BlackPacific Capital


The Oil Saga- Running as Fast as You Can to Essentially Stay in Place

Posted on 31 December, 2015 at 14:00
Weekly Market Assessment
The Saga Continues: Running As Fast As You Can To Essentially Stay in Place
The almighty natural depletion and decline curve. This is the dilemma oil exploration and production companies drilling wells and especially unconventional wells in the the United States have to deal with. It goes like this- every major oil field has a natural decline curve, where oil production decreases over a specific amount of time due to the nature of the reservoir and the materials drillers put into the well to extract the oil. In the United States, tight shale basins have "ultra high depletion rates" which force oil companies to drill more wells to keep up with the lost production from the previous well. An endless cycle that costs tons of money to keep production coming online to satisfy demand. 

It's like running as fast as you can to essentially stay in place. A simple way to explain this, is that in the first year a well produces 1,000 barrels of of oil a day, by the end of that year it loses 70% of its production and now only produces 300 barrels a day! On my last assessment, I discussed the need for capital spending on current and future oil production. The reason for this, is that companies that work in tight oil shale basins using unconventional drilling techniques face a massive decline in oil production. To combat this curve they have to spend more and more money on future wells to just keep production flat! Crazy...right? I thought you just drill a hole in the ground and oil just endlessly flows to the surface. Crude production is a capital intensive undertaking, as well as being highly dependent upon massive amounts of debt sourced financing. If you take away the capital, production has no choice but to decline! 

Through advances in technology, unconventional drilling companies have reduced drilling days and brought on more wells to replace the loss in production from legacy wells. This of course has helped in bringing down the cost per well however this also has an impact on the oil production. Oil reservoirs are extremely temperamental. If too much oil is extracted too quickly or if the wrong types or amounts of secondary efforts are employed, the amount of oil that can be recovered from a field can be greatly reduced; this is known in the oil world as "damaging a reservoir." 
So its a double edge sword in the oil production business and many say this decline curve is the Achilles heel of unconventional drillers. Below are type curves that express how scary these curves are in terms of lost production. 

[Depicted above is the decline curves for two of the most prolific U.S. Shale Basins in the United States. Both show the massive decline in production in just 12 months. Wells in the Bakken producing 600 barrels per day only 12 months later end up producing 175 barrels per day]

So the obvious question is how much do they decline? Try ~70% decline in production over the course of one year! Year two is ~35%, year three is ~20% and the fourth year in oil production is cut by ~17%. I couldn't believe these figures and how no one was talking about how much production drops off in such a short period of time.
Now that we know the decline rate and production free-fall in the United States, how does this compare to the worldwide decline rates? According to Core Laboratories, which is the leader in providing technology for improving a wells production and operates in 50 countries located in every major oil-producing provinces, provides services to the world's major, national, and independent oil companies, the worldwide decline curve has increased. They state in their most recent conference call that the, "newly estimated net worldwide crude oil decline curve rate is 3.1%, up 60 basis points over earlier estimated worldwide crude oil decline curve rates of 2.5%." So we know there is an ultra high decline rate in tight shale basins, its also in conventional wells around  the world and increasing! Oil producers are constantly fighting this decline monster that never sleeps and takes billions of dollars to feed.   
David Demshur, Core Laboratories CEO, goes onto say, "applying the estimated 3.1% net crude oil production decline curve rate to current worldwide crude production of approximately 85 million barrels per day, means the planet will need to produce over 2.6 million barrels of new oil by this time next year or production will yet again fall internationally. To maintain current levels of production a year from now, the planet will need to produce 2.6 million new barrels, that's just not going to happen." The reason why... as I mentioned last assessment, the enormous decrease in capital spending by oil exploration and production companies. They simply cant afford to drill new wells or greenlight new projects because of the current price of crude is not economical! 
This worldwide decline rate of two plus million barrels is inline with current oversupply estimates mentioned by analysts.  Are the estimates wrong about the current oversupply of crude? Is the market being irrational about these decline rates and not factoring them in? I doubt it, however, like I have mentioned before, market sentiment plays a large part in commodities and prices tend to overshoot to the upside as well as to the downside.  Without more spending by oil producing companies, oil production will head into dire straits. If the market gets a hint of being undersupplied, it will be too late, as new production will not be able to enter the market in time to slow down consumption, this leaves only one lever for the market to pull, which is higher prices to slow demand!  

 Even the U.S. Energy Information Administration (EIA) has come out and admittedly expressed the production decline in U.S. shale basins. The EIA stated that "in a 2015 monthly drilling productivity report found that most of the 7 inland shale basins that account for nearly all of the domestic oil production growth between 2011-2014 are now in decline." We have to remember that over the course of 10 years, 100% of worldwide supply growth came from the United States and the Canadian Oil Sands. A decline in these two regions alone will either balance the market or most likely create an undersupplied market.  

 Andrew Hall, a legendary oil trader sums it up perfectly. "Now that these companies are reducing their capital expenditures, accompanied by ultra high decline curve rates and production declines are likely to accelerate. New projects in high cost resources plays are being postponed or cancelled. The impact from these decisions will not be felt before 2016 because of the long lead times involved. But that also means such lost production cannot be quickly recouped should the market need it!"  We cant fight this decline curve, all we can do is continue to find and invest in new oil fields to replace the ones that are being depleted. Making the Watchlist: Below are the stocks that I will be looking at over the coming months.  I will provide the the current stock price and why I am watching them. I will comment on them as I continue to keep an eye on them.  You will be able to see and follow their growth and/or decline. Chart links may be attached.

See What I'm Trading:You can now view all my real-time trades by following this link, BlackPacific Capital1. This new site shows my trades, in real time the minute they are bought and sold. Below you can also click on the stock symbols, trade strategy or prices which will lead you to this new site. The site offers a full risk/return profile and video detailing the strategy of the trade. Note: When looking at the option positions every contract equals 100 shares.     

 BlackPacific Capital has created three funds. The first is the Total Return Fund and the other is the Growth Fund. Both of these funds will be compared against the S&P 500. Both will hold a total of no more than five companies each. The Total Return Fund is a low turnover fund where every holding must have a dividend and be undervalued to its peers. The growth fund is made up of momentum high growth stocks where the turnover rate is much higher. Below are their Weekly and Year to Date returns. For more information and to see the holdings in each fund click here
New holdings and liquidated positions:
 I have added EOG Resources to the Energy Fund at $70.75. It is not included in last weeks returns.          

S&P 500 Return 
Week: 2.52%
Year to Date: 0.32% 

Total Return Fund Return 
Week: -2.78%Year to Date: -2.46%

Week: 3.74%
Year to Date: 15.67% 

Week: 1.28%
Year to Date: 1.28%

Categories: Weekly Market Assessment