The Kingdom’s war
Since the middle of 2014 Saudi Arabia has been waging an oil war with the rest of the oil producing world. Having lost market share and status as the preeminent Middle East power, the Kingdom is playing their trump card to achieve their goals of:
- Increasing market share;
- Reasserting dominant status in the Middle East; and
- Maintaining stability at home for the long term.
Post the 2008 financial meltdown, Saudi Arabia has steadily lost market share in the USA to high cost US shale and Canadian oil sands producers. Their position as the USA’s Arab ally has deteriorated as evidenced by the Iranian nuclear deal and lifting of sanctions, and challenges from Shia nations in regional conflicts (i.e Syria and Yemen).
To reassert their status, the Kingdom is playing their best hand. Is the strategy working? Below Vital Data Science analyzes the effects of Saudi Arabia strategy and surmises what comes next.
The war for market share
While in United states oil production is down (chart 1) and imports are beginning to rise (chart 2) implying the strategy is working, a closer look reveals a more complex picture. This war is not for the USA market share.
Chart 1: USA oil production
The largest benefactors of the drop in US production have been Iran, Iraq, and Kuwait in OPEC; and Canada and Russia in the non-OPEC producers. Iran and Iraq are enemies of Saudi Arabia; Russia is aggravating Saudi Arabia in Syria; and Canada is a high cost producer. So while high cost shale production in the USA is on the decline (chart 3, note that gas production is stubbornly holding in), the Kingdom’s strategy has not played out as expected quite yet. As we show below, the future of oil demand is outside North America and the OECD, and here Saudi Arabia is also facing stiff competition, however is well positioned.
Chart 2: USA crude oil imports
Oil economics are a function of operating costs and geology. Geology is a major determinant of drilling costs as it dictates well depth, length of horizontal, and completion strategy. However, recently market forces have exerted great influence on drilling and completion costs as well. Geology also influences the revenue side of the equation by dictating the composition of the hydrocarbon coming out of the well, initial well pressure and flow rate, and well decline rate.
Chart 3: USA production from top shale plays
In the shale basins, as a resource play develops three things happen: 1) wells become more productive; 2) rigs become more efficient; and 3) wells become more ‘complicated’ (i.e longer horizontals, more proppant, more fracking stages, etc.). How these dynamics balance combined with the hydrocarbon composition and commodity prices determine the play’s overall economics. Chart 4 is a graphic representation of items 1 and 2, and it can be seen in Chart 4 that rig efficiencies have significantly increased in all major USA shale plays, however increases are now slowing as many producers have found the right formula in each play. Chart 5 illustrates item 3 where, like rig efficiencies, well complexities appear to have peaked. The result of well and rig efficiencies peaking and producers finding the correct well type in each play is the commoditization of drilling and completion services. When a product becomes commoditized, differentiation disappears and price is determined by supply and demand factors. We come back to this point below.
Chart 4: US shale rig efficiencies
Chart 5: Top - N.A. well dimensions, Bottom - N.A completion details
Producers drill wells and market the product. If producers earn acceptable returns (common hurdle rates in the oil and gas industry are between 10% and 15%) they will drill more wells. When lots of producers in lots of basins earn acceptable (or better) returns, rig counts increase; otherwise, the opposite occurs. Current rig counts are far below production sustaining levels (Chart 6) indicating, as everyone knows, producers are currently not earning acceptable returns.
Coming out of the financial crisis, the majority of drilling activity was focused on shale basins which are characterized by high initial production rates followed by very high decline rates (Chart 7); as USA producers have stopped drilling production has began to decline (Chart 3) and domestic barrels are being replaced by imports (Chart 2). Due to the commoditization of drilling and completion services, lower demand has driven the cost of these services down significantly. Lower drilling and completion costs combined with higher well and rig efficiencies have made domestic shale production competitive with imports. Has well productivity increased and costs decreased enough to drive out imports and increase domestic production?
Chart 6/7 - USA shale play rig counts, USA shale play monthly decline rates
Table 1 shows recent drilling, completion, and infrastructure costs, as well as operating and breakeven costs for some of the main US shale plays. It can be seen most plays have locations in the money at today’s commodity prices, however shale producers are unlikely to get too excited about deploying capital until WTI is above $60/bbl and is expected to stay there, as this pricing would enable mass drilling of economic wells.
Table 1: USA shale play economic data
In Canada, oil sands production needs relatively high (>$65/bbl) oil prices to achieve adequate full cycle returns, much higher for mining projects. The crude produced in the oil sands, though some is upgraded, is generally heavy grade and receives a significant discount from WTI, so a WTI price of more than $75/bbl is likely needed before Canadian Oil Sands producers get excited about expansions again. However, oil sands operating costs are in the neighbourhood of $35/bbl and dropping, so while we will not see any expansion projects in the oil sands (excluding Fort Hills which is almost complete) being started any time soon, the recent increase in prices will be enough for Canadian heavy oil and oil sands producers to continue to bring on shut in wells and continue pumping.
Canadian shale production has breakeven prices that range with the top USA plays, however Canadian producers pay higher prices to market their products which disadvantages their hydrocarbons versus similar plays in the USA, and is why Canadian rig counts have been hit even harder than those in the USA. Canadian rig counts should not be expected to increase significantly through 2017 and gas production will begin to decline; oil production as well, but less than gas because oil sands production will hold in (assuming a return to normal operating rates post recent fire event).
While OPEC conventional production enjoys very low breakeven prices, fiscal breakeven prices are a different story. A recent analysis by the Dallas Fed shows the fiscal breakeven price of the oil producers and assesses their ability to continue competing at today’s commodity prices (Table 2). Excluding Qatar, no OPEC member’s production is economic on a fiscal basis. However many of OPEC’s larger members have the ability to withstand low oil prices for years and even decades (Kuwait, Qatar, UAE). They can tap capital markets, reduce and eliminate subsidies, increase taxes, and tap sovereign wealth funds. All ofthese options will be painful, however.
Consider Russia a weaker OPEC member - low well breakeven price, high fiscal breakeven price, low tolerance to withstand current commodity prices for long. While they have taken admirable steps to avoid what seemed like imminent catastrophe, the economy is in shambles and continuing to deteriorate. Look for Mr. Putin to continue Orwellian tactics which serve three purposes: focus attention domesticallyaway from the economy; blame deteriorating economy on outside forces; and retain sphere of influence on the global stage. There is a limit to the success of these tactics and it is quickly being reached. Expect increased internal volatility and external hostility from Russia. While Russia bas been successful at stealing market share in the oil war, this will become more difficult as the countries private and government finances become constrained and sanctions remain in place.
Table 2: OPEC fiscal breakeven prices, oil asset buffers, and debt to GDP ratio
In summary, USA shale oil and gas production is declining, and while increased well productivity and the commoditization of oil field services has made USA shale plays more competitive, oil below $60/bbl WTI will not incentivize much new drilling activity. Canadian shale production will follow asimilar production profile as USA shale production. Canadian oil sands production will hold at current levels even though recently competed projects will not achieve acceptable returns - capacity additions in the oil sands are a thing of the past for now. Russian production will decline from lack of investment. Weaker OPEC nations are already starting to see production decline from lack investment and this will continue. OPEC’s strong nations, like Saudia Arabia, will be able to grow production and win back market share. The Kingdom’s strategy is working, it is just taking.
Supply and Demand
The USA is currently the worlds largest consumer of hydrocarbons (Chart 8), however the future of oil consumption is outside of the USA and OECD (Chart 9). Consumption of hydrocarbons inside the OECD is stalling, while outside of the OECD it continues to grow. Particularly strong growth is occurring in India, Africa, and China (Chart 10). Asia now accounts for a larger share of liquid fuel consumption than North America with higher demand growth rates than North America. With European demand in decline, in the near future Asia will surpass North American and Europe as the key demand centre for liquid fuels.
Historically, Saudi Arabia has been China’s main supplier, however Russia is stealing market share and in 2015 became China’s largest oil supplier. Russia’s geographic proximity to China and willingness to provide flexible deal terms have allowed the Russians to steal market share. As Russia becomes more isolated in Europe, the Chinese market will become more important. India is mainly supplied by Iran and Iraq. If the Kingdom is to grow market share in India, it will be competing with other low cost suppliers, however neither Iran nor Iraq has the capability to withstand low prices for as long as Saudi Arabia.
Chart 8: Global liquid fuels consumption market share
Currently Africa only consumes about 4% of the worlds liquid fuels, however is the fastest demand growth region on the globe. With a young population, developing economies, and growing transportation infrastructure, in the long term Africa has the potential to be a prize for oil producers. However, the continent is self sufficient in oil, and acts as an exporter and competitor to Saudi Arabia.
Chart 9: OECD and non-OECD liquid fuel consumption
Chart 10: non-OECD liquid fuels demand growth indices
Current market dynamics and geopolitical pressure are incentivizing Saudi Arabia to keep pumping, which is what they will do. Iran and Iraq who are both trying to increase production after years of sanctions and war are also incentivized to keep pumping, lest they lose market share or regional clout to Saudi Arabia. Canadian oil sands producers will keep pumping and take market share in the USA. Russia and the weaker OPEC members will will try to hold in but ultimately see production declines from lack of investment; there will be tension in these countries and will spill over their borders into their region (i.e. Europe, the Middle East, and Africa).
Production is declining in many basins, and countries with less formidable war chests than Saudi Arabia are coming under pressure as a result of lower oil and gas revenues. The gap between supply and demand is narrowing (Chart 11). Anticipation that recent supply disruptions may close the gap sooner than initially expected has powered the price of crude in recent weeks.
Chart 11: Global oil supply and demand
While global oil supply and demand is beginning to physically balance, it will take time. Currently at historical highs and continuing to rise, the pace of global crude inventory increases is beginning to slow (Chart 12). When inventories stabilize, likely sometime in 2017, sooner if current supply disruptions continue, oil prices will have support to stay above $50/bbl. Lack of investment in Non-OPEC supply nations will lead to declining production and strong OPEC players will increase production to take market share, however at the expense of decreasing their spare capacity. As spare capacity diminishes and demand rises at a faster rate than supply (Chart 11, Chart 13) a pinch point will be reached.
Chart 12: Global crude inventories
An important consideration is the response USA shale producers to $50/bbl crude. There are two points to consider: new drilling, and the inventory of drilled but not completed wells - the so called fracklog or DUCs. As we have shown, a $50 barrel will likely not trigger mass drilling increases since many wells are still either marginally, or not, economic at this price. Rystad, and energy consultancy, estimates that there are approximately 4,000 drilled but uncompleted wells in the USA. Of these wells, approximately 1 mmbbls/d of production is economic at $40/bbl. If these wells can be completed and production put online, then much of the USA’s declining production can be offset without incremental drilling, keeping inventories high and putting a cap on prices. This was not happening at $30/bbl but will as prices have stabilized over $40/bbl and have touched $50/bbl, we can expect some producers to go in and start completing drilled wells to capture the cashflow. The fracklog will not offset USA production declines completely, and production will continue to decline.
Chart 13: Global supply and demand indices
In summary, the oil market is beginning to show signs of physically balancing. However, high inventories, OPEC production increases, and the fracklog in the USA will keep the market over supplied through to the first half of 2017. In 2H17 and beyond, the oil market will begin to tighten, and may even see a pinch point during times of supply disruptions, price can then increase significantly above $50. Lack of investment in the industry will leave it susceptible to supply shortages during periods of high geopolitical, weather, or other related stresses.
If you have not already stepped into energy investments, given our macro view, this is may be a good time to begin entering the space. As many companies have already rebounded substantially from cyclical lows, balancing valuations with future potential is critical. Companies which will succeed are those which have weathered the low commodity prices successfully as a result of financial discipline and a strong asset base, have large well inventories and can drill or complete those well inventories. Below we analyze Marathon Oil Corp. and Noble Energy, two American non-conventional oil companies. Both are well setup to succeed in a low commodity price environment, however the analysis illustrates two different paths through the commodity cycle and how they impact equity investors. The commodity price plunge has been an event which, as Mr. Buffet once famously said, showed who’s been swimming naked as a result of the tide going out.
Noble Energy vs. Marathon Oil Corp: A tale of two commodity cycles
Marathon (“MRO”) and Noble Energy (“NBL”) are two well respected, USA based exploration and production companies. Both are heavily invested in onshore, domestic shale plays, and both provide international exposure. MRO is heavier weighted to liquids with ~70% of production coming from liquids, versus ~45% for NBL. Whereas NBL has been able to grow production since the oil wars began, MRO’s production has cratered along with its valuation (Charts 14/15). We believe that NBL is the better investment.
Before diving into the comparison, a very brief review of key financial metrics. Both companies are financially stable relative to the sector. MRO completed a financing at the end of February 2016 to shore up their finances, whereas NBL has been able to maintain a stable investment grade credit rating without tapping equity markets. Both companies are positive cash flow, and both companies have have current ratios north of one. This is where the similarities end.
Charts 14 and 15: MRO and NBL production and EV
NBL consistently generates more cash flow and consistently holds lower per boe breakevens (Charts 16/17). NBL’s drilling success has given the company a higher valuation relative to MRO, it trades at a ~$15,000 per flowing boe premium (1.3x) to MRO (Chart 18). On average, NBL will generate >2x more cashflow per boe produced than MRO, last quarter NBL increased their edge over MRO to 3x (Chart 19). Therefore, on average a barrel of hydrocarbon in NBL’s hands will generate two to three times more cashflow to an investor than a barrel of hydrocarbon in MRO’s hands, but only costs investors 1.3x more for that barrel.
Charts 16 and 17: MRO and NBL CFPS and implied breakeven prices
Reserves are an important factor when evaluating oil and gas exploration companies, and this is where MRO has the significant edge at 15 years of proved reserve life at current production rates, vs NBL’s 9 years. However, given NBL investment grade credit rating, ability to generate cash flow, and the liquidity of oil and gas properties in the USA, current reserve life is not a valuation defining issue. NBL will always be able to tap the market to purchase reserves as they deplete their existing ones. Further, a major cause of MRO’s longer reserve life is simply the fact that they’ve let their production slip.
On the surface MRO and NBL look similar, a deeper drill provides a example of two different paths through the commodity cycle. NBL maintained an investment grade credit rating, high cash flow, and did not issue equity. MRO, despite having an excellent asset base was not able to find the same financial success. While NBL rates at 1.3x MRO price per flow boe, they are able to generate 2x-3x more cash flow per flowing boe and therefore present a buying opportunity.
Chart 18: Price per flowing boe
Chart 19: Cash flow per flowing boy
It has taken some time but the Kingdom’s strategy is working. While significant competition for market share exists, Saudi Arabia is well positioned to outlast weaker rivals and ultimately take back their market share. However, in any war there are casualties and collateral damage: North American drilling has collapsed and weaker, debt laden producers are going out of business; weaker oil producing nations’ economies are in free fall; and even the Kingdom has been forced to contemplate and adjust to life in a lower for (much) longer pricing environment.
The oil market is beginning to physically balance, however will likely not return to tightness until mid 2017, unless current supply disruptions continue. World demand is currently growing at a faster pace than supply and OPEC is pumping harder to capture market share; when balance in the oil market is reached there will be less spare capacity than there has been historically available to cover inevitable supply shocks. Thus, a new bubble is being created.
Now is not a bad time to step into the space, however investors ought to be mindful of company valuations which may have outpaced future prospects. Investors should seek out companies with healthy balance sheets, large land positions in key shale basins, and large well inventories which be quickly drilled. One such company we believe will succeed is Nobel Energy.
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