TEMPEST IN THE ALASKA TEA POT REDUX
April 11, 2017 § 1 Comment
Here we go again. Presidents making decisions that are largely symbolic in the face of economic realities. The latest is a report that President Trump will shortly issue an executive order to promote oil and gas exploration and production in the Arctic and Atlantic.
I had previously written that President Obama’s 11th hour decision to ban future sales of leases in the Arctic would have no net effect on the industry in the foreseeable future. His ban on the Atlantic coastal waters was more interesting, in that it stopped at approximately the North Carolina border with Virginia. Interesting, because previous exploration had shown potential in the North Carolina waters, more so than Virginia. I think some exploration is likely as a hedge, but actual development will await the sorting out of the true impact of shale oil, as discussed below.
The industry has gone through a secular change. Predicting oil price has proven even more tenuous than in the past. When conventional oil (as opposed to the more recent shale oil) was the only product, oil price prediction entailed understanding the development pipeline, usually years in duration, while factoring in political instability in the oil producing nations. Further assisting the crystal ballers was OPEC, which manipulated prices to remain in the vicinity of USD 100 per barrel. Since about 2015 all that has gone out of the window. Shale oil in the US caused a halving and it has been seesawing around USD 45 ever since. What the future bears depends on the source. In the past, there had always been the outlier analyst predicting USD 200 or some such. But the consensus was in the low one hundred region. Now we have polar opposite predictions regarding supply and demand from the likes of Goldman Sachs and Morgan Stanley. Sort of the definition of uncertainty. Not the best climate for long term investment. More on that below.
Sustained low prices decimated the ranks of the shale oil producers, resulting in 100 bankruptcies and default on USD 70 bln in debt. But a new force has emerged. Major oil players with deep pockets, such as ExxonMobil and Royal Dutch Shell, have taken large positions. More importantly, those two plus Chevron are committing to USD 7 bln investment in 2017 (some estimates are up to 10 bln.) in shale plays, primarily in the Permian Basin. This is a giant leap from before, when the emphasis was on offshore development. This comes shortly after the Shell announcement of withdrawal from the Arctic “for the foreseeable future”. This withdrawal is from continued development of existing leases. That would appear to indicate a disinterest in any more leases in auctions, enabled by the reported President Trump order. In fairness, that does not necessarily follow. Even if they are backing off on development offshore, new leases will still be bought as hedges. This is evident from the recent robust lease sales in the Gulf of Mexico. This is in the relatively benign environment of the Outer Continental Shelf (OCS). But an Alaska lease is a horse of a different color. The costs and environmental risks are much higher and the time to first oil (forget gas; that is even more in the doldrums of price than oil) is double that in the OCS.
Uncertainty, with concomitant higher discount rates, particularly hurts long term plays. By contrast, shale oil plays are short term in the extreme. Due to the steep decline rates, new wells must be drilled to keep up the production. These wells take a couple of weeks, not years. When the prices drop, drilling can be curtailed and then picked up at the drop of the proverbial hat. This flexibility is a key to the resilience that shale oil has shown to saw tooth prices. Furthermore, breakeven costs have dropped dramatically. At first these were due to steep service company discounts, which in turn caused bankruptcies among the smaller players. The big boys will inevitably raise prices, especially now with the reduced competition. But the industry is seeing genuine technology advances dropping costs even in the face of the upcoming service price increases. These advances will continue. A Shell spokesman recently stated that they were profitable in the Permian at USD 40 and that “newer wells” were profitable at USD 20. There is little doubt the industry is “high grading” their prospects: mostly just the most productive areas are being exploited. I think that is sustainable until additional technology driven cost reductions bring the lesser prospects back into play in roughly the three to five-year time frame.
The foregoing arguments underline the point that with oil companies likely struggling to pay their dividends in a low-price scenario, shale oil is a good bet. Expensive forays into the Arctic with long term payouts will be off the table in the foreseeable future. Presidential actions on leasing are mere tempests in the Arctic teapot.