Friday, July 12th, 2019
Happy Friday and welcome to Energized, your weekly look into the geopolitics, news, and happenings of energy markets.
For our American audience, I hope you all had a wonderful Fourth of July weekend with friends and family and congratulations to the United States women’s national soccer team for winning the World Cup.
Curated weekly oil and gas newsletter
Fast Facts – Houston Chronicle “Fuel Fix” as of Sunday, July 6th, 2019
Light, sweet crude (dollars per barrel): $57.51
- Last Week: $58.47
Natural Gas (dollars per million British thermal units): $2.418
- Last Week: $2.308
Rig count (United States): 963
- Last Week: 967
Last week, we concluded our coverage of the Data-Driven Drilling and Production (DDDP) conference. You can find past issues of Energized on our website. For convenience, here are the three DDDP issues as well as a link to our DDDP landing page.
The Dawn of Digitalization: Adapting to Change and Issues with The Current Operational Model
New Frontiers: Incremental Steps Towards Achieving Widespread Digitalization
Cutting Edge: Crowing Achievements in Data-Driven Solutions
Coverage from this year and years past
+U.S. surpasses 12 million barrels a day, EIA reports – Houston Chronicle
“Texas alone produced almost 5 million barrels a day in April, up more than 25 percent from the beginning of 2018. And much of that growth has come in the Permian Basin, an aged oil field revived by new drilling technology.”
+The Permian Basin’s Flare Problem – Gas Compression Magazine
“Natural gas prices at the Waha Hub, which represents West Texas and Southeast New Mexico, USA, turned negative in April as natural gas production continues to soar above pipeline capacity in the Permian Basin. As a result, widespread natural gas flaring has engulfed the region in a cloud of methane. The good news is that the oil and gas industry has pushed to decrease emissions from engines, pumps, and compressors. Still, flaring natural gas is a big problem in the United States. According to the Environmental Defense Fund, flaring wastes US$275 million each year.
The flare problem will only get worse if natural gas production continues to surge higher. According to the US Energy Information Administration (EIA), gas production averaged 83.2 bcfd (2.4 x 109 m3 /d) in 2018. The Interstate Natural Gas Association of America (INGAA) estimates that North American midstream operators will spend, on average, US$27.5 billion per year on oil, gas, and natural gas liquids (NGL) infrastructure for the next 20 years. Devotion to industrial might is one thing, but if infrastructure can’t keep up with growing production, then there’s a risk that methane emissions will continue to rise.”
The article suggests that the golden years of the petrochemical industry are behind us, citing evidence such as average operating margins falling by 22% among 52 chemical companies Q12019 over Q12018 as well as spot prices for North American high-density polyethylene falling by 1/3 since March 2018.
The Gulf Coast chemical manufacturing industry employs 68,000 people. The region fare’s better than the rest of the p-chem industry thanks to low-cost natural gas access which provides feedstocks for petrochemicals.
“When the downturn hits the chemical industry, profits will fall for Gulf Coast producers, leading to delayed investment decisions, lower production and slower startups of new plants that could delay or reduce the creation of jobs, analysts said.”
Additionally, the petrochemical industry is tied to GDP growth. That means if a recession hits demand will likely fall since world economies consume more plastics during periods of strength and growth. A majority of economists think the next recession will come by the 2020 election.
Chemical exports to China, which have fallen 24% from the previous year, are a huge revenue builder for Gulf Coast chemical companies. Escalating trade tensions could further dampen petrochemical forecasts.
The article is a fantastic read into the headwinds facing the petrochemical industry, affecting large companies and employees alike.
+ OPEC, Russia, formalize cooperation pact – The Wall Street Journal
+ OPEC’s Partnership Concentrates Power in Riyadh and Moscow – The Wall Street Journal
The big global event during our three-week coverage of DDDP has been the new importance of Russia working with Saudi Arabia to manage crude production.
Business & US Production
In response to the recent news on Saudi-Russia energy cooperation (in the “Geopolitics” section above), we are diving deep into an analysis of US production.
+ Production Decline – Can the US stay on the hamster wheel? – The Drilldown: In-depth answers to oilfield questions (Episode 116)
+ ConocoPhillips, 2019 Annual Meeting of Shareholders, May 14th, 2019 – Ryan Lance, CEO ConocoPhillips
Episode 116 of John and Richard Spears’ podcast, “The Drilldown”, got me thinking about the sustainability of US production growth as it relates to global supply. I highly suggest you visit the link above, it’s a phenomenal 13-minute episode on this topic.
Addressing this issue through a macroeconomic and financial lens in terms of the expectations of publicly traded companies as well as the goals and objectives of different business strategies is intended to cast a broad net across the scope of this discussion. We encourage you to become a member of our EKTi community to continue the conversation on our forums.
In years past, publicly traded oil and gas companies had the green light from shareholders to engage in several risky but potentially profitable business strategies such as:
- Taking on a lot of debt, thereby leveraging their balance sheets.
Many companies had as much debt as their market capitalization, thereby making their enterprise value double what the value of their company was to shareholders. This means that every dollar made is really like making two, and every dollar lost is really losing two. In a cyclical business, this only raises the stakes, making good times amazing and bad times terrible.
- Taking a large chunk of net income and paying out a quarterly dividend.
Although this is a common practice among stocks across all sectors, taking a large chunk of net income and paying a quarterly dividend eliminates the possibility of using that profit to pay off debt. Meaning, shareholders will be appeased with a dividend at the expense of an ever-expanding debt balloon that continues to inflate with interest.
- Free cash flow allocated to capital expenditures.
Instead of pocketing free cash flow, which is simply the profit from operations, oil and gas companies were encouraged to spend free cash flow on new business opportunities. This is yet another high risk, high reward move.
Pocketing free cash flow to pay off debt or return cash to shareholders by increasing dividends is a safe and secure way to manage a balance sheet. But, companies were encouraged to pull the trigger if an opportunity came knocking at their door.
Well apparently, there was a lot of opportunities because guns were blazing across the country as businesses continued to rack up expenses on the logic that investments would pay off down the road.
Many recently listed, small, publicly-traded tech stocks in Silicon Valley have the same green light that these oil and gas companies once had. Even larger tech stocks like Netflix and Amazon barely squeeze out a profit, opting instead to take their revenues from their high margin subscription model businesses and allocate them to new ventures.
But the oil and gas companies have come under heavy scrutiny from investors who have seen the bankruptcies and mismanagement of balance sheets after the wake of the last downturn in 2014.
Now, according to John Spears “the discussion that investors have had with oil companies has gone from growth at all costs, to capital discipline at all costs, to now free cash flow at all costs”.
He goes on to articulate that operators went from “outspending cash flow, to spending within cash flow to now free cash flow generation”.
This means companies are underspending cash flow, or basically going under budget so that they can buy back stock, increase dividends, or even pay down debt.
It’s a 180-degree turn from the high growth mindset attributed to energy companies in years past.
Take Oxy for example, who perfectly illustrates the old model that investors once hailed as “bold and courageous”. Oxy has watched its share price fall to a 12 year low, now sitting at a price below even the worst price Oxy hit during the Great Recession.
Yes, it’s that bad for Oxy, who had hoped that it’s Anadarko bid backed by Buffett would bolster shareholder confidence.
Meanwhile, Chevron’s share price, a company on the other side of the Anadarko coin, is near an all-time high. That’s quite the contrast, and it’s because Chevron is paying a smooth 4% or so annual dividend, managing its free cash flow, and demonstrating capital discipline while also boldly pushing in the Permian and other plays.
Further down the conservative spectrum is E&P giant ConocoPhillips. ConocoPhillips only pays a 2% dividend, has barely any Permian assets, but is widely regarded as one of the most, if not the most, disciplined United States E&P company. CEO Ryan Lance has repeatedly said that he will not chase expensive Permian deals, opting instead to say “We’re sticking to our plan”.
ConocoPhillips is all about reducing their breakeven price per barrel, not necessarily chasing new opportunities. “We can pay a growing dividend and sustain our production at less than $40 per barrel [WTI], and we can do that because we have a portfolio that doesn’t have a lot of capital intensity. We have high margin production, and we have a relentless focus on the cost side of the business. Captured in our company today we have $16 billion barrels of resources that have a cost to supply that average less than $30 per barrel [WTI].” – Ryan Lance, CEO ConocoPhillips, 2019 Annual Meeting of Shareholders, May 14th, 2019.
ConocoPhillips demonstrates a strategy focused on improving existing operations, not expanding current operations with more assets like Oxy.
It’s not for me to say which company is right or wrong, I’m merely here to tell you the different strategies that companies are executing in the space, and where the trend is going.
Now, on to US production and its impact on the global stage…
Although the trend is headed towards cash flow discipline, the Spears brothers argue that because production decline rates are so sharp in unconventional wells, potentially declining over 50% in just one year, the number of new wells must continue to increase more and more year over year to keep up with global demand.
But what about wells that seem to produce forever?
Yes, there are those old wells in some of the earlier conventional fields, in Wyoming for example, that yield just a few barrels per day. But that’s a conventional well. The problem is that the US has become the leading oil producer because of shale, but shale well production drops off so drastically that the monthly decline in US production from existing wells is 550,000 bpd or 6.5% per month. Compound that annually, and that’s over 50% per year.
Essentially, there’s a 6.5% discount on US production every month. The math adds up, given that, as mentioned shale wells can decline over 50% after the first year. That goes to show you just how unconventionally-oriented US production is.
That being said, the Spears brothers go on to note that the US is the only reliable place in the world where production is going up. US production increased by 2.3 million bpd in 2018 and is expected to increase by 2.1 million bpd in 2019.
Global demand is increasing 1.2-1.4 million bpd, meaning the US is supplying 150% of the incremental demand in global oil consumption. But, all this growth is coming from shale, meaning more wells will have to be drilled.
Let’s do the math…
Just to cover the 550,000 loss that the US experiences every month from declining production from shale wells, the US would have to produce an additional 6.6 million bpd per year. On top of that, there’s the 2.3 million bpd net growth that is allowing the US to become even more oil dominant, meaning that the US has to produce close to 9 million bpd just to net that 2.3 million bpd net growth.
The Spears brother calculated that last year, the US completed ~11,000 horizontal wells. The problem is that all of the newer wells aren’t as productive as the older shale wells because the locations aren’t as good. John Spears put it well when he said: “We’ve got more oil than we need to replace, and replacing it with wells that weren’t as productive as they were a year ago, now all of a sudden that standstill number [11,000], becomes close to 14,000 wells this year.”
What John is saying is that the US will need to produce from 3,000 additional horizontal wells this year just to match what we did last year because the wells aren’t yielding as much. That’s on top of managing the production declines from older shale wells, which takes a lot of money. Next year, it could be 16,000 or more horizontal wells.
Hypothetically speaking, if companies solely devoted maintenance capital expenditures towards maintaining production from year to year, instead of focusing on growing production, the number of completed wells will still have to rise, but so will the price of oil.
Maybe one day we will all look back and thank Oxy for their cavalier capital management strategy focused on increasing production to become the Permian’s largest acreage holder. If all companies were focused on decreasing breakeven costs and improving existing operations like ConocoPhillips, then oil prices would surely skyrocket due to a stagnant and declining supply.
It depends from stakeholder to stakeholder. Shareholders would want a company to manage its operations, maybe even cut production so oil prices rise. But energy consumers want supply to stay high so that oil prices stay low. It seems Oxy is fighting the battle for United States production growth at the benefit of the consumer.
Shareholders might want to be careful of bleeding Oxy by selling their stock. It might just be the company that ensures supply rises, oil prices stay low, and inflation doesn’t lead the US economy into another recession.
Then again, with the production declines being what they are, maybe Oxy is fighting a losing battle and current US production growth is unsustainable.
Judging the infrastructure problems in the Permian alone, it’s hard to see how the US can build enough pipelines to sustain the 6.6 million additional barrels per day needed to maintain current production numbers.
Regardless, give the Spears podcast a listen. The brothers addressed some of the most prevalent issues affecting the business of oil and gas today. It’s certainly something to think about as Russia and Saudia Arabia team up to combat rising US production.
Most of you are already familiar with our Oil 101 course, at least the free version. Did you know that we have companies that license the course to use as internal training for sales, IT and operations teams? If your group needs this, let’s talk.
Have a great weekend!
EKT Interactive Contributing Editor
Head Writer | Eau Claire Writing
Eau Claire Writing is a Houston-based freelance writing company that specializes in gas compression, turbomachinery, onshore and offshore drilling, and well service content for the oil and gas industry.
Think you know someone who would enjoy this newsletter? Pass it on! They can subscribe here.