Tuesday 9 December 2014

A Follow Up On Supply Side Destruction

I posted here about how I believe markets will behave. My particular emphasis was on the precarious nature of the status quo. Namely, that it's unstable; because current output levels can not be maintained in this current price environment.

It seems to me that the Saudi's need to convince the market that their strategy is the new status quo. Period. We will produce oil if it's economical, our oil is economical down to $x, so good luck with your oil! Similar to forward guidance in monetary policy, the swing producer can only move markets with words if their actions (or more specifically, their communicated future actions) are deemed credible.

Arguments against the credibility of this new non-price supportive strategy seem to hinge on the 'break-even' fiscal story (which gets mentioned all the time and I largely ignore when it comes to KSA). However, in terms of sheer economics, market share, market power, geo-political and regional balances of power, alternative fuel viability, the KSA seems likely to pursue their market grab. At the very least we need to consider it credible until proven otherwise.

Implications of Lower Prices

Although we hear it discussed more and more, I still believe the heterogenous nature of oil market is underreported. First, defining oil is inherently difficult, what we call 'oil' is crude oil, the EIA summarizes the variety here where oil is classified according two qualitative variables: density (API) and sulfur content (sour/sweet). Sweet oil is good (less refining required to get useable product). Mid density is good (the heavier the oil the more 'energy' is contained in the carbon chain, it's a balance between energy content and difficulty in cracking it in the refining process).

The second differentiator is the price differential. In Canada we know all about this. These differentials are driven by the local quality of the oil, but also the ability of that oil to get to markets that want them. The EIA article above outlines that globally. In this article from Bloomberg describes inter-regional price differentials. Which is where things start to get a bit more interesting. First let me set this up a bit.

This article by Euan Mearns on Seeking Alpha points sketches out where the 'new oil' is coming from. Namely, Canada and the United States:

Figure 2 Global production of conventional crude oil and condensate has not changed since May 2005 despite a prolonged spell of record high oil price. All of the growth has come from expensive LTO and tar sands. The toxic mix of high debt and losses in the LTO industry that are in the making may short circuit the global banking system again.
Here, LTO refers to the Light Tight Oil that is typically referred to as shale oil (not to be confused with oil shale). This is the Bakken, The Eagle Ford, the multi-stage fracks, all that good stuff.

So that's the set up. Why these sources of oil have been prolific is something we'll skip over (how much is ingenuity, how much is the recent steady state of $100+ oil?). But where this gets interesting is when you consider the variation in production costs.

Prices and Production Costs

Again, this is an incredibly difficult figure to make sense of. These costs vary with the factors mentioned above. The regulatory and transportation frameworks are also key. But aggregated I think we can fairly make some interesting and relevant inferences.

Decline Rates: By definition, if decline rates increase, the number of new wells that need to be brought online to maintain production levels also increases. This isn't controversial. How quickly wells decline is another difficult thing to be accurate on, however, it isn't controversial to suggest that LTO wells have significantly higher decline rates.

It will be interesting to watch how oil sands and LTO production behave if oil prices continue to hover in this lower range for a significant portion of time. You'll see capex budgets slashed in Alberta, without any real production decline (rather a reduction in growth), but how will LTO production behave?

It will depend on the fiscal health of these companies and the duration of $70ish oil, but since LTO requires drilling activity to maintain production levels, and increased drilling activity to produce the production growth we've seen, any hiccup in capex will have a much larger impact then we'd see in any other oil play.

Costs vs. Prices: Let me butcher Econ 101 here: shut down isn't justified simply when operations are cashflow negative. Rather, you have to make a few considerations. The future behaviour of both costs and price. Costs have both a sunken and operating portion, where the sunken portion are more long run (infrastructure, regulatory, exploratory, etc.) and operating costs refer more to the actual production and transportation of oil to markets.

Again, with high decline rates comes more drilling, comes more regulatory issues, comes more infrastructure (increased production points). And these decisions happen in real time. Oil sands projects have massive upfront costs. They also have high operating costs (relatively speaking). The difference is in how the economics impact production volume.

LTO companies can immediately cut the sunken costs by reducing drilling activity. How long it takes to work through the backlog of well sites ready to go (with significant sunken costs) remains to be seen. But I have to believe that if low prices stretch through this drilling season into next year's drilling season, we're bound to find out.

Oilsands production might stagnate, but remember that massive upfront investment also results in fewer individual decisions.

Duration: Steep decline rates also mean that when a new LTO well is brought into production is more important to the lifecycle economics of the project. Rune Likvern has done alot of interesting work on decline rates and the subsequent economics. While, his overall production predictions have not come to fruition, the underlying logic still remains solid (in my eyes). In this follow up posted on Peak Oil Barrel, Rune makes some interesting points.

Most relevant here is the notion that the leverage that has enabled this massive drillout of the LTO plays in the United States are likely also conditional on the high price of oil. Now we have pressure from both the strict cost and benefit economics of the oil well, but also, the exogenously determined credit conditions. Being in the finance game I know that when some guy in some office some where gets freaked out about a negative trend, the tap can turn on and off pretty quick. Might the tap turn off quick here? It likely depends on the expected duration of these low oil prices.

Remember, LTO producers are firms, they have no access to printing presses. They dividend out their earnings. They are accountable to quarterly reports. They are not national oil producers. This makes for the most efficient model when it comes to exploiting economic plays. But when they become uneconomic? Well... we might just find out.


I believe we will see supply reduction and prices rebound. Over what time frame? No idea. But if the KSA won't take on the entire burden. The first domino to fall will be the US Shale producers. They've had the greatest impact on global oil production. But the nature of the oil production and the debt factor will necessitate blinking first.

Wednesday 3 December 2014

Supply Side Destruction

As discussed here, OPEC's latest (last?) decision to not reduce production in order to arrest the recent fall in price, has lead to alot of speculation about what we're likely to see come out of this.

Now, I should start by confessing to being totally wrong on this type of occurance happening. While I'm not quite convinced that I need to scrap my overwall Peak Oil Dynamic world view (explained here), this certainly has caught me by surprise.

One of the key factors of the Peak Oil Dynamic world view was that the conventional cheap oil is shrinking both in aggregate and proportionally to expensive and/or unconventional sources. That logic led me to believe that the offshore oil market would be strong going forward and we'd see oscillating prices around that $100 mark for awhile but likely a steady secular rise in prices until someone figured out renewables.

Obviously, the oscillation didn't happen. Why? This is a supply side phenomenon.

From the IEA
Demand growth may not be as rapid, but it is still growing. And despite what all the hippies are saying, there is no viable replacement on the horizon.

So the collapse in price must be supply side.

Where that supply is coming from is interesting. I'd think about this 'new oil' in two seperate categories: expensive oil and cheap oil. Basically, expensive oil is the oil that was made available due to the $100+ price of oil (and SOME technological improvements, but don't kid yourself it was mostly the price), and the cheap oil is the production that is from conventional legacy sources that for political reasons have not operated at or near full capacity in some time. Think Libya, Iraq, Iran, etc.

Now, price certainly has an impact on cheap, politically sensitive oil production levels. But those effects are typical complex and to entangled in secondary and tertiary political/social/economic effects and so I will leave them be.

The more interesting of these two sub-sections of 'new oil', the expensive stuff, are where things will get interesting and where marginal barrells will be taken off the market if an exogenous supply reduction is not imposed.

In terms of simple Econ 101, suppliers will either make due at the lower price level, or we would expect the marginal producers (those requiring $70-$100+ oil to maintain operations) will drop off.

In oil's case, things are complicated by the wide divergence in a number of factors, a few of which are: 1). the sunk cost of different production methods, 2). the decline rates of different production methods, 3). what market the oil is sold into, 4). the firm's fiscal health, 5). the firm's hedging strategy.

Again, mix, oil, politics, and big business, and all you can do is make guesses. Popular opinion seems to be fairly mixed, with a number of folks suggesting that the wheels will fall off the shale boom and other suggesting they've all hedged out any risk.

This piece in the Telegraph has a few interesting items:
US producers have locked in higher prices through derivatives contracts. Noble Energy and Devon Energy have both hedged over three-quarters of their output for 2015. 
Pioneer Natural Resources said it has options through 2016 covering two- thirds of its likely production. “We can produce down to $50 a barrel,” said Harold Hamm, from Continental Resources. The International Energy Agency said most of North Dakota’s vast Bakken field “remains profitable at or below $42 per barrel. The break-even price in McKenzie County, the most productive county in the state, is only $28 per barrel.”
So those are the headline numbers, but this of course begs the questions: how do you determine the break even cost? Is that break even on existing production? Is that break-even to maintain current production levels? Is that break even to maintain current growth rates in production levels?

And all credit to this article for taking the time to wade into this discussion but I have to disagree with the following quote from Ed Morse at Citigroup:
Mr Morse says the “full cycle” cost for shale production is $70 to $80, but this includes the original land grab and infrastructure. “The remaining capex required to bring on an additional well is far lower, and could be as low as the high-$30s range,” he said. 
Critics of US shale may have misunderstood its economics. There is a fast decline in output from new wells but this is offset by a “long-tail phase” for a growing number of legacy wells. The Bakken field has already reached 1.1m bpd, and this is expected to double again over the next five years.
I don't believe we know too much about how these legacy wells will behave. Also, we need to remember that these growth rates, in the context of fast production decline, are necessarily the result of increased drilling.

Now, to maintain drilling, you need to maintain acerage and the expansion of infrastructure IF prices remain depressed beyond what drill sites have been allocated. Beyond that then the full cycle cost is back in play.

Another items to consider is that the best portions of an oil play typically get drilled up first. Of course, a play isn't known in it's entirety from the get go, but it's not unrealistic to expect that the 'sweet spots' are more likely have played a starring role in the ramp up in production.

Also, remember that when companies are talking about break even costs in the media they also have stock prices to maintain. Any highly leveraged play gets increasing leveraged when stock prices dip. That combined with a reduction in cash flow (even if most of it's hedged) is a dangerous game to play.

So you want to watch for a couple of items: a reduction in drilling activity and a reduction in the per well production rates.

This article in Reuters showed a reduction in drilling permits issued dropped over 40% in November, which is a bit of an eye opener. But to be honest with you, I don't have a clue about the typical fluctuations in permits so I took it with a grain of salt.

The author also cites Allen Gilmer at Drilling Info who suggested that this was mostly due to companies wishing to avoid tapping new sweet spots in this depressed price environment. So the exact opposite of what I said above.

Who the hell knows. But it should be interesting to watch.