying is the most likely scenario.

Completion activity isn't likely to match the rig count drop, so producers are likely to dip in the DUC stockpile. As a result, what happens if completion activity is just slightly lower y-o-y but DUCs still decreases?

Rystad estimates that production will average +235k b/d per year from Q4 2019 to Q4 2022. This would put US oil production at 13.6 mb/d by the end of 2022.

Now what happens if oil prices rise?

One scenario we obviously have to consider, especially given our forecast, is what happens when oil prices rise? What will US shale producers do then?

Source: Rystad Energy

Our analysis indicates that given the debt maturity profile coming due over the next 7 years, the US shale capex discipline will be higher than average. The board of directors will be more fixated on refinancing the debt and keeping a healthier balance sheet as the first priority before production growth.

In addition, the lack of investor enthusiasm for the US shale as a whole is starting to show with the dismal equity and bond performances this year.

We believe the combination of this debt maturity wall, accelerating decline rates, and lack of investor interest will keep the production growth slow. Although we do keep in mind that you can never say never.

But given all the data points we see, it's more likely than not that peak US shale growth is behind us.

Implications for Global Oil Markets

The oil market is getting complacent just at a time when US shale growth slowdown is real and there's a lack of conventional oil projects starting up after 2020.

Source: Goldman Sachs

The end result is a classic case study of the boom-bust cycle. Prices never exactly reached equilibrium and as a result, a boom is expected to follow.

Without the growth of US shale from 2020 and onwards, there will be a lack of supplies and given that the gap can only be filled with long-term conventional projects, high oil prices will be needed for multiple years before companies are willing to invest.

Disclosure: I am/we are long UWT. 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.