US oil production – challenges and implications
June 2016 | TALKINGPOINT | SECTOR ANALYSIS
FW moderates a discussion on US oil production – challenges and implications between Tim Murray, a managing director and head of energy origination at Benefit Street Partners L.L.C., Buddy Clark, a partner at Haynes and Boone LLP, John C. Vanderhider, a partner at Opportune LLP, Allen C. Barron, president of Ralph E. Davis Associates LLC, and Sylvia Barnes, a principal at Tanda Resources LLC.
FW: How would you describe the current state of the global energy market?
Murray: The global market is oversupplied by about 1 percent to 2 percent, a very narrow balance that adds significant volatility to the crude oil markets. Considering global depletion rate is 5 percent to 10 percent when the industry is spending billions of dollars, the lack of investment over the past 16 months will lead to an acceleration of depletion. The market should rebalance in short order, but perhaps deferred due to high inventory levels and potential for reduced global demand. It appears global oil demand has recently been projected to increase according to EIA estimates, so rebalancing should be achieved by late 2016 or early 2017. Considering the oil sand production costs in Canada exceed $50-$60/BBL, the 2.5 MMBOPD produced from that resource is at a significant negative cash flow margin that cannot be maintained indefinitely. Removal of those barrels, either due to unfortunate fire impact or financial sustainability, would rebalance the market overnight. Unstable production areas in Nigeria and Libya could also accelerate the rebalancing should disruptions occur in those areas.
Vanderhider: The global energy market is truly undergoing a volatile transformation amid the longest industry down-cycle in history. We are 23 months into a current down-cycle which has been marked by excessive oversupply of oil & gas inventory levels in the face of weakening global demand. Saudi Arabia’s decision to hold market share in 2014 while US shale producers were generating historic production gains, along with OPEC’s reluctance to implement any production cuts, have had a devastating impact on commodity prices and consequently has forced all upstream and services companies to re-evaluate their viability in today’s global market. Cash is king and all companies are reassessing the necessary steps required to be competitive and profitable in a market impacted by volatile commodity prices and limited access to capital markets.
Barron: The global energy market is very unstable with recent OPEC meetings creating a vast divide between member countries. OPEC production is up about 6 percent from its average production in 2014 to about 32.1 million barrels per day. There is a separation between OPEC members; a number of nations are cash-poor which has lead to increases in production in an effort to generate cash to meet domestic spending commitments. Saudi Arabia’s change of oil minister is an attempt to bring some stability to its energy planning while the kingdom borrows funds on the international market. Iran is emerging from economic sanctions and intends to increase oil production to previous levels. Production in Iraq has shown an increase but political instability there threatens any reliability long term. Nigeria and Libya appear unable to offset production declines during times of insurrection and political instability. Global overproduction into an oversupplied market with storage at maximum levels results in pricing uncertainties for any producer trying to maintain cash flow.
Barnes: The global energy sector could be described as having recently come to the sober realisation that effectively a strong surfactant has been poured into our bubble bath, and the froth has dissipated. We have come to recognise the inescapable need to operate with scrupulous efficiency, and manage our capital structures with intense attention to detail and keen risk assessment.
FW: What do you consider to be the major trends and developments impacting US oil production over the past 12 months?
Barron: The continued decline in product prices to a temporary levelling off, followed by periods of increase, retraction, increase and false stability resulted in uncertainty in corporate planning and overall reductions in budget and capital infusions. This accelerated a downward trend in rig activity, drilling, completions of wells actually drilled, a reduced borrowing base and restrictions to new capital resulting in a slow decrease in the overall energy production in the US. The general M&A market declined with the deal count of transactions of over $100m decreasing from 122 in 2014 to 57 in 2015. Reminiscent of the downturn of the 1980s, companies reacted quickly with cuts in budgets and personnel, restricting exploration and development programmes and reducing field operations to levels that, at best, only maintained the status quo or kept declines at a reasonable volume.
Barnes: A major development impacting US oil production over the last 12 months is growing acknowledgment that oil prices may stay lower for longer. Knowing that our newly found domestic capacity to grow production has the power to undermine world oil prices – this has effectively resulted in a glass ceiling on crude. This realisation is impacting management and investor decisions, resulting in reduced capital expenditures, less interest in exploration ventures and fading support for R&D.
Clark: US producers are faced with right-sizing their debt to their asset base. Producers in lower cost basins will have more flexibility to work with their capital and debt providers. For producers in basins requiring crude prices above $50-$60 barrel, their options will be much more limited. Over 70 North American producers have filed for bankruptcy relief. Easily we will have more than 100 bankruptcy filings before the end of the year, and likely much sooner. Over the next 12 months the major trend will be companies exchanging debt for equity either in a negotiated restructuring or through the bankruptcy courts. The strategy is to cut all discretionary capital expenditures, sell off non-core assets, reduce G&A costs to the bone, hedge when possible, negotiate early termination fees and overall cost reductions with service providers. In addition, producers will need to negotiate – as needed, and where possible – waivers under debt covenants. If covenant relief is not available, producers will need to look for more expensive ‘rescue capital’ either in form of preferred equity offerings or more expensive debt. The corollary trend will be opportunistic acquisitions by producers with sufficient dry powder and more manageable capital structures who will buy up assets from distressed or bankrupt producers selling assets to pay off their debts.
Murray: US onshore production depletion is accelerating but has been masked by substantial new oil production brought on in the GOM deepwater. There are only a handful of plays that work at $30-$40 oil, so activity has declined precipitously. There is a large inventory of drilled and uncompleted (DUC) wells that may be brought on in a more favourable oil price environment, but are unlikely to stem the tide of declining US onshore oil production. Drilling and completion processes have become more efficient and lower cost due to pricing concessions from the oilfield service (OFS) companies, but the industry is now at a level at which there is unlikely to be much improvement without higher oil prices.
Vanderhider: Commodity prices, rig count and capital markets continued to weaken dramatically as the downturn unfolded over the past 12 months. The US rig count is down approximately 78 percent from September 2014. Leverage, liquidity and survival became the biggest concerns to US producers. They have responded by significantly reducing development activities, including drilling wells but deferring completions until prices stabilise and acceptable financial returns can be achieved. A renewed focus on technology innovations and cost synergies has served to significantly reduce drilling, completion and operating costs in many fields. Break-even prices have come down materially across many US basins. US oil production is finally starting to reflect producers’ efforts to reduce supply glut, as production is now below 9 million barrels per day for the first time in 17 months.
FW: What is the outlook for the US exerting influence over OPEC’s ability to maintain market share?
Vanderhider: US oil production has become an integral part of worldwide oil supplies. As a country, the US ranks as the third-largest oil producer behind Saudi Arabia and Russia. US influence is dependent upon the aggregate impact of actions initiated by all domestic producers, therefore it is less predictable than solitary actions initiated by sovereign nations. It is anticipated that US strategy will be focused on achieving higher commodity price realisations and acceptable profit margins, both of which are influenced by improving supply/demand imbalances. US companies could complicate OPEC’s ability to maintain market share but it is not anticipated in the near term.
Murray: OPEC’s sustained over-production is somewhat of a surprise to the industry because current oil prices are insufficient to support the maintenance of their society. It seems Saudi Arabia’s primary focus is to damage the economies of their enemies in Iran and Russia, and they seem willing to drain their treasury to inflict as much damage as possible. The ancillary effect is to diminish oil sand, unconventional, deepwater and other higher cost sources of oil production. I don’t believe the US market can influence US policy until the current administration leaves office.
Barron: The outlook is probably not too great. Unless the US begins to export significant volumes of oil and reduces its own importation of oil, there will be little change in the supply side of world markets; consequently, OPEC should remain in a position to maintain production and market share. Individual percentage share will begin to change as member countries with remaining capacity increase production for cash flow to replace those who begin to experience production difficulties – that is, unless the US is allowed to enter the world supply picture in a meaningful way.
Barnes: The ability of the US to exert influence over OPEC’s ability to maintain market share is limited. I anticipate OPEC’s actions will directly reflect whatever view Saudi Arabia has vis-à-vis Iran; in other words, until the Saudis are comfortable, Iran will behave in a manner they find reasonably acceptable. Saudi Arabia and therefore OPEC will ensure Iran’s access to free cash flow will be constrained by moderated oil prices.
FW: With oil prices having dropped to approximately $40 a barrel, can you outline the strategies the US oil industry has been taking to maintain its productive capacity? Additionally, how has the industry absorbed the impact of a minor reduction in overall production capacity and a major reduction in the drilling and completion of new wells?
Barnes: I don’t see the US oil industry being that focused on maintaining productive capacity. Rather, I see it concentrating on maintaining cash flow and meeting financial obligations. Many jobs have been lost and lives have been impacted by the oil & gas sector having to react to reductions in drilling and completion activity. The resiliency of our industry is astounding, as demonstrated by the concurrent, but less dramatic, reduction in overall production capacity.
Clark: More efficient and effective drilling and completion techniques have emerged. Due to a severe drop in active rigs and natural decline curves, production has started to roll over and should continue to fall until producers gain confidence that prices have reached the bottom of this latest price cycle.
Murray: As in all previous cycles, Oil Field Services (OFS) takes the brunt of the impact to adjust the industry cost structure to a level that restores activity. At the current activity level, there is insufficient investment to replace the high decline rate of the recent surge in unconventional production. Companies that are still financially viable are retrenching to focus on the core sweet spots of their unconventional plays.
Vanderhider: The US oil industry has focused its development initiatives on top tier basins, most notably the Permian Basin, the Eagle Ford and the SCOOP/STACK plays in Oklahoma. It has also utilised advanced drilling and completion technologies to increase production and recoverable reserves. The industry’s cost structure has been driven lower and break-even levels across the US for drilling have meaningfully declined. Service providers have been forced to reduce contract fee rates in order to secure work in a shrinking and an ever-increasing competitive market. Only recently has US oil production started to decline, despite the significant reduction in the rig count initiated in 2014 due primarily to drilling in prolific top-tier basins.
Barron: The US has essentially returned to the days of a $40 +/- oil industry. New projects in the deep Gulf waters, deeper costly shale plays and unconventional reservoirs demanding extensive completion techniques are all on hold for most of the industry. Overall production is being maintained with minimal decline with returns to conventional reservoirs, vertical well development, known sweet spots in established shale plays and utilisation of horizontal wells with sophisticated fracking technology developed during the days of high priced oil & gas, are now available at significantly reduced drilling and completion costs. Companies are renewing acreage leases selectively, negotiating for drilling and completion services on multi-well programmes, reducing operating costs in the field and even corporate overhead in order to reduce finding costs and operating expense on a per unit basis.
FW: To what extent have you observed a reduction in the direct costs associated with oil production operations in the US – particularly related to technology developments? How have firms taken advantage?
Vanderhider: Firms have attacked all cost categories in an effort to enhance margins. Technology developments have played an integral role through field automation, improved compression and enhanced gathering systems. Emphasis has been placed on eliminating non-essential expenses and driving drilling and completion costs down 30 to 35 percent coupled with field controllable expenses down by 15 percent. It is important that firms understand the structural changes in costs resulting from improved drilling techniques and completion processes versus cyclical reductions in costs that will go away when commodity prices rise.
Barron: A basic observation is that companies are applying the drilling, completion and especially frac stimulation technology developed during the years of price increases and high overall product price and service company charges. These techniques developed over the period of time where product sales made the development and testing costs possible, are now being applied by operators in a significantly lower price environment and at much lower cost. Drilling with the use of multi-well drilling pads, increases in lateral lengths, the number of frac stages, the amount and type of frac proppant, and so on, have all contributed to lower finding costs. To the extent possible, these savings are being applied to both conventional and unconventional reservoirs. Drilling and completion costs have fallen by 50 percent in certain basins and operating expenses may be down by 20 percent or more. These reductions are expected to continue for not only the near term but into the general price recovery that may take several years.
Barnes: Reductions in direct costs associated with oil production operations in the US are obvious, and have resulted largely from advances in drilling and completion technology and reservoir management. Drill time metrics, completion costs, IPs, EURs and cash flows have all benefitted from the last decade of technological advances.
Murray: A growing trend in the unconventional space is lengthening of laterals and increased proppant loading driven by lower drilling, pipe and proppant cost. Another trend is the voluntary curtailment of production and DUC inventory, awaiting higher oil prices before opening choke, increasing pumping cycles or completing DUCs. Utilisation of 3D seismic to further refine the sweet spots has also progressed.
FW: In your opinion, given the current oil production landscape in the US, what effect do you believe this situation will have on oil price recovery and financial markets going forward?
Clark: Oil prices will recover as production drops off from reduced drilling – basic supply and demand. Over time, if the price increase is steady enough and long enough, the market will again overheat, capital will become readily available and prices will top out and begin the next down-cycle. Near term, the latest price collapse has thrown a very large dose of cold water on financial markets – equity, bond and bank debt – that will keep capital both conservative and at a cost premium; for example, higher interest rates, more restrictive covenants, shorter maturities, simpler capital structures. As always happens, it will take a number of years before the markets forget that prices that go up, can and will eventually come down. At which point we will see a relaxing of pricing, covenants, extension of maturities, and so on, to a point where producers can afford to drill even more wells, increasing overall supply, exceeding demand and causing the next price collapse.
Vanderhider: Declining oil supply, coupled with incremental demand, is leading to an expectation of higher oil prices in the near term. There is near unanimous consensus among Wall Street firms that oil prices are trending upward. Financial markets will be stronger once prices stabilise and the next up cycle begins. All components of the capital markets will generate investor appetite once the underlying fundamentals of the industry improve. Product supply and demand must move closer to rebalancing for a confidence to be developed regarding the staying power of improved commodity prices. Significant inventory of drilled-but-uncompleted wells by US producers will be brought online as oil prices improve which will serve to slow the rate of price escalations in the near term.
Murray: I sincerely believe there will be no ‘snap back’ of unconventional production when prices recover. The simple irrefutable fact is that the OFS sector has been decimated and there will be a significant delay before services will be available to restart the production ramp up. Many OFS companies have filed bankruptcy, their equipment is in disrepair and, most importantly, their personnel have left the industry. Recruiting and training OFS personnel, refurbishing equipment and fielding efficient crews will take considerable time and much higher service costs. Financial markets will also require some time to recover from the substantial pain experienced in this cycle. Public markets especially will cast a wary eye on the industry for some time, but as in all previous cycles, the exuberance will return in time.
Barron: The current environment of essentially $40 oil and $2 gas should result in a continued slow decline in overall production of perhaps another 0.5 to 1.0 MMBOE per day. Vertical completions in conventional reservoirs will continue and some horizontal wells in select unconventional and shale plays will also be profitable for some operators. A $40 to $50 environment for oil and $2 to $2.50 gas environment would help to stabilise US production as drilling would increase in certain basins, drilled but uncompleted wells would steadily be completed, and a relaxing of the financial markets should probably begin throughout the industry. Over $50 oil and $2.50 gas on a sustained basis with the outlook for a gradual increase to $70-plus oil and $3-plus gas in five or so years, would probably be necessary to bring a moderate resurgence to the industry.
Barnes: Given the current landscape, reductions in productivity should ultimately support higher oil prices; the laws of classic microeconomic theory still hold. In the face of relatively stable demand, an increase or decrease in supply will support a respective decrease or increase in price. However, the effect of the strong, silent hand of the Saudis cannot be ignored; until the Saudis are more comfortable with the Iranian situation, the rules may appear to bend a little. Financial markets, as usual will react to perceived risk and return opportunities. Capital availability, in debt and equity, and public and private situations, has been negatively affected by the views of both investors and regulators relative to the industry’s weakened ability to respond to further downside scenarios. Once the risk/reward pendulum swings back into the positive realm, I anticipate we will see a cyclical recovery in financial market activity in the oil & gas sector.
FW: What advice would you give to operators for managing the challenges posed by the current environment, and their implications? Is targeting highly productive areas in unconventional resource plays the best way forward for experienced operators?
Barron: Operators must continue to manage drilling and completion costs with planned development, pad-site locations where possible, locked-in contracts and negotiating minimal service contracts for both drilling and operating services. Minimising debt and living off cash flow always proves successful, but exchanging debt for equity may offer the only alternative for some operators to survive when high debt burdens threaten their existence. Some highly productive areas afford higher rates of return and high cash flow to a small number of operators, but the industry may be better positioned for a return to both vertical and horizontal well development in conventional reservoirs. The expanded use of current technology developed for the unconventional plays during the previous few years affords the experienced operators a method to increase production and returns while keeping finding costs at a minimum.
Barnes: My advice would be to keep asking ourselves “What if we are wrong?”, “What range of scenarios may occur” and “What may be the obvious consequences and the unintended consequences?” Targeting highly productive areas is always a good idea – but don’t forget about conventional as well as unconventional plays.
Vanderhider: I would recommend that operators focus on core-of-core unconventional resource plays where break-even prices are easily attainable at $40 oil. Work profitable basins and focus on improving balance sheets through downsizing, capital markets or asset sales. Pursue A&D opportunities in core basins that further achieve operational synergies and cost reductions. Cost management and operational efficiencies are mandatory during times of depressed commodity prices. I would remain diligent in focus on asset quality, particularly as it pertains to break-even costs and remaining drilling inventory, as investors have become increasingly discerning of asset quality in today’s low price environment.
Murray: Some of the best returns I have witnessed over my 32 year career in energy finance have come from investments made in the darkest hours before the dawn of recovery. Operators who can acquire or merge in this low point in the cycles have the wind at their back and often realise outsized returns when prices recover. Whether acquiring reserves, companies or expiring acreage, operators who are still financially viable can capture assets at the lowest cost seen in years.
Clark: John Templeton is credited with saying the four most expensive words in English are “this time it’s different”. Every CEO and board member should print out Mr Templeton’s observation and post it everywhere in the company, so that the next time prices rise the company remains vigilant to the risks that commodity prices are, and always will be, inherently volatile.
FW: How do you envisage the US oil production landscape unfolding over the coming months and years? Are there any particular trends and developments which could radically transform oil markets?
Murray: We expect private equity and alternative investment firms will profit from the reluctance of the public markets to invest in the industry near term. Add in the unprecedented and radical bank loan regulations recently promulgated by the OCC and current administration, bank capital will be increasingly difficult to raise and will be more restrictive and expensive. With restricted and more expensive capital, the industry will recover but the timeline will be extended. As a consequence, I expect industry activity will resume but at a more measured pace – until the lessons of this cycle have been forgotten.
Barnes: Our industry has achieved dramatic advances and successes. I expect the fruits of our technological advances, combined with our tenacity in the face of challenges, will serve us well and result in stronger and more efficient operations. In time I expect to see renewed interest in conventional plays, and select exploration initiatives based upon 3D seismic analysis, resulting in substantial hydrocarbon discovery.
Barron: The US production landscape will become somewhat levelled as several operators will either disappear or be absorbed due to financial restructuring of the market. Development of high cost shale and unconventional plays will at a minimum. The A&D market should increase as companies are forced to divest of assets to meet borrowing requirements. Private equity will be the major source of capital in the industry reflecting tightness in the public markets. Eventually the bankruptcies and restructurings will run their course. A change in the global market such as a collapse in Venezuela, increased instability in Iraq, Nigeria and Libya to name a few, and a rapid increase in Russian oil production, could all affect US production and fuel domestic exports. Stability in the world markets will probably result in slow but continued US loss of production by another one million barrels per day with prices remaining in the low $40 per barrel range throughout most of 2016.
Clark: Sheikh Yamani said in 2000, “The Stone Age came to an end, not because we had a lack of stones, and the oil age will not come to an end because we have a lack of oil”. The only truly transformative trend that would alter the hydrocarbon-age landscape will be cost efficient, light weight, energy storage, such as third or fourth generation batteries.
Vanderhider: I anticipate there to be continuing pressure on oil prices given the glut of oil that exists today, thereby encouraging development drilling constraint. With increased bank regulation and rating agency downgrades focused intently on the E&P sector, US producers will continue to be more fiscally responsible in everything that they do – from rightsizing the workforce and balance sheets to managing processes and cost structures on desired investments. Technology innovations and cost efficiencies should be the operational focus of producers with a clear understanding that the industry will be leaner and acceptable profit margins will be hard fought. Basin break-even prices will continue to come down. US oil production levels should continue to decline until price stability is achieved and capital markets reopen. US producers are vulnerable to another price decline as experienced in the summer of 2015 should the immediate response to improvement in oil prices to be to aggressively pursue shale drilling and quickly complete the outstanding inventory of drilled-but-uncompleted wells.
Tim Murray has served as managing director and head of energy origination with Benefit Street Partners LLC since 2015. Previously he was a managing director for GSO Capital Partners responsible for investing and raising capital for the energy team at GSO. Prior to joining GSO, he was a managing director of Guggenheim Partners. Mr Murray has served as chairman of the Capital Markets Committee and board member of the Finance Committee of the Independent Producer’s Association of America. He can be contacted on +1 (713) 965 7975 or by email: email@example.com.
Buddy Clark is a partner at Haynes and Boone, LLP and chairs the firm’s energy practice focusing on oil & gas finance, representing producers, banks and private capital providers in secured credit transactions and equity investments. He has been recognised as a leading lawyer in energy law in the Houston Business Journal’s list of Who’s Who in Energy, Best Lawyers in America, and Euromoney’s Guide to the World’s Leading Energy and Natural Resources Lawyers. He can be contacted on +1 (713) 547 2077 or by email: firstname.lastname@example.org.
John Vanderhider is a partner in the corporate finance group of Opportune LLP. With over 30 years of M&A business experience, including nine years as a senior executive in industry, he leads the M&A due diligence practice within Opportune where he is also responsible for oversight of quality of earnings assessments in conjunction with debt and equity infusions into companies. Mr Vanderhider has managed client transactions in excess of $30bn since the formation of Opportune. He can be contacted on +1 (713) 237 4819 or by email: email@example.com.
Allen C. Barron is president of Ralph E. Davis Associates, LLC, a worldwide energy consulting firm that evaluates exploration and development properties throughout the world for public and private companies. He joined Ralph E. Davis Associates, Inc. in 1978. He later left to form his own consulting practice then joined Golden Engineering Company as manager, becoming president of the subsidiary H.J. Gruy and Company before returning to Ralph E. Davis Associates, Inc. in 1993. The firm was then merged into Opportune LLP in early 2015. He can be contacted on +1 (713) 360 0201 or by email: firstname.lastname@example.org.
Sylvia Barnes has over 30 years of oil & gas financial experience and a background in engineering. As principal and head of energy advisory services of Tanda Resources LLC, she focuses on upstream investments and consulting. The majority of her current assignments are related to restructuring and liquidity management engagements. Ms Barnes was head of oil & gas investment and corporate banking at KeyBanc Capital Markets from October 2011 through April 2015. She can be contacted by email: email@example.com.
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