Welcome to the crippled edition of the Oil Markets Daily!
The American shale is not dead. And when it comes to analyzing the growth of shale oil production in the United States, the analyst community falls into two extreme categories. A group led by Rystad Energy estimating that US shale could reach ~ 16.2 million b / d by the end of 2030 at $ 50 / b of WTI and another group that believes that US shale will decline structurally under ~ 9 mb / d by 2021.
Source: Rystad Energy
The truth is somewhere in between. The American shale is not dead and the EIA 914 report for July (released late September) and August (released late October) will prove it.
Source: EIA, HFI research
The reason for this is that US July oil production rebounded to ~ 11.3mb / d after a near complete return to closed production. August saw a similar recovery, but the monthly average will be affected by storm closings.
After August, however, the rebound is over. US oil production is expected to continue rolling with no sign of a rebound until the second half of 2021 if oil prices are well above $ 50 / bbl WTI by then.
Source: EIA, HFI research
As you can see in the graph above, US oil production has stabilized around ~ 11 mb / d for the remainder of 2020 and the first half of 2021. But our data suggests that the EIA is underestimating largely the current recovery but also subsequent rates of decline. .
At $ 40 / bbl WTI, US shale oil production will drop below ~ 10 mb / d by the second half of 2021. There is no improvement in well productivity that will reverse the trend. The only way for the US shale to reverse the impending decline is to drive up oil prices. Even at ~ $ 70 / bbl WTI, we estimate that given the new capex orientation policies to target ~ 50% to ~ 70% of OCF on capex, US shale oil production will grow at a measly ~ 35k b / d to ~ 75k b / d per month (growth rate is based on average targeting of capex on OCF).
As a result, the glory days of the ~ 200 Mb / d growing US shale are long gone.
Big implications for inflation trends too
There’s a great chart by Mike Rothman from Cornerstone Analytics that was released two weeks ago.
Source: Cornerstone Analytics
The graph essentially illustrates how much US oil production has contributed to the growth in global oil supply since 2010. While the graph is not self-evident, the United States has essentially contributed all of the growth. global supply since 2010, while non-OPEC countries have been broadly stable. .
The importance of this could be related to the era of cheap capital between 2010 and 2016. The Fed’s quantitative easing policy and investor appetite for pursuit of yields drove the US shale to borrow at a very low price to finance drilling. The cash outflows were huge, to say the least, and if the investments had been kept in line with the cash flow, US oil production would have been stable.
And when it came to cheap credit, it came in the form of dedicated credit facilities or RBLs. These lines of credit were, in our view, the number one reason American small shale companies spent massively more. The reasoning was simple:
Every six months, the RBL’s banks would assess the progress the company is making on its drilling and exploration program (e.g. investments). And the greater the progress (eg, more money spent), the more reserves could be derived. The value of the RBLs was assessed on the proven part of the reserve book. Banks typically took 65 cents out of the dollar regardless of the proven reserve value. And since the banks did not evaluate the producers on its cash flow or its generation of free cash flow, but rather on the reserves. Businesses have found that the more they borrow and spend to prove reserves, the more they can borrow.
This positive self-reinforcing mechanism has allowed companies to continue to borrow and drill without any consequences. Until, of course, the $ 100 / bbl oil days were over and companies realized that RBLs were a double-edged sword. But that’s not even the worst. The oil crash that followed was rather short-lived, and since 2014 to 2017 productivity gains have increased dramatically, companies realized that they could still make the same kind of spending and prove their reserves, but at a Lower price.
Then came COVID-19 which made RBLs worthless. What we mean by this is in a normal market environment where WTI might say the bottom at $ 40 / bbl, an RBL still had value because banks could underwrite reserves at that $ 40 price. / bbl. But in the COVID-19 pandemic, the WTI turned negative. And regardless if the oil price futures outlook was $ 40 in 2021, the calculation of the net present value of the reserve-based lending model made all reserves current and proven to be virtually worthless.
Banks then quickly realized that the entire RBL model was built on false pretenses of reserves. And businesses are now realizing that RBLs aren’t really cash given the ability of banks to revalue every six months.
To put it simply, RBLs will be virtually non-existent by the end of 2021. Banks that have lines of credit with producers today come in the form of covenants-based facilities, which are not subject to restrictions. same expensive semi-annual determinations. These will likely replace RBLs, but because covenants based installations have tighter limits and are in fact based on cash flow metrics, producers will be forced to spend within cash flow limits rather than in the flaw we saw in the previous cycle.
This fundamental shift in how credit will be provided to the American Shale will make a difference day and night in the future growth of the American Shale. And since the availability of credit is extremely tight and available only to large, wealthy producers, the growth engine that propelled the United States to become the largest oil producer is no longer there.
The American shale is not dead, but it is paralyzed for life. The main source of finance for most E&P, the reserve-based lending facility, is all but extinct by the end of 2021. Without this cheap source of bank capital, energy producers will be forced to spend in cash flow. Bigger producers like Pioneer have already moved towards new investment policies by spending only ~ 50% to ~ 70% of OCF on Capex. This significant shift in capital spending will dramatically alter the future of the trajectory of oil production in the United States.
As a result, people seriously underestimate how significant the recent decline in US oil production really is. While we would say the American shale is far from dead, it’s really crippled this time around.
We are finally entering the bullish phase of the rally in energy stocks. With valuations still completely disconnected from oil market fundamentals, we believe investors should be positioned to take advantage of the rising oil market. We are now offering a 2 week free trial and if you would like to read our WCTWs this week please click here.
Disclosure: I / we have no positions in the mentioned stocks, and I do not plan to initiate any positions within the next 72 hours. I wrote this article myself and it expresses my own opinions. I am not receiving any compensation for this (other than from Seeking Alpha). I have no business relationship with a company whose stock is mentioned in this article.