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The Power of the Wave Principle

Oil Drilling Our Way Into Oblivion

Commodities / Crude Oil Dec 20, 2014 - 09:17 PM GMT

By: Raul_I_Meijer

Commodities

Oh, that sweet black gold won’t leave us alone, will it? West Texas Intermediate went through some speedbumps Friday, but ended over +5%, though still only at $57. Think them buyers know something we don’t? I don’t either. I see people covering lousy bets. And PPT (and that’s not the one we used to spray our crops with).

The damage done must be epic by now, throughout the financial system, but we’re not hearing much about that yet, are we? We will in time, not to worry. Everyone’s invested in oil, and big time too, and they’ve all just become party to a loss of about half of what both oil itself and oil stocks were worth just this summer.


There’s those who can ride it out and wait for sunnier days, but many funds don’t have that luxury. Who wants to be manager of Norway’s huge oil-based sovereign fund these days? With all these long-term obligations entered into when oil was selling for $110, no questions asked? The Vikings must be selling assets east, west, left and right. But they’re not going to tell us, not if they can help it.

Just like all the other money managers who pray every morning and night on their weak knees for this nightmare to pass. Your pension fund, your government, they’re all losing. BIG. They’ll try and hide those losses as long as they can. But trust me on this one: all major funds have oil in a prominent place in their portfolios. And there’s a Bloomberg index that says the average share values of 76 North American oil companies, i.e. not just the price of oil, have lost 49% of their value since June. There will be Blood with a capital B.

The discussions over the past few weeks have all been about OPEC, whether they would cut output or not. And I’m not really getting that. There are 3 major producers today, you might even label them swing producers: Saudi Arabia, Russia, and the US. But all the talk is always about OPEC cutting. What about Russia? Well, they can’t really, can they, with all the sanctions and the threat they are to the ruble. Russia must produce full tilt just to make up for those sanctions. The Saudis know that if they cut, other producers, OPEC or not, will fill in the gap they leave behind. At $55 a barrel, everyone’s desperate. Therefore, the Saudis are not cutting, because it would only cost them market share, and prices still wouldn’t rise.

So why does everyone in the western media keep talking about OPEC cutting output, and not the US, just as the same everyone is so proud of saying the US challenges the Saudis for biggest producer status?! Why doesn’t the US cut production? It’s almost as big as Saudi Arabia, after all. Why doesn’t Washington order the (shale) oil patch to tone it down, instead of having everyone talk about OPEC? I know, energy independence and all that, but it’s still a curious thing. Want to save the shale patch? Cut it down to size.

Anyway, this is what we have on offer: the oil industry faces a triple whammy. Oil prices are down 50%, oil company share valuations are also down 50%, and their production costs are rising, in quite a few cases exponentially so. That’s what they, and we, face while slip-sliding into the new year. Do I need to explain that that does not bode well? Let’s do a news round. Starting with Bloomberg on how the shale boys are stumbling over their hedges and other ‘insurance’ policies. All you really need to know is: “Producers are inherently bullish ..” And then you can take it from there.

Oil Crash Exposes New Risks for U.S. Shale Drillers

Tumbling oil prices have exposed a weakness in the insurance that some U.S. shale drillers bought to protect themselves against a crash. At least six companies, including Pioneer Natural Resources and Noble Energy, used a strategy known as a three-way collar that doesn’t guarantee a minimum price if crude falls below a certain level, according to company filings. While three-ways can be cheaper than other hedges, they can leave drillers exposed to steep declines.

“Producers are inherently bullish,” said Mike Corley, of Mercatus Energy Advisors. “It’s just the nature of the business. You’re not going to go drill holes in the ground if you think prices are going down.” [..] Shares of oil companies are also dropping, with a 49% decline in the 76-member Bloomberg Intelligence North America E&P Valuation Peers index from this year’s peak in June. The drilling had been driven by high oil prices and low-cost financing.

Companies spent $1.30 for every dollar earned selling oil and gas in the third quarter, according to data compiled by Bloomberg on 56 of the U.S.-listed companies in the E&P index. Financing costs are now rising as prices sink.

The average borrowing cost for energy companies in the U.S. high-yield debt market has almost doubled to 10.43% from an all-time low of 5.68% in June, Bank of America Merrill Lynch data show. [..]

Pioneer, one of the biggest U.S. shale oil producers, used three-ways to cover 85% of its projected 2015 output, the company’s December investor presentation shows. The strategy capped the upside price at $99.36 a barrel and guaranteed a minimum, or floor, of $87.98. By themselves, those positions would ensure almost $34 a barrel more than yesterday’s price.

However, Pioneer added a third element by selling a put option, sometimes called a subfloor, at $73.54. That gives the buyer the right to sell oil at that price by a specific date. Below that threshold, Pioneer is no longer entitled to the floor of $87.98, only the difference between the floor and the subfloor, or $14.44 on top of the market price. So at yesterday’s price of $54.11, Pioneer would realize $68.55 a barrel.

Where does this turn from insurance to casino, right? It’s a blurred line. Nobody worried about that as long as prices were NOT $55 a barrel. But now they have to. Pioneer gets $68.55 a barrel. Big deal. That’s still well over 30% less than in June.

In Europe, oil is a big issue too. They still have some of the stuff there after all. And that too has halved in value. North Sea oil is a large part of total UK tax revenues, but it’s also energy independence. And already there are people saying that the entire industry is dying.

North Sea Oil Industry ‘Close To Collapse’

The UK’s oil industry is in “crisis” as prices drop, a senior industry leader has told the BBC. Oil companies and service providers are cutting staff and investment to save money. Robin Allan, chairman of the independent explorers’ association Brindex, told the BBC that the industry was “close to collapse”. Almost no new projects in the North Sea are profitable with oil below $60 a barrel, he claims. “It’s almost impossible to make money at these oil prices”, Mr Allan, who is a director of Premier Oil in addition to chairing Brindex, told the BBC.

“It’s a huge crisis.” “This has happened before, and the industry adapts, but the adaptation is one of slashing people, slashing projects and reducing costs wherever possible, and that’s painful for our staff, painful for companies and painful for the country. “It’s close to collapse. In terms of new investments – there will be none, everyone is retreating, people are being laid off at most companies this week and in the coming weeks. Budgets for 2015 are being cut by everyone.”

His remarks echo comments made by the veteran oil man and government adviser Sir Ian Wood, who last week predicted a wave of job losses in the North Sea over the next 18 months. US-based oil giant ConocoPhillips is cutting 230 out of 1,650 jobs in the UK. This month it announced a 20% reduction in its worldwide capital expenditure budget, in response to falling oil prices.

Other big oil firms are expected to make similar cuts to their drilling and exploration budgets. Research from Goldman Sachs predicted that they would need to cut capital expenditure by 30% to restore their profitability at current prices. Service providers to the industry have also been hit. Texas-based oilfield services company Schlumberger cut back its UK-based fleet of geological survey ships in December, taking an $800m loss and cutting an unspecified number of jobs.

[..] .. as a lot of production ceases to make money below $80 barrel (it’s now in the region of $63), North Sea producers and those in their supply chain now face pressure to cut costs sharply. Those costs have been rising steeply in recent years. And measured per barrel of production, they’ve been rising at an alarming rate.

400,000 people work in the industry in the UK, plus at least twice as many in supporting fields, and most of those jobs are in Scotland. Not good.

And it’s not going to stop either, as the following Bloomberg piece makes crystal clear, and for obvious reasons. Once you’ve dug a well, you have to squeeze it for all you got. Makes perfect sense to me.

But… A 42-year record in US domestic production just as prices plummet by 50%, that has to be a game changer. And then you run into problems.

Exxon Mobil Shows Why US Oil Output Rises as Prices Plunge

Crude oil production from U.S. wells is poised to approach a 42-year record next year as drillers ignore the recent decline in price pointing them in the opposite direction. U.S. energy producers plan to pump more crude in 2015 as declining equipment costs and enhanced drilling techniques more than offset the collapse in oil markets, said Troy Eckard, whose Eckard Global owns stakes in more than 260 North Dakota shale wells.

Oil companies, while trimming 2015 budgets to cope with the lowest crude prices in five years, are also shifting their focus to their most-prolific, lowest-cost fields, which means extracting more oil with fewer drilling rigs, said Goldman Sachs. Global giant Exxon Mobil, the largest U.S. energy company, will increase oil production next year by the biggest margin since 2010. [..]

“Companies that are already producing oil will continue to operate those wells because the cost of drilling them is already sunk into the ground,” said Timothy Rudderow, who manages $1.5 billion as chief investment officer at Mount Lucas Management. “But I wouldn’t want to have to be making long-term production decisions with this kind of volatility.”[..] U.S. oil production is set to reach 9.42 million barrels a day in May, which would be the highest monthly average since November 1972, according to the Energy Department..

Existing wells remain profitable even as benchmark crude futures hover near the $55-a-barrel mark because operating costs going forward are usually $25 or less, Tom Petrie, chairman of Petrie Partners said. That’s why prices that have tumbled 47% from this year’s peak on June 20 haven’t prompted any American oil producers to shut down wells, said Petrie. The average cost to operate an existing well in most parts of the U.S. “is about $20 a barrel,” Petrie said. [..] Until you dip into that and start losing money on a cash basis day in, day out, you don’t think about shutting in” wells.

Once oil companies sink cash into drilling wells, lining them with steel pipes and concrete, blasting the surrounding rocks into rubble with hydraulic fracturing, and linking them to pipeline systems, they have no incentive to scale back production, said Andrew Cosgrove, an analyst at Bloomberg. Those investments, which represent “sunk costs,” are no longer a drain on cash flow, Cosgrove said. Instead, they generate capital companies use to repay debt, fund additional drilling, pay out dividends and buy back shares, he said.

Exxon Chairman and CEO Rex Tillerson pledged in March to raise output by an annual average of 2% to 3% during the 2015-2017 period.

Things run fine at existing wells. Prices get governments in Russia and other producers into trouble, but most can catch that fall up to a point. In the US shale patch, it’s a different story, because there it’s not like once you’ve drilled a well, you can move for years to come. Saudi’s famed Ghawar field has been gushing for 60 years. Shale wells deplete 80-90% in just two years.

It’s like comparing a business that can keep durable goods in stock for years, with one that has only perishables and needs to move them ASAP. A whole different business model, but operating in the same market, and competing for the same customers.

The shale patch can exist in its present form only if it has access to nigh limitless credit, and only if prices are in the $100 or up range. Wells in the patch deplete faster than you can say POOF, and drilling new wells costs $10 million or more a piece. Without access to credit, that’s simply not going to happen.

Don’t forget, shale companies came into the ‘new lower price era’ with big debt issues already in place – borrowing well over $100 billion more annually than they earned, for at least 3 years running, and then in Q3 2014 they spent ‘$1.30 for every dollar earned selling oil and gas’ according to Bloomberg’s E&P index.

Q3 is July, August and September. On July 1, WTI traded at $106. On September 30, it still did $91. And in those days, at those prices, the industry bled $1.30 for every dollar earned. What is that ratio today? $2 spent for every $1 earned? $2.50? More? That is not a different business model, that is not a business model at all.

Existing wells, those already drilled, will be allowed to be emptied, but then it’s over. Who’s going to continue to pump millions upon millions into something that’s a guaranteed loss? Nobody. And not only that, but lenders will start calling in their loans, and issue margin calls. “The average borrowing cost for energy companies in the U.S. high-yield debt market has almost doubled to 10.43% from an all-time low of 5.68% in June”, says BoAML.

That’s about all we need to know. Shale was never a viable industry, it was all about gambling on land prices from the start. And now that wager is over, even if the players don’t get it yet. So strictly speaking my title is a tad off: we’re not drilling our way into oblivion, the drilling is about to grind to a halt. But it will still end in oblivion.

By Raul Ilargi Meijer
Website: http://theautomaticearth.com (provides unique analysis of economics, finance, politics and social dynamics in the context of Complexity Theory)

© 2014 Copyright Raul I Meijer - All Rights Reserved Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.
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