Friday 16 January 2015

The Supply Side: Cracks showing?

IEA Revises Production Down for 2015

The IEA's revision of non-OPEC supply growth in January's Open Market Report hints at the supply side destruction I've speculated about previously.

While they point to a 175k bopd revision in Columbia, they also show a 95k bopd in the US and 80k bopd in Canada. The article speculates that price may not turn quickly, but these low prices aren't likely to achieve any sort of steady state equilibrium (emphasis is my own):
The most tangible price effects are on the supply front. Upstream spending plans have been the first casualty of the market's rout. Companies have been taking an axe to their budgets, postponing or cancelling new projects, while trying to squeeze the most out of producing fields. For the most part the supply effects will not be felt immediately, but further down the road, through project delays and faster decline rates. Nevertheless, expectations of non-OPEC supply growth for 2015 have already been downgraded, with growth for the year adjusted downwards by 350 kb/d since last month's Report and more steeply so for 2H15. Colombia and Canada lead the declines. Expectations of US light, tight oil production growth have also been revisited, but so far the cuts do not exceed 80 kb/d compared with our already conservative previous estimates, as many producers appear to be well hedged against short-term price drops. 
There's alot of meat in that, but I think this is a question of market interpretation. To me, when I read that, I see high cost oil as being the intuitive easy casualty. But with Canadian oil growth coming from the oil sands it merely gets pushed back a time period.

The light tight oil game is where the action will be. Production won't drop in the short term due to price hedging.Which makes sense. But what happens when those hedges need to be renewed? What happens when the financing used to drill the wells coming on line need to be re-upped on the next wells?

LTO Decline Rates

I keep harping on this, but it just seems like the story to me: faster decline rates. It's almost worth subscribing to these IEA reports just to get the more detailed version, but that's a huge differentiator.

Accepting the premise that the US LTO is the marginal barrel of oil (ie. that it's incredible production growth has largely led to the supply glut we're seeing) then the implication of it's behavior and sensitivity to these market conditions is paramount. Decline rates are important because they need to be replaced with new production before growth can occur. That LTO has achieved that so far is incredible. And according to my premise has been the most impactful development in terms of this supply glut/price gutting.

Market Implications

Remember, markets move on expectations. Sure, the current real time conditions (price obtained, quantity produced, etc.) matter, and arguably matter the most, in forming those expectations. But when these companies go to market for financing they will be faced with financiers concerned with the price obtained in the future and the quantity produced in the future. Both of which get murkier by the day. Uncertainty requires price premiums.

Remember, saying that someone is well hedged also means that someone hedged them unprofitably. Did they adequately price in the possibility of sub $50 oil when the contracts were written? I'm guessing they didn't. So if there were any wells deemed marginally economic with these contracts locking in the well hedged prices, they likely won't be any longer even if price rebounds to $100.

The players writing those hedges may exit the market altogether or they may re price those hedges. The point is that this past 6 months has to materially impact expectations (for the majority of us that didn't see sub-$50 oil coming), risk premiums, and general participation rates.

That is strictly on the hedging side. But the same applies to financing. What was the range of price used in sensitivity testing? My assumption is p ($50) last summer was tiny if even considered. Will it remain that way if oil prices rise back up to $100+ by this summer? There is no way. Again, as financing gets more expensive or dries up previously marginal economic wells aren't drilled.

Aggregate Impact

The physical properties of LTO being high initial production (IP) into a steep decline places a greater importance of these wells continuously being drilled. Aggregate production from a play depends on it, I've referred to this previously as the need to increasingly increase drilling activity. Particularly if you consider the creaming effect (cream rises to the top, top prospects are drilled first) and a maturing LTO play.

So again, if prices remain low I think we'll see the IEA consistently revise this US projection number down.

I look forward to next month to see if I'm full of shit or not!

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