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Shale Breakeven Overall Estimated Below $55/bbl as E&Ps Do More With Less

U.S. shale producers are pulling out more oil and gas at a much lower cost, setting them on course to accelerate activity later this year and into 2018.

Based on guidance by U.S. exploration and production (E&P) companies, domestic oil supplies should grow by 900,000 b/d in 2018-2019, but supply/demand should be close to balancing, according to a review by Goldman Sachs. Activity in the onshore is expected to accelerate big-time into the second half of 2017 (2H17), said Goldman analyst Brian Singer.

"As we move through 4Q2016 earnings season, covered company producers that represent 43% of overall 2016 U.S. oil supply and 77% of U.S. oil supply from our coverage have reported or provided 2017 guidance," Singer said. "Thus far, 4Q2016 covered U.S. production is minus 1% versus our estimate on average. Despite this, we have slightly raised our outlook for year/year (y/y) growth in 2017/2018, partly as we see modestly greater acceleration in 2H17," with capital expenditures (capex) in line so far. "Overall, we see first half 2017 U.S. oil supply from producers that have reported thus far 1% below prior expectations and 2H17-2018 1% greater."

The focus now is on 2018, with producers on track to build U.S. oil supplies by 900,000-1.1 million b/d, Singer said. E&P companies covered by Goldman that have provided long-term production guidance "show ease of growing U.S. oil supply through end of the decade. As we have highlighted previously, the visibility of shale growth has emboldened companies to provide long-term production guidance."

Investors now are trained on the impact from ramping up shale production this year to full-year 2018 production.

"Our base case calls for U.S. oil growth of 900,000 b/d y/y in 2018, which assumes acceleration in market share gains by covered companies in 2018 versus 2015-2016," Singer said. "Our upside case, which assumes similar market share gains, would imply 1.1 million b/d. Oil demand has surprised to the upside to end 2016, accommodating greater U.S. shale growth, but we believe our upside case for 2018 U.S. production would pose downside risk to our $55/bbl 2018 West Texas Intermediate oil forecast, all else equal."

The rangebound outlook for prices puts the emphasis on execution. E&P companies that outperform need to differentiate themselves through execution, i.e., meeting or beating guidance without a disproportionate capex raise; use multiple compression to benefit from U.S. shale growth; or increase free cash flow.

Many E&P companies are raising 2017 production guidance and ramping up activity more quickly than expected, which means investors have renewed focus on the trajectory of growth into 2018 -- and the potential for a supply surge to overwhelm the market.

Goldman estimates that U.S. oil production in the first six months of 2017 should fall overall by 1%. However, 2H17 and full-year 2018 production is on track to be 1% higher.

"The outlook for 2017 capex is broadly unchanged, plus-41% y/y for covered E&Ps that have reported so far," Singer said. "Overall, we see an implied 2017 exit rate for U.S. oil production growth of 800,000 b/d, the average of y/y growth in 4Q2017/1Q2018 of 700,000-900,000 b/d." The pace of growth by producers not covered by Goldman may play a big role in determining 2018 production levels.

"We have seen a relatively swift increase in rig activity from uncovered producers, with six private producers each adding five-plus rigs since the May bottom," Singer said. "Private producers have lost market share to covered companies the past two years. Our base case assumes this will continue at an accelerated pace, because covered companies in our view have better more contiguous positions in the cores of the shale plays and should see greater productivity gains."

BofA Merrill Lynch Global Research analysts also see unconventional U.S. activity playing a big role in global oil prices. In the annual medium-term oil outlook research report issued on Monday, Francisco Blanch and his team are forecasting crude prices will average $50-70/bbl through 2022, down from a previous forecast of $55-70/bbl. Among the downside risks to prices now is shale technology.

"Over the past couple of years, oil companies have been vocal about reducing costs aggressively throughout all layers of the industry to cope with a 'lower for longer oil price environment,'" Blanch said. "Whether it is due to currency moves or actual cost depreciation, many oil companies around the world have survived the price meltdown by bringing down breakeven costs."

Looking at the cost curve of E&Ps not members of the Organization of the Petroleum Exporting Countries (OPEC) cartel, analysts determined that the weighted average breakeven cost is now $58/bbl. "A similar analysis was done in 2014 and the weighted average stood at $66/bbl," Blanch said. "In the U.S., breakeven costs for most major shale plays now stand below the $55/bbl mark. Unsurprisingly, this is the level at which the deferred West Texas Intermediate (WTI) forward curve has been anchored at for more than eight months."

A "small" pick-up in global spending is seen through 2018. "Of course, the small pick-up in activity we expect this year is far from offsetting the 46% drop in global spending in the past two years," Blanch said. "We expect most of this year's increase to come from emerging markets and Canadian companies, while U.S. producers seem to maintain spending relatively steadily year/year."

In the U.S. shale industry, "maintaining steady spending now seems equivalent to increasing output," he said. Last October Blanch and his team warned that U.S. shale output was about to reverse its declining trend. Based on the recent Drilling Productivity Report from the U.S. Energy Information Administration, shale output from the main basins bottomed out in January, "and we should see a 40,000 b/d sequential increase this month, driven almost entirely by the Permian Basin."

The recent rig additions is part of the reason for the impending rebound in output. However, productivity gains cannot be underestimated, Blanch said. "The easiest way to measure this on the rig level is by looking at oil production per rig in new wells. Results are astonishing, with steep increases every month in all the major shale basins, although the Permian is starting to look relatively more mature on this measure."

The current productivity revolution, if it persists, is going to have meaningful and long-lasting consequences for non-OPEC production and thus long-term oil prices," Blanch said. "True, part of the gains can be attributed to the collapse of the rig count as only the most efficient rigs remained in place. Yet on the well level, productivity gains have picked up even more in the past couple of years."

The BofA Merrill Lynch team estimated that the six-month cumulative production for an average well has increased by 32% on average across the major basins since 2014. The Permian's productivity gains outperformed, at about 64% on a well level. The bank's oilfield service (OFS) analysts expect the U.S. rig count to reach about 667 by 4Q2017, averaging 612 for the year. To estimate U.S. shale production growth over the next five years, Blanch and his team conducted a price sensitivity analysis based on breakevens, drilling potential, annual decline rates and productivity gains.

"We estimate that U.S. shale production will decline annually by 270,000 b/d, on average, until 2022 in a $40/bbl WTI environment. At $50/bbl, growth returns, though only at a small average of 240,000 b/d. Should WTI trade at $60 for the next five years, growth reaches 700,000 b/d, at at $70/bbl it reaches 950,000 b/d."

OFS costs are picking up, but they may be partly offset by less regulation.

"As crude oil prices recover, cost reflation is likely across the sector, whether from service companies or producers themselves. Rig day rates started to pick up last December by 1% month/month, and latest data show a 3% monthly increase in January. According to our US oil service equity research colleagues, the mix between spot and term contracts to hire rigs has improved, with long-term contracts representing 20% of total work in January, well above the 10-11% in August-November. This suggests US oil producers are anticipating cost hikes in the next six-12 months.

"On the other hand, we also expect a more pragmatic approach to regulation from the new administration," Blanch said. "This may reduce the costs associated with regulation and improve profitability, partly offsetting the uptick from cost inflation."

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