Champagne Oil

Some rough notes to help frame an outlook for E&P companies

OIL OVERVIEW
The 2014 downturn in oil prices was caused by oversupply (not lack of demand); thus a correction of supply will improve prices

  • Oil supply/demand fundamentals will tighten through 2017
  • The incentive cost-curve for E&P companies reflects a significant reduction in industry activity levels above $50-60/bbl (barrel)
  • The Organization of the Petroleum Exporting Countries (OPEC) cartel – created in 1960 – is broken; this will increase oil price volatility
  • There will be an oil supply shortfall of 6-8 mbpd (million barrels per day) in a few years; we will need prices of $50 to $70 to motivate new oil out of the ground

PRODUCTION & COSTS
E&P companies continue to make significant strides in reducing costs

  • Oil fields saw huge capital expenditure cuts in 2015
  • Total capital budgets are projected to decline another 40% year-over-year in 2016; however, efficiency gains mean that production will decline less than previously expected
  • E&P companies will soon enter a M&A (merger and acquisition) cycle, possibly around the fourth quarter of 2016
    • Major oil companies will find it more efficient to acquire smaller existing companies and their reserves rather than explore new fields
    • In the 1980s, E&P M&A happened about 9 to 18 months after oil prices bottomed

SHALE PRODUCTION

Shale oil production (aka, tight oil production) should come roaring back

  • Shale production saw a 25% cost deflation in 2015
  • Shale production should see some inflation as restarts pick up in 2017 and pressure pumping prices (will tighten fastest), then sand prices, and then eventually the land rig prices increase in that order
    • Capacity utilization across the supply chain is low.  There is latent capacity to add 200 rigs, but will eventually need to add 100s more rigs, which will tighten capacity utilization.
  • New efficiencies won’t come as quick

DEEPWATER PRODUCTION
To stay competitive, deepwater oil production needs to re-engineer and redesign its methods to deflate costs about 40%

  • $70 oil does not help capacity utilization in the deep rig market
  • Higher oil prices are needed before new projects receive the green light
  • The deepwater market will remain under pressure unless prices move higher

SHALE vs DEEPWATER
Whereas a shale company can activate capital quickly and see new oil within nine months, a deepwater project takes 5 to 7 years (in a good scenario) to see payback from the point of first investment, so the economic incentive has to be stronger

  • Analysts look at breakeven because it is simple to estimate, but in reality, oil companies look at the probability of profitability or internal rate of return (IRR)
  • The reactivation of shale will cap oil at $65 to $70; thus, we are now halfway through the upcycle in prices from the recent lows
    • Since we are not returning to sustained +$100 oil in the next 18 months, companies geared towards lower priced oil (i.e., that are not over-levered in their finances) should do okay

BALANCE SHEETS
Look at free cash yield per cost of debt

  • In the early part of recovery cycle, companies with high debt had a higher run-up in prices than quality companies, but $70 oil does not allow everyone to de-lever
    • At a certain point, having a strong balance sheet becomes important

INVESTMENT RETURNS
Big oil’s IRR has degraded over the last decade because of poor decisions, poor acquisitions, and poor project execution

  • That situation should correct
    • The reduction in capital investment should help the industry make better decisions
    • Execution outcomes should improve with less projects