Updated: Apr 14, 2020
OG BRIEF #6
March 11, 2020
Oil Price War and Politics
Oil futures plummeted into the $30's after Saudi Arabia slashed prices and ramped up production in response to Russian reluctance to scale back output. Makes logical sense, right?
Does Saudi's choke opening strategy sound familiar? Some may call it a political "choke hold" on Russia and US Shale.
Others claim it's the Coronavirus.
“It starts with the virus,” said Daniel Yergin, Vice Chairman of IHS Markit. “In the first quarter, we estimate that oil demand compared to last year was down almost 4 million barrels a day.” That’s significant. Add to that price slashing plus an output hike from Saudi Arabia, protecting the “Petrodollar,”, US sanctions on Russia’s sub-Baltic Sea gas pipeline to Europe, and an election year where geopolitics are extremely heightened: we have an all-out price war. The WallStreet Journal writes "The situation has gone from gloomy to grim. Oil demand is down. The coronavirus has reduced trade and travel. Riyadh offered oil discounts of as much as $13 a barrel. The Saudi’s just lifted a finger and said “pricing discount."
Shale Fights For Survival: This Time it's Different
In 2016, during the previous downturn (also an election year when we saw a low of $26 per barrel in late February) investors poured billions into cash-strapped U.S. firms through equity offerings and private funds. OPEC+ agreed to curtail output to support prices, which also subsidized higher-cost shale drilling.
The difference now is that many of the loans secured by E&P's in the days of "Permania" in 2017 - when underdeveloped drilling leases were flipped and sold for $25,000-30,000/acre or more at $50+ oil - have debt maturities expiring in 2021 and 2022. At $30 oil, the value of this acreage is significantly less, and many drilling locations have been overestimated during the previous lending spree.
The banks have caught on, aren't forking out cash for undeveloped acreage, and only considering proven reserve acreage for deals today. The problem is, you have to drill and complete shale wells to develop proven reserves. This means producers have to spend millions of dollars in borrowed capital in order to prove reserves in less developed shale fields. Obviously this creates a huge problem when banks are demanding free cash flow that isn't being returned in many fields at current pricing.
"During the last price war, OPEC members were surprised by the resilience of US shale producers, and eventually chose to cut their own production instead. This time around, many observers expect US producers to be under greater pressure from investors/lenders" writes Mark Finley, Fellow in Energy and Global Oil at Rice University's Baker Institute for Public Policy.
Kimberlite Chart on US Rig Count vs. Oil Price & Well Count
The Wall Street Journal writes that “Companies could continue selling assets to generate cash, but only if there are interested buyers offering reasonable prices - a big if.” Which goes to show that the small to mid cap producers are being squeezed most. Only the strong will survive, and right now, the strongest producers are the large vertically integrated ones that also benefit from scale and low pricing in the refinery product chain. John D. Arnold, a billionare investor, said that the problem with independent shale producers is that “Overhead is eating them alive. Checkerboard acreage makes them inefficient. No one wants to put up the cash, so the industry seems to be frozen." This may likely lead to consolidation. The latest pricing moves are part of a strategic game after robust U.S. shale production fundamentally shifted supply, market share and pricing power. Saudi Arabia pushed prices down late in 2014 to curb U.S. production, but it didn’t work: Producers cut costs while lenders and investors stepped in to keep the shale party going. Russia has had enough. It seems to be betting that the price war will permanently impair U.S. production and market share. Now Saudi Arabia wants Moscow to reconsider production cuts, but there is no evidence yet that playing hardball with Russia will work. “Bankruptcies will be more substantial and have a bigger impact on supply than they did back then,” said Shawn Reynolds, a portfolio manager at asset firm VanEck. “There’s only a dozen or two [shale] companies that can survive at $40.” Scott Sheffield, CEO of Pioneer Natural Resources says “Probably 50% of the public E&Ps will go bankrupt over the next two years." At sub-$40-50 oil, he may be right.
But ultimately, Yergin said, “I don’t think this can last very long because it’s going to hit everybody’s finances including that of the countries,” referring in particular to Saudi Arabia and Russia. The silver lining may be that “$35 oil reduces the economic case for cutting fossil fuels. Green-energy plans might be shelved" according to the Wall Street Journal.
Energy Stocks Dive to a 15-Year Low on Monday
Apache (-54%) Oxy (-52%) Marathon (-49%) Diamondback (-48%) Whiting (-40%) Parsley (-39%) Pioneer (-39%) Noble (-30%)
BP (-19%) Total (-18%) Shell (-17%) Chevron (-15%) Exxon (-12%)
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US Rig Count
According to Enverus, "The number of well starts in the US totaled 18,108 in 2019, down by 1,353 spuds YOY, or 7%, as the second half of the year experienced a decline in activity. H1 was actually up by 253 well starts YOY, or 3%, but H2 was down 1,606 YOY, or 16%. Q4 had the lowest quarterly number of the year at 4,119, down by 352 sequentially and by 986 compared to 4Q18. In contrast, 4Q18 had been the most active quarter of 2018. Comparing Q4 to the prior quarter, the Permian not only remains the most active major shale region but was also the only one to increase well starts, with a 22-spud rise to 1,795. Rockies well starts were down 149 to 772, the Midcontinent tumbled by 94 to 353, the Northeast dropped 64 to 316 and the West Coast was 30 down to 180. Other regional declines were more modest. As evidenced by the data, operators scaled back operations in Q4 as the price outlook failed to improve, especially for natural gas and NGLs. The current year doesn’t appear much rosier, and another YOY decrease in well starts is fairly certain. There are 805 rigs running in the US as of March 5, representing a 22-rig monthly decrease and down by 254 from a year ago."