$45 Is The New $50, But US Oil Rigs Should Start To Decline If WTI Stays ~$45 For A Few More Weeks
Jun 28, 2017
We expect to see US oil rigs start to level off and decline this summer if WTI stays ~$45 for a few more weeks. A weaker US$ this week has helped WTI bounce modestly off its bottom to $44.80 today, but we believe it needs to point to the higher $40s to prevent US oil rigs from declining. US oil rig levels ultimately respond to oil prices. The data shows the R2 correlation has been 0.959 for US oil rigs, on a 12 week lag, to WTI oil prices. This suggests that US oil rigs should start to respond soon to the recent drop in oil prices. Plus we believe the comments from quality shale/tight oil producers at the US sellside conference this week support the view that $45 oil is the price starting to impact drilling levels. US oil production should still keep increasing, but a decline in US oil rigs will help with the investor tone to oil later in 2017.
Ultimately US oil rigs respond to changes in WTI oil prices. The number one factor for capital allocation decisions for oil and gas companies is oil and gas prices. But there are always other factors that will impact how quickly E&P drilling responds to moves in spot WTI oil prices, in particular how quickly WTI has moved either up or down, the access to equity/debt capital at reasonable price, lease obligations, etc. Overall, the most significant factor delaying the response, either up or down, for US oil rigs is the current level of hedging at higher prices and the ability to hedge at higher (acceptable) oil prices. Hedging is a much more significant factor in the US as many US oil and gas companies will hedge over 80% of production ie. this week, Pioneer Natural Resources confirmed it was 85% hedged for 2017, but also importantly noted they are ~35% hedged in 2018.
The “Data” shows that the R2 correlation of WTI and US oil rigs is excellent at 0.959. The ultimate response of US oil rigs to moves in WTI prices is supported by the data. One of our oil sector graphs shows WTI oil prices and US oil rigs. We focus on Jan 1, 2014 onward as that is really the start period for US shale/tight oil having step change on the break even oil price for plays. There is no precise timeline, but the rough timeline is that $60 was the break even price in 2015, improved to $50 in 2016, and now its more like $45. Break even may not be the most accurate description, but we would consider break even when the RORs are at least 40% or so ie. a high enough half cycle return to drill. The tracking of US oil rigs follows these WTI oil price moves. The below graph shows how US oil rigs followed WTI oil prices both up and down. The R2 correlation for these two graphs is 0.741, however if we add a 12 week lag (to reflect the response time for oil rigs to oil price moves), the R2 correlation increases to 0.959. It also notes that it has been ~9 weeks since the most recent oil price decline, which statistically suggests that a decline is coming if oil prices stay ~$45 for a few more weeks.
Oil Prices As A Leading Indicator of US Oil Rig Activity
Source: Bloomberg, Baker Hughes, Stream Asset Financial
This week’s US sellside conference is reinforcing that rig levels for quality shale/tight oil producers should start to decline modestly with oil at $45. It may not be a big drop, but the message seems to be that $45 oil is going to lead to oil rig decreases in the near term. Part of this is planned but there is no question that oil below $45 makes an easy decision for shale/tight oil producers to finish up programs and not start new programs. We wanted to focus on this week’s US sellside energy conference to see what the US shale/tight oil producers were planning in the face of the $8 to $9 drop in WTI over the past month. Plus this is likely the last major US sellside energy conference before the Q2 releases at the beginning of Aug. We were able to review the transcripts and presentations of several shale/tight oil producers. The WTI oil price that seemed to be the pressure point was $45. (i) Pioneer noted its Permian had IRR of 40% at $44 oil. PXD had no change to their Permian rig levels, but noted the two Eagle Ford rigs are “just about through drilling the 11 wells we planned for this year” ie. Eagle Ford rigs are going to zero shortly. (ii) Sanchez Energy is focused in the Eagle Ford. SN did not say indicate any specific oil rig change, but did say “That plan in the short-term still exists, though we are looking at ways and doing the analytics around where would we cut, if oil stays at $45 which it seems to be doing for right now.” (iii) SM Energy is primarily focused in the Permian and to a smaller amount to the Eagle Ford. SM said “With that said, if you think about 2017, we’re pretty well committed to our program for this year at this point. It’s really not going to change much. We currently have six rigs drilling horizontal wells in the Midland Basin. We just finished up our program in the Eagle Ford for the year in terms of drilling” ie. there will a drop of the Eagle Ford oil rig. (iv) Concho Resources is focused in the Permian. CXO said “our rig count is currently at 21. We expect to average less than that for the year. That’s been the plan all along. That’s certainly convenient with where commodity prices sit today, but that is the plan”. The slide shows the average for 2017 will be 19, which implies a 4 less oil rigs in H2/17.
We expect the lower quality/weaker financially oil players to be more impacted by WTI at $45. One of the other themes that came through in the quality shale/tight oil producer presentations is that most of them have strong financial positions and/or strong hedging in place. They were clear to highlight this in their presentations. To a great degree, they do not have to make any near term changes, rather they are just modestly reducing rigs. However, like any cycle, the financially weaker oil producers won’t have the same staying power and should have declining oil rigs with WTI at ~$45.
Unfortunately, the momentum of 2017 drilling and DUCs should still lead to US oil production increasing into 2018. Even if WTI stays at ~$45 for longer and leads to modestly declining US oil rigs, US oil production is still expected to go higher. There is a lag impact on lower drilling to impacting production and that is compounded by the increasing DUCs (Drilled UnCompleted wells). (i) Pioneer noted that it “we’re drilling three well pads, it takes about 150 days to put these wells on production”, “And so you can see that we feel like 2018 is sort of baked in now because of this big wave effect of having brought the rigs on. The big influx of new production hits in 2018. So, having a substantial growth here in 2018 is not of any concern or whatsoever, it’s going to happen”. (ii) Sanchez made a strategic $2.3 billion Eagle Ford acquisition in Q1/17 that had a lot of low hanging fruit , in particular 132 DUCs. Converting DUCs does not show up in the oil rig count. This week, Sanchez reaffirmed its focus on DUCs in 2017, saying “and as noted here, our focus for this year is going to be converting the PUDs that we have to PDNP and PDP. With the Comanche acquisition came 132 DUCs, so you don’t really find that quite often, but the bulk of our 2017 capital at Comanche is really going to focus on the DUC completions and the conversion of those PDNP reserves to producing reserves”.
Lower US oil rigs counts will be a key point to changing the tone of oil later in 2017. The major negative oil tone items are likely increasing oil production from the US, Libya and Nigeria. We believe Libya and Nigeria oil production levels will be a major topic/decision item for OPEC in the lead up to the Nov 30 meeting. It will be important for OPEC to restrict supply in some way from Libya and Nigeria. But the market has to see that US oil growth rates will decline. A weaker US$ has helped WTI bounce modestly off its bottom to $44.80 today, but we believe it has to be pointing to higher $40’s to prevent oil rig declines. The R2 correlation reminds us that US oil rigs respond to WTI oil prices, and that the expectation is that continued WTI around $45 should lead to lower US oil rigs this summer. We believe this week’s US shale/tight oil producer comments support the view that $45 oil is the price starting to impact drilling levels. Even if US oil rigs start to decline modestly, we expect US oil production to keep growing in 2018 with the momentum in drilling and DUCs. However, a decline in the US oil rigs will give the potential for US oil production to slow growth and possibly stop growing in 2018 and will help with the investor tone to oil later in 2017. This will be even moreso, if the normal H2 seasonal increase in oil demand starts to reduce the excess global oil stocks around the world.