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E&Ps May Spend Less But Still Produce More, Say Analysts

More upstream capital expenditures (capex) will be cut over the coming weeks as sliding commodity prices set in gear a new equilibrium for the industry through 2015. However, like North America's unconventional natural gas, spending cuts may do nothing to stop the sustained flow of domestic oil, according to Goldman Sachs.

"The decline in oil prices continues unabated," analysts said last week. "We believe the oil market is experiencing a cost re-basement which makes determining when the market is oversold extremely difficult, as the price at which rebalancing occurs is now a moving target to the downside. For the market to be oversold, it requires prices to be far below costs, which are in flux as much as the oil price given the sharp declines in other commodities, currencies, rig rates and oil services costs.

"On top of downward cost pressures, efficiency is being forced on the industry with evidence of high grading, where rigs in noncore areas are being re-directed toward core, lower-cost resource plays. All this suggests that costs are falling nearly as fast as the price, which means oil producers can spend less to get the same or potentially even more in terms of production."

Goldman said there appeared to be some evidence of a rebalancing beginning to occur, "and it is trending faster than our forecast, which was based upon $70/bbl. But the rebalancing is far from sufficient which creates more downside risks."

The overall U.S. rig count dropped by 29 for the week ending Dec. 12, but "this was almost entirely in vertical rigs, not the horizontal rigs used in shale production," Goldman analysts said. Through the start of last week, 12 U.S. producers since early November that represent about 8% of 3Q2014 U.S. oil production had issued 2015 capex and production growth guidance, they said. (More operators cut their targets this week.) As of Dec. 15, weighted average U.S. capex budgets were down about 12% year/year (y/y).

"However, each is still forecasting production growth on average in 2015 versus 2014, except one which is guiding to flat y/y production. So while reductions in capex are coming faster than expected, it is unlikely to translate into less supply than expected, highlighting both the rapid cost reductions with rig rates already down by 15-20% and efficiency gains through high grading."

Capex cuts by the wide ranging group of exploration and production (E&P) companies have been a surprise to Tudor, Pickering, Holt & Co. (TPH) analysts. They said last Thursday the E&P "mindset" has changed drastically with balance sheets "now of sole importance and drives spending closer to cash flow." And because of relatively high oilfield service (OFS) costs and relatively low commodity prices, "we continue to believe this is the right strategy heading into 2015."

U.S. drilling rigs to fall, with the pace set to quicken early next year.

"This should help correct the market by late 2015 if demand holds, as we see potentially 800-plus rigs dropped if oil remains below $60, putting the U.S. in decline by 2016." Earlier this month, Wunderlich Securities Inc.'s Irene Haas said conversations with private E&Ps indicated half of the Permian Basin rigs could fall, while up to 500 rigs could be coming down over the next two months (see Shale DailyDec. 12).

"Most companies will still report year/year growth given 2014 momentum," but the exit rate between 4Q2014 and 4Q2015 is going to be flat in many instances, according to TPH.

E&Ps may need to cut more than one-third of their capital spending relative to 2014 to maintain current debt levels after the plunge in crude oil prices, according to Wood Mackenzie Ltd. The consultancy estimated that a 37% cut overall in capital expenditures (capex), or about $170 billion total, could be required by producers if Brent prices were to hover around $60.00/bbl; West Texas Intermediate (WTI) has been trading $5.00-10.00/bbl lower. Those capex cuts would be in addition to the estimated $9 billion in reductions announced by E&Ps in the last few weeks.

"Operators in an intensive development phase have the least optionality to respond," said principal analyst Fraser McKay, who compiled the latest corporate analysis. "Most other international oil companies (IOC) have flexibility to rein in spend to keep finances on an even keel. But shareholder dividends and distributions are likely to be a significant part of the spend cuts for some companies."

At $60/bbl, only three of the top 40 IOCs generate "sufficient" free cash flow to cover capex, including distributions, according to Wood Mackenzie. Based on recent announcements by E&Ps that are planning to reduce 2015 capex, independents already are assuming average oil prices of $70, analysts said.

With the collapse in oil prices, the merger and acquisition (M&A) market also is being shaken, with some transactions now shelved and would-be buyers disappearing, McKay said. Sellers won't get the offers they had expected only a few months ago. Until a new "consensus" emerges, typically at least three to six months from the point that prices stabilize, which is "some way off."

However, the uncertainty and corporate distress may create opportunities for companies with the appetite and capacity to take advantage.

"Weak oil prices through 2015 will ratchet up the pressure on the most financially stretched in the sector," said Wood Mackenzie M&A analyst Luke Parker. "Expect to see falling deal valuations and the emergence of a true buyers’ market."

Concerns about the oil market "will be inescapable in 2015," said Wood Mackenzie’s Paul McConnell, principal analyst for global trends. "With no sign that OPEC is reconsidering its decision to leave production targets unchanged, the impetus falls on non-OPEC producers to limit supply growth and bring the market back into balance."

Weaker than expected global economic growth may exert more pressure on prices. Longer term, deep-seated geopolitical, economic and technological trends may point to a new era of weak hydrocarbon demand growth. "Such a scenario represents a high-impact tail risk for energy companies in the years to come," McConnell said.

At current oil prices, McConnell said the big risks for energy companies are:

  • Buybacks, even the oil majors' programs, because of a lack of free cash flow;
  • Dividends, although some may seek to sustain them in the near term; and
  • Market ratings, because share prices now are implying $75.00/bbl long term.

Projects in pre-development, those awaiting final investment decisions, or FIDs, could see a lot of cutting in 2015, with $127 billion of global industry greenfield investments at risk, according to Wood Mackenzie. Also, expect less high-risk frontier exploration and more efforts put on the mature, lower-risk plays.

There will be distressed sellers and other opportunities emerging for cash-rich buyers. "Large-scale corporate consolidation may be closer than it has been at any point since the late 1990s," Wood Mackenzie analysts said.

"History shows that value creation through M&A is largely driven by commodity prices: for buyers that believe in long-term oil above $80-90/bbl, 2015 could be a year to go long."

Liquefied natural gas (LNG) export projects appear to be more risky too -- at least for the short term, McConnell said.

"Slowing gas demand growth has led to concerns that China will struggle to absorb contracted LNG, which will double over the next three years. Suppliers will be hoping for a cold 2015, but the background of a low oil price environment will place pressure on LNG prices. However long-term growth prospects remain compelling, and Russia will continue to cement its pivot east with China gas deals."

The majors and the independents could gain the upper hand going into 2015 on one front: recontracting for OFS, whose outlook has changed dramatically in recent months.

"The average short-term oilfield service purchases growth has dropped from 3.9% to minus 1.8% from August to December 2014," said Rystad Energy analysts. "Backlog-driven segments like the subsea market show more resilience to a short-term drop, contrary to short lead time services like well services and commodities."

The amount of liquids from unconventional plays has surprised the oil markets this year, Rystad said. The Norwegian-based forecaster continuously surveys short-term plans by E&P companies field-by-field. Since August, "we have gradually reduced our short-term oilfield service demand outlook in light of the falling oil prices." The latest forward projection, released this month, assumes a Brent oil price of $70/bbl in 2015 and $85 in 2016.

Overall, the short-term oilfield service demand growth has decreased by 570 basis points (bp) to minus 1.8%, by Rystad's estimates. "This is the first time since 2009 we expect the market to be in a decline." Subsea still should be a growth market in the coming year, but the backlog is less strong in 2016. Maintenance and operations are mainly operating cost-driven and less exposed to capex cuts.

The situation appears worse for the drilling well-driven segments.

"Well services and commodities have the largest decline in absolute terms from 4% to minus 4%," Rystad said. "Large activity reductions onshore in North America and internationally reduce demand and prices. Drilling contractors have been taken down from 4% to about minus 2%, slightly less than the services due to the long-term rig rates. The development of offshore platforms and demand for surface equipment has declined 4 % as $250 billion worth of projects have turned uncommercial for sanctioning in 2015 and 2016."

OFS operators with large backlogs should withstand the volatile climate the best. However, "we find the well service companies...will be harmed by an approximate 12% decrease in activity in North American shale and a sudden halt in offshore investments."

There could be a strong rally and a strong drop in energy stocks for a while, which is normal during down cycles, TPH said. "Historically around the bottoms of cycles, energy stocks trough coincident with commodity prices. There's a steep rally once commodities bottom followed by net treading water for several quarters (with lots of volatility both directions) until sea legs for the next upcycle are gained."

Goldman's team emphasized that the current volatility in the oil markets is a "supply-driven bear market and not demand driven. We have to go back to the mid-1980s to find another supply-driven bear market. Because the surplus is supply-driven, it is easily observable in the future, unlike demand shocks that are instantaneous, so the market is trying to rebalance the future, not so much the present." During the 2000s, Goldman forecast severe supply-driven oil shortages but they never happened "because long-dated prices dragged the market high enough to slow demand and bring on marginal supplies.

"Once again the market is trying to rebalance the future, by re-basing industry costs to take out the excess marginal production," Goldman said. "As the industry takes the 'fat' out of the system that was built up over the past decade, the new equilibrium price is dropping sharply -- where it settles is unknown right now, but we can comfortably say it is likely below our estimates from last month. Once we have cost data early next year from this time period we will have a better idea, but in the meantime volatility will likely remain high with risks skewed to the downside as the market searches for a new equilibrium."

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