Oil: Can recent gains be sustained?

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Simona Gambarini, Research Analyst, ETF Securities

Rig counts: Do they really matter?
Rotary rigs are machines used for drilling vertical and horizontal wells for exploration, development and production of oil and gas. Rig counts are considered an important barometer for the drilling industry as they reflect potential changes in output levels. Sustained oil price changes can have a substantial impact on companies’ decisions, prompting a fluctuation in the number of operating rigs. Historically, oil rigs have taken about 16 weeks to adjust to lower oil prices. During periods of strong declines in WTI crude price, like during the 2008 crisis, oil rigs have halved in the following four months.

However, the shale revolution has permanently changed the shape of the global oil industry. Back in 2008 shale oil was just a fraction of total US oil production. Today 60% of US oil production comes from shale formations. This is also reflected in the different composition of rotary rigs today compared to 2008. Horizontal rigs currently account for 75% of total active rigs while only 15% of rigs are classified as vertical. The situation was almost entirely reversed in 2008. Horizontal rigs are commonly used in the production from shale formations as they allow for a much wider area of the rock to be reached and for more oil and gas to be extracted. As such, the change in the composition of the total rig count gives a guide as to how prices are affecting how output is distributed across the industry.

The sharp correction in oil prices has already prompted a 19% decline in US oil rigs since the end of August. However, vertical rigs accounted for 37% of the decline since August 2014 and for 65% of the decline since January 2014. While horizontal rigs have also declined by 12% since the end of August, further cuts in shale production are needed to rebalance the oil market.

A decline in rigs per se does not necessarily imply production is actually falling, as it could also be a reflection of efficiency gains in the industry, whereby fewer rigs are required to extract oil from shale formations. Pad drilling, for example,

allows rig operators to drill multiple wells with the same rig by concentrating wellheads at the surface, while rig mobility has translated into substantial cost cuts.

Hence, looking into wells statistics can provide more insight into the shale industry dynamics. While the number of wells is yet to decline, the apparent arrest in their growth in the second half of 2014 might already be a positive sign.

Unlike conventional wells, which can produce at relatively stable rates for a sustained period of time, shale oil and gas wells experience an initial burst of production in the first few years of their lives, followed by a sharp decline thereafter.

Post Carbon Institute, a think tank specialised in energy-related issues, estimates that the average shale oil well declines at a rate of 60% to 91% over three years while a conventional well declines at an average annual rate of 5%. According to the North Dakota’s Department of Mineral Resources, production from an average Bakken well declines by 65% by the end of the first year, another 35% by the end of the second year, and a further 25% in the following 2 years. As a result, an increasing amount of wells have to be drilled to offset the natural decline in production from shale formations.

Breakeven prices
In a world where marginal production is determined by shale rather than conventional fields, breakeven costs are critical to sustaining output levels even in the short term because production from existing wells is not stable and oil companies must keep drilling new wells simply to counteract the natural rate of decline in output. However, different formations within the same shale deposit might have very different breakeven prices and produce substantially different amounts of oil. Hence, it is essential to take the geology of different deposits into account to assess the feasibility of different shale projects.

The resilience of US shale may prove greater than the resilience of OPEC. While OPEC initiated a price war against the US on the assumption that half of all US shale output would be vulnerable below US$85, most of North Dakota’s Bakken field remains profitable at or below US$40 per barrel. Moreover, most US producers have hedged their production for most of 2015, locking in higher prices through derivative products.

While full cycle costs for shale production are around US$70 to US$80, the residual capex required to bring on an additional well is substantially lower and the price floor is decreasing by an average of US$10 a year thanks to improvements in production efficiency. While investment in oil exploration is already being cut, development spending of existing fields is unlikely to be substantially reduced. This means that capacity will nonetheless increase and so will the infrastructure investment to transport and store the additional capacity made available.

Meanwhile, the majority of OPEC’s countries are estimated to

require oil prices of at least US$90-US$100/bbl to balance their fiscal and external budgets. While some countries can run budget deficits, the appetite to do so will wear thin as the cost of financing starts to increase.

Note: external breakeven oil prices = oil price at which the current account balance is zero. Fiscal breakeven oil prices = oil price at which the fiscal balance is zero.

At current prices, Saudi Arabia is losing about US$10bn per month from its foreign currency reserves. While Saudi’s reserves are ample, a prolonged time of low oil prices in a period of increasing threats from neighbouring countries might not be in Saudi Arabia’s best interest. Defense accounts for a large portion of Saudi’s national spending. In June 2014, just before the plunge in oil prices, Saudi Arabia announced a 20% increase in its defense budget, the largest nominal annual increase since 2007.

Threats from extremist groups in Iraq, Syria and Yemen and escalating rivalry between Sunni and Shia’s adherents in Iraq and Lebanon are likely to keep Saudi Arabian military expenditure elevated, thereby putting its fiscal balance under continued pressure.

While US oil rig count is pointing in the right direction, we do not expect substantial production cuts before HY2 2015. Price weakness is eventually going to hurt the profitability of US shale projects with some companies likely to be pushed out of the market and production finally decreasing. We believe that OPEC countries will see these developments as a positive move and will motivate a cut in its June 2015 meeting.

However, the cartel will move with caution recognising that despite the recent reduction in rig counts, US production could easily rise once again. Saudi Arabia, the largest producer in the cartel, is reluctant to give up market share and will wage the price war as long as it takes to reassert its market dominance. However, increasing threats from neighbouring countries might force Saudi Arabia to cut production sooner to replenish its finances.


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