Four stocks to watch as U.S. shale production struggles
Signs are emerging that the era of cheap and widely available energy coming to an end. People all over the world are discovering that oil and gas are necessary if the energy supply is to be uninterrupted. Shortage of Europe has often hit the headlines over the past few months. What’s new is that it catches a lot of people off guard. I’ve been discussing this possibility for a few years in articles on oil prices and I’ll link a few below if you want to go back and examine my original thesis in light of current events. In this article, we will explain why we believe that shale production, currently on the rise, could plateau and even decline as the year progresses.
It’s no big secret as to how we got to this point. Crude inventories are below historical 5-year averages. Thanks to cold weather and the booming LNG trade to the east, natural gas supplies are 6.2% below year-ago levels and just above the 5-year average. There are a myriad of reasons – and we’ll just list what we think are the main drivers – why oil prices have reached today’s levels. These reasons range from government messages to oil and gas companies to OPEC+’s fairly stoic restoration of the 9.5mm BOPD they cut in 2020 and, of course, the incredible recovery of the economy. world, especially here in the United States.
I have written a number of articles on shale oil prices and the broader energy market over the past two years. In these articles, there was great value in American shale companies that was not yet reflected in the market. I also discussed the likely impact of nearly a decade of underinvestment in new upstream supplies by beleaguered oil companies struggling to survive in a lower energy reality for longer. There are a few that I would recommend looking into after reading this article.
Why U.S. Shale Companies Are So Undervalued
It’s too late to avert a major oil supply crisis
The response from drillers to the rising price has been subdued but nonetheless gratifying as this week alone we broke through the 600 rig level not seen since 2020. We even put 10 frac spreads back to work, the total reaching 254. Something about $80.00 oil perhaps? Of course it is. The rig count is probably 50-75 rigs above what it would likely be with oil below $70.00.
PrimaryVision, chart by author
The increase in drilling has led to shale production approaching its early 2020 levels of 9.3mm BOPD, as well as the activation of DUCs which we have discussed on several occasions. More recently in a Article on oil prices earlier this month. The number of DUCs continued to fall through December, with another 214 wells coming online according to today’s issue of the EIA Drilling Productivity Report. This increase in production has led the Energy Information Agency (EIA) to forecast a continued increase in production this year, as we noted earlier, with production eclipsing demand for most of 2022 and 2023. If we were to add the 800K BOPD the agency expects us to add it would take another +/- 200 rigs and another 50 frac spreads, to land at around 9.7mm BOPD. Something else would also be needed.
This brings us to the heart of our thesis that continued gains in shale production are problematic due to the age of the inventory currently in production and the remaining Tier I drill sites.
If you have read many of my articles on shale producers, you come across the term- rock quality. It refers to a number of characteristics of a production interval which may include, but are not limited to, interval depth and thickness, natural permeability, crude quality, gas oil ratio, formation pressure and temperature. All of these will affect how much it costs to drill a well and the amount of production per day, and the economic life of the well that can be expected to produce. It will also impact the rate of decline – the rate at which oil production declines as water rushes in to replace it. But let’s not stray too far from our central thesis.
A central thesis in two parts
First, the producing wells in the shale lands are aging and an increasing number of wells will be depleted each month as they go. The takeaway from the chart below is that 8-10 months online and a shale well has produced about 2/3 of the oil it will ever produce. The water cut rises – let’s understand something, nature abhors a vacuum, right? Yes. Thus, as oil is extracted, water begins to constitute an increasing amount of daily production. Somewhere between 18 and 20 months, we’ve reached 90% of potential ultimate recovery, and… it’s time to call the cement truck. Ignore the amounts here, the point is that sinks that have been online for over a year are heading to P&A town. Let’s also agree that we’re oversimplifying here to make a point, because the quality of the rock – that’s it again – will play a big role in the decline curve of a particular well or field.
For the sake of simplicity, let’s agree that a horizontal well and a shale well mean the same thing. It’s a little oversimplified, but it’s probably 98% true. Let’s not quibble.
Each year we usually add approx. 20K wells in the United States This corresponds to the number of active wells in the Permian and Eagle Ford basins, 66530, the two basins which account for about half of daily shale production.
If you just average the number of wells with shale production at 8.5mm BOPD, that comes out to 52 BOPD, which means the bulk of those wells are long past their peak and heading towards extinction .
The takeaway here is that current drilling barely replaces the 20,000 odd-numbered wells that experience terminal decline each year, having produced 90% of all they are likely to produce. It will take a lot more drilling to impact that figure just with new wells.
Another little well-kept secret
Let’s say you’re an oil producer in 2019. Oil prices are in the tank, not as low as they will be, but your business is keeping its head above water. You bring your executive operations team into your office and ask them to spend their investment money on the best prospects.
And that’s exactly what the companies did. A Article Rystad noted that in 2020 companies are emphasizing Tier I sites.
“Five months into 2020 and three months into the resulting downturn and collapse in drilling activity, we are seeing operators increasingly focusing on sweet spots. This should translate to Tier 1 acreage accounting for a record 47% share of total drilling activity this year, compared to 36% to 40% between 2016 and 2019.”
Now the same article notes that while the Midland and Delaware basins likely contain another 15-19,000 Tier I locations, using the same logic we applied above, the focus can be on areas of level II and III. The reasoning being that with the higher break-even points for these lower levels, it makes sense to develop them with the high prices currently being received.
Some of the distinctions between levels can be overcome by technology, on a case-by-case basis. This will depend, for example, on whether a well is level II due to its depth or distance from the sell lines, or perhaps whether it is lower grade rock, with pressure natural, lower porosity and permeability, or if the GOR is more gas oriented than oil oriented. . As I said, many variables distinguish the levels.
Your takeaway meals
Energy stocks continue to be undervalued relative to current demand for oil and gas. If indeed we see shortages of critical crude, gas and refined fuels, I believe the current uptrend will shift significantly upwards. The world is still addicted to fossil fuels, whether it likes it or not.
The companies that were the best performers in 2021 will likely continue that outperformance in 2022. The steps many of them have taken to secure premium Tier I drill locations, with M&A activity from both years to ensure their long-term survival comes heavily developed. Actions taken by Occidental Petroleum, (NYSE:OXY), ConocoPhillips, (NYSE:COP) Pioneer Natural Resources, (NYSE:PXD), Devon Energy, (NYSE:DVN) and others considered in the context of this new era should start adding value to these businesses.
It’s not too late to buy these companies, subject to your own investor risk tolerance for growth and income.
By David Messler for Oilprice.com
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