Crude's new normal
The fracking revolution
The biggest new thing in crude, the breakthrough that changed the playing field — and players — is the explosion of U.S. production thanks the advances in fracking technology. It made the United States the future swing producer of crude oil, according to the EIA.
But fracking and the disruptions it caused is a two-way street. As increased U.S. production helped lower the price of crude oil and Saudi Arabia and OPEC responded by entering into a market share war pushing crude oil even lower, breaching the $30 level for the first time since 2003, it shut in long-term projects.
As crude plunged, not only did the independent frackers shut down rigs and face bankruptcy, but longer-term projects and investments were recalibrated.
“We cut $1 trillion in energy projects globally; what we added in the shale patch is a pittance,” Flynn says, citing research at Wood MacKenzie that estimates a
$1 trillion retracement in capital expenditures by oil producers across the globe. “Why make a project to pump 50 years down the road if there is not going to be the demand? That starts the new super cycle for oil,” Flynn says.
With crude doubling from its bottom and OPEC cutting production, fracking production returned to fill a lot of the gap, but it will not fill all of it, and it will not replace the long-term effect of that drop in global investment.
“On the supply side, everybody is putting a lot of hope in shale production, which is great but a lot of people who are talking about putting a cap on oil [prices] don’t really get the gist of the problems with shale,” Flynn says. “It is the decline rate. It is like a hamster on the wheel, you have to keep consistently drilling shale to continue with increased production. We are still below where we were two years ago and we added a lot of rigs.”
Shale can help stabilize price in that it has become efficient, but efficiency replacing long-term investment can be a problem. “They are also doing it because they can shut it off real quick if prices fall. That is more efficient; the problem is it is coming at the expense of longer-term sustainable projects,” Flynn says. “An individual well may produce 3,000 barrels a day. Six months from now you are down to 2,500 barrels, two years from now you are down to 250 barrels. It is a very steep, sharp decline rate. If I put a rig in the Gulf of Mexico, I might be pulling oil out of there with little decline for 10 to 20 years. Hell, Saudi Arabia is still pumping with little decline from wells they drilled 50 years ago.”
Chirichella adds, “Fracking on land is a much lower risk than putting one of those cities out in the Gulf of Mexico.”
Larry agrees. “I can bring an onshore fracking rig operational and get it at low rates. I can produce oil out of that rig onshore on a frack site, as much or as little as I want to. I can keep it on a minimal run rate at whatever covers my cost,” he says. “An offshore or conventional rig you just drill and take whatever comes out. There is no way to choke it off. When you have these unconventional wells you have the ability to bring out as much as you want or as little as you want.”
Flynn adds, “Shale isn’t a panacea. I don’t want to underestimate its impact because it changed the world, but it doesn’t have the ability to replace the trillions of dollars of cuts in more traditional projects.”
For example, “In the arctic Russia spent millions but it is not going to be profitable until oil hits $70; but if you open up a shale patch, you can do it cheaper,” Flynn says.
So, as prices rebounded back above $50, many shale producers got back to work, but projects requiring billions of dollars in investments will wait for more sustained price increases and clearer signs of demand growth.
“If prices go down, I just take the rig off, and I make my money. When you make a commitment out in the arctic or some of these more traditional projects, you are talking billions of dollars, and if prices go down you are screwed,” Flynn says. “The problem is when the market begins to tighten, as it inevitably will, you can’t drill fast enough to keep up with the demand.”
Flynn presents the challenge for producers. Shale is more economical because its cheaper and can be shut in. Longer-term projects will produce more, but may not be economical in the long-term, especially if crude prices remain south of $50. He sees the next super cycle higher when demand rises more than shale producers’ ability to meet it, with fewer traditional projects online.
The EIA notes that production in the Gulf of Mexico set a record in 2016 and forecasts rising production in 2017-18, but that only tells half of the story (see “More oil, less research,” above). The increased production is a matter of price, but if demand grows rapidly the sharp decline in exploratory and development wells will make ramping up production extremely difficult.
It is hard to feel bad for oil producers complaining about prices levels they would be celebrating a decade ago, even harder to believe what they claim to be their breakeven cost, but it’s best to follow the money. And the drop in investments could be telling. When crude exploded above $100, it led to a huge increase in investment, and when that bore fruit, it led to a decrease in price, one that was more sustainable than many analysts thought. Then OPEC decided to try and punish the new producers in an attempt to win back market share rather than cut production to increase prices. We all know how that played out.
The OPEC play did not work, or at least caused more pain than they have planned on. Frackers have proven to be more nimble and efficient on a cost basis than initially thought, and while this is bearish in the short-term — the ability to pump relatively cheaply at current price levels — it could be bullish in the long-term as investment in longer term energy projects are not made.
“The bulls were proven right last year,” Flynn says. “This year we still have something to prove. We have a shot to get to $73 this year. I believe we will resume an uptrend. If you look at the projected increase in demand globally, which looks to be between 1.3 to 1.7 billion barrels, if you look at U.S. consumer confidence numbers at a 16-year high; if you look at auto sales, which are going to be at a record high [for two consecutive years] — and they are not buying Teslas, they are buying big fuel-guzzling cars — and demand is going to rebound. Globally, the economy is in good shape led by U.S. growth.”
The technical guys are more bearish. “On a technical basis, it looks very unhealthy; on a fundamental basis, we have more oil in tanks sitting in the ocean because we can’t even unload them,” Shaffer says.
For Larry it is all about credit. “If oil goes up to $60, that will be an incentive for the onshore guys to pick up production, but will they be able to get credit at reasonable rates?” he asks. “A bank is not going to give you money unless you can prove that you are going to make money. A national company goes to the government to get money, in the United States we go to a bank.”
Chirichella expects crude to trade at $50 to $60 in the next six months, then it will be about demand. “If the U.S. economy picks up and the [global economy] follows the additional demand will more than offset the additional production,” he says. “Don’t forget that we had three or four years of tremendous cuts in upstream capital expenditures, which means there are a lot of places in the producing world where production is going to tail off because they haven’t spent money on it.”
Longer term, he says the $70 to $80 range is possible assuming a growing demand curve and if OPEC continues to defend prices when they need to and doesn’t go off on another market share war. “If they go into another market-share war then all bets are off and we are back down to $30 or $40,” Chirichella adds.