Exploration

Oil: Get Ready For “Much Lower For Much Longer.”

Harold Hamm has been speaking out about the big problems associated with the continued growth of U.S. oil production. Hamm runs Continental Resources Inc., one of the biggest shale producers in the country with drilling operations that run from the Bakken in North Dakota to Oklahoma. He also was an early supporter of Donald Trump’s candidacy, and remains an informal adviser to the president on energy.

U.S. production “could go pretty high,” Hamm said at the CERAWeek by IHS Markit conference in Houston, one of the largest gatherings of oil executives in the world. “But it’s going to have to be done in a measured way, or else we kill the market.”

The Energy Information Administration recently said U.S. production will rise to 10 million barrels a day by the end of next year, more than 10 percent higher than now. If so, shale drillers will capture market share from OPEC, largely filling the increase in global oil demand.

Michael Fitzsimmons put together the following article on this very subject and provided some insight into how the increased drilling budgets for some of the biggest shale drillers could comprise the stability of the markets and the price of oil. Could oil drop back down to sub $40 per barrel?

Continental’s Harold Hamm Puts His Finger On Shale Oil’s (Unsolvable) Big Problem

Summary

– Hamm says the U.S. needs a “measured” production response or else it will “kill” the oil market.

– But unlike central planning OPEC countries, there is no way for the U.S. – with its many large, medium, and small-sized producers – to have a “measured” response.

– Even Hamm’s company, Continental Resources, plans to grow production ~20% this year even though breakeven is $55/bbl – $7/bbl higher than Friday’s WTI close.

– Meantime, big companies like Exxon and Chevron are pivoting to short-cycle shale drilling.

– “This will end badly. I am changing my view from “lower for much longer” to “much lower for much longer”.

Shale Oil Billionaire Harold Hamm

For over two years, my outlook for oil prices has been “lower for much longer.” Recent comments from oil executives at the recent CERAWeek conference cause me to update that view to “much lower for much longer.”

Harold Hamm recently summed the situation up quite succinctly by saying the U.S. industry could “kill” the oil market if it goes on another spending binge. Hamm said U.S. production “could go pretty high” but:

“…. it’s going to have to be done in a measured way, or else we kill the market.

But that’s the problem in a nut shell: who is going to dictate that domestic oil production growth be done in a “measured way”?

Ever since OPEC’s decision to increase production in the fall of 2014 to drive prices down, domestic oil companies have continued to enjoy excellent access to debt and equity markets. Acquisitions continued – particularly in the hot Permian Basin. Wall Street seems unconcerned with earnings (as in net income) and instead appears to focus on cash flow, even though that cash flow is tied directly to the (very risky) price of oil, and to a lessor extent – natural gas.

Once OPEC made the decision to cut back production, oil quickly rose to over $50/bbl. Domestic shale producers then responded hedging future production to lock in a price of over $50/bbl. That, combined with easy access to capital from Wall Street, has spurred a quick and robust production response:


According to the EIA, U.S. domestic oil production most recently peaked at almost 9.6 million bpd in June of 2015. After oil prices swooned and the rig count collapsed, production fell to under 8.5 million bpd in July of last year. However, the response to the OPEC production cut announcement was both quick and powerful as it took only 7 months before U.S. production broke through the 9 million bpd level in February and was up to 9.09 million bpd as of last week.

Meantime, domestic crude oil storage levels have reached all-time highs and are significantly above the rolling 5-year average:

Source: EIA

It’s like watching a re-run of a disaster waiting to happen. And no one can stop it. The reason is simple: OPEC countries have a centralized decision-making process that can control production output. In the U.S., you have a handful of very large oil companies, dozens of mid-sized producers, and over a hundred small-sized companies and they are all looking out for #1 (i.e. themselves).

They are all wanting to grow production for their shareholders – not to mention that in many cases executive compensation is tied to production growth (whether or not that production growth is actually profitable).

So back to Hamm’s statement – there is no way to insure a domestic “measured” production response to OPEC’s cut. In fact, it is just the opposite. An “un-measured” response is assured.
Until, of course, prices collapse again – and they certainly will. Note what Al-Falih, the Energy Minister of Saudi Arabia said at CERAWeek: it would be “wishful thinking” to expect that Saudi Arabia and OPEC “will underwrite the investments of others at our own expense” through production cuts.

Meantime, Hamm’s own company – Continental Resources (NYSE:CLR) – has a $1.9 billion budget for 2017 and expects exit production to grow in a range of 19-24% to 250,000 to 260,000 boe/d:

Source: CLR’s Raymond James Presentation (available here).

Continental has been extremely successful in pivoting from the Bakken to the SCOOP and STACK plays in Oklahoma (see my article Continental Brings In Some Monster $TACK Meramec Wells). The company says it will be cash neutral at $55/bbl. But WTI closed Friday at $48.49/bbl. So I would ask Harold Hamm – if you are cash neutral at $55/bbl, does it make sense to grow production ~20% this year with oil currently at $48.49/bbl? Sure the company has some hedges, but you understand my point. Like so many other oil producers’ CEOs, Hamm apparently wants a “measured” response by every company but his own. And that is why the “measured” production response problem is, to put it bluntly – unsolvable.

And I am not picking on Continental. EOG Resources (NYSE:EOG) recently announced a $3.7 billion to $4.1 billion capital program this year – up 44% YoY. EOG expects to grow production 18% YoY as compared to 2016 average daily production of 282,500 boe/d.

Leading Permian Basin producer Pioneer Natural Resources (NYSE:PXD) has announced it plans to grow production to 1 million boe/d by 2026 by following a 15% CAGR:


Source: March Presentation (available here).

Here Comes The Big Boys

As if production growth from the major shale oil producers isn’t bearish enough, both Chevron (NYSE:CVX) and Exxon Mobil (NYSE:XOM) are now pivoting to short-cycle shale drilling. Both companies want to allocate less capital to multi-year mega-projects requiring multi-billion dollar investments in an oil-price environment that looks shaky (to say the least).

For example, this year, Exxon is going to spend 1/3 of its drilling budget on shale. Exxon displayed a slide at the recent analyst meeting that showed it intends – or has the opportunity – to nearly quadruple Permian Basin production by 2025:


Source: Exxon Mobil Analyst Meeting Slide (available here)

Summary & Conclusion

Despite Harold Hamm’s plea for a “measured” production response (let alone his own company’s plans to grow spending and production this year), there is simply no way to do so in the United States. Independent oil producers are looking out for themselves. Executive bonus plans are many times tied to production growth – whether the production growth is profitable or not.

So production will continue to grow – relatively quickly – until OPEC and Russia push back with a plan to increase their own production. Prices will crater, and they’ll be another bust in the domestic oil patch.

This is exactly why I wrote the Seeking Alpha article ‘What If U.S. “Big Oil” Bought And Mothballed EOG Resources, Pioneer Resources, and Whiting Petroleum’? in October of 2015. Because, there isn’t a solution to a “measured” production response without the big fish swallowing the little fish and “taking out” production. But that never happened during the latest price swoon because the valuations of the mid- and small-sized companies were so high (despite losing money on every barrel they produced….) that “Big Oil” could buy property much cheaper than companies that had current production. So companies EOG, PXD, CLR and WLL are still out there … pumping away.

Those 4 companies alone will have average daily production of nearly 1 million bpd this year.
Making matters worse are the hedge books these companies have in place. So even if WTI falls precipitously, many of these companies will continue to grow production in the face of lower prices (at least for a while…) because they have already sold future production forward at more than $50/bbl.

Get ready for “much lower for much longer.”

As a result, I continue to favor the midstream sector – companies that will benefit from higher production volumes in their pipelines and storage facilities; those that have the potential to tap the export market; and those tied to refiners that will produce more gasoline as the economy picks up steam and gasoline prices fall. Some companies to consider are Phillips 66 Partners (NYSE:PSXP), NuStar (NYSE:NS), TransMontaigne Partners (NYSE:TLP), and Enbridge (NYSE:ENB). I have written articles on all of these companies, so feel free to take a look.

Resourced Seeking Alpha

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About: Continental Resources, Inc. (CLR), Includes: CVX, ENB, EOG, NS, PSXP, PXD, TLP, XOM Michael Fitzsimmons Oil & gas, dividend investing, research analyst

Compiled and Published by GIB KNIGHT

Gib Knight is a private oil and gas investor and consultant, providing clients advanced analytics and building innovative visual business intelligence solutions to visualize the results, across a broad spectrum of regulatory filings and production data in Oklahoma and Texas. He is the founder of OklahomaMinerals.com, an online resource designed for mineral owners in Oklahoma. ☞Email:g.knight@oklahomaminerals.com

 

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