Zero US Producer Equity Issues In Q4/19 + Surplus US DUCs Soon Depleted + Declining Oil Rigs = US Oil Production Plateau In H1/20?
Dec 6, 2019
We may not have a detailed US oil growth model, but we can’t help believe US oil production is soon to reach a plateau and possibly a small step down after seeing the negatives to key input factors to calculate Permian oil growth getting worse in Q4/19. Our recent Oct 7 webcast for the SAF Group 2020 Energy Market Outlook highlighted our view that the math says Permian growth forecasts have to be lowered and lowered significantly. In the two months since our webcast, we have seen key input factors get even worse – the surplus (rainy day fund) of DUCs are being depleted quickly and will soon be gone, there have been zero equity issues for US producers in Q4/19, and US oil rigs are declining more than expected in Q4/19. These are happening at the same time as Permian PDP decline rates look to be confirmed at just under 40%, which poses challenges to growth. Refreshed capex budgets should lead to an immediate increase in US oil rigs in Jan but, with the lack of new equity, we don’t believe that rate and timing of US oil rig growth from refreshed capex budgets will be enough to offset the impact of the depletion of DUCs. It doesn’t mean US average oil production in 2020 won’t show YoY growth, but we believe it points to US oil production plateau in H1/20 and effectively zero YoY growth when looking at exit 2019 to exit 2020. The challenge for growth is that the big drawdown in DUCs since May gave a one time supply burst and likely accounted for almost all of the growth in US oil production in H2/19. With the surplus DUCs soon to be gone, our concern is that the steady increase in US oil rigs won’t be enough to maintain that DUC driven higher oil production level. Rather we also see the potential for a modest step down in US oil production levels, before returning to a period of sustained, but much lower oil growth based on increasing US oil rigs without the benefit of new equity capital. A US oil production plateau in H1/2020 will be big positive to oil as we move into H2/2020.
Zero US producer equity issues in Q4/19 + surplus DUCs soon depleted +declining US oil rig = US oil plateau in H1/20. The major theme of our recent Oct 7, 2019 webcast SAF Group 2020 Energy Market Outlook [LINK] was the math says Permian growth forecasts have to be lowered and lowered significantly. We just believed (and still believe) that every input into the equation to calculate oil growth are worse than a year or even six months ago. And if all the inputs are lower, then the answer to the equation has to be a lot lower, not just a little bit lower. Our webcast highlighted the key inputs of increasing Permian decline rates, decreasing capital for Permian and all US producers, US oil rigs still going lower, Permian well productivity down in 2019 and DUCs likely being overstated. In the past two months, we have seen a number of the major US sellside firms dramatically lower their US oil growth forecasts for 2020. We may not have a detailed US oil growth forecast model, but we can see that the key input factors to any detailed US oil growth forecast models are worse today than they were two months ago.
But most aren’t looking at exit to exit oil growth, rather are highlighting the growth in 2020 average vs 2019 average in describing oil supply/demand. The narrative on US oil growth continues to be on YoY growth to the average 2020 oil production forecasts. We have to remember that all of the recently reduced US sellside oil growth forecasts for 2020 still have some reasonable level of YoY growth when comparing 2020 full year average to 2019 full year average production levels. Given the dramatic reduction in the surplus (rainy day fund) DUCs, zero equity issues in Q4/19, and greater than expected decline in US oil rigs, we believe the narrative and focus for oil markets has to turn will US oil peak/plateau and how low will be the YoY growth between the 2019 exit and 2020 exit. There is a very different perspective if we say there is zero YoY growth from the 2019 exit vs saying US oil growth will be up 1 mmb/d in 2020 vs 2019. ConocoPhillips CEO Lance was on CNBC Squwak Box on Wed and his outlook for 2020 oil markets is a good example of how almost everyone compares oil supply/demand outlook going forward – one that compares average 2020 vs average 2019. We created a transcript of his CNBC interview comments [LINK]. Lance said “ Ryan Lance: Yeah, you know we see slowdown, I mean its definitely slowing down. It looks like to us like its bottoming a bit. We see demand fairly healthy next year on the oil side, about you know, 1 million barrels in growth in oil demand. The market is thinly balanced in a $50-$60 kind of world, as long as OPEC keeps 1 to 1.5 million barrels a day off the market like they have been doing. The US is going to grow again next year, we will produce probably close to a million or more barrels of liquids per day next year of incremental growth. So the unconventionals and what the US is doing has been remarkable, and that’s going to continue. Now, productivity is slowing a little bit, so you might say that its turning over a just a little bit as the access to capital for some of the smaller E&Ps is reduced. The banks are not loaning, the IPO markets aren’t available to these companies, so we see some lessening of that impact, but there’s going to be growth out of the US, and its probably going to consume all of the demand growth which is going to keep a lock on price as long as OPEC keeps doing what its doing.”
Zero equity issues to US produces in Q4/19 will limit the rate of increase in US oil rigs in Q1/20. We disagree with the general narrative that equity markets continue to be weak for US oil producers, As bad as its been, its even worse in the last two months as there have been zero equity issues in Q4/19. We don’t recall seeing a zero equity issue quarter before, its even worse then when oil dipped below $30 in Q1/16. This zero equity issue quarter is significant as it mean the level of US oil rig increase will be limited to refreshed capex budgets with capex being generally limited to cash flow. We think equity, not debt, issues are the key to how much US oil rigs will ramp up. US producers are already under market pressure to keep spending within cash flow and not let debt get out of control. We don’t think producers would make any significant expansion in levels just using debt. There isn’t anything visible on the horizon, even with an OPEC+ higher cuts expected today, to suggest new equity capital is coming back to US producers.
US Energy Producer Equity Issuances
The surplus (rainy day fund) of Drilled UnCompleted (DUC) wells is being depleted faster than expected and will soon be gone There are two critical indicators for how much the US oil production can grow in 2020 – the level of US oil rigs drilling new oil wells to add new production and the level of DUCs that can be drawn upon to add new production. Thanks to the Raymond James oil team for highlighting the faster than expected depletion of surplus DUCs in the past two months with their comment this week “Energy Stat: DUC Season is Back! Biggest Ever Draw in October; EIA DUC Inventory Down ~750 in 2H19”, which also highlighted their view that ‘As a result of this, DUC “months of inventory” have declined by ~25% in 2019, and are now nearing what we believe are “normal levels”. From Jan 1, 2017 thru May 31, 2019, DUCs increased by 2,789 and there were only two months that saw decreasing DUCs. However, from June thru Oct, DUCs were reduced by 732 or an average of 146 over the 5 months. Note that the MoM reduction in DUCs was 204 in Sept and 225 in Oct, well above the average of 146 over the May 1 thru Oct 31 period. This is a significant event as it means that the surplus (rainy day fund) of DUCs inventory is being depleted faster than expected and will soon be eliminated.
And using the surplus DUCs has, as expected, led to a large one time supply burst to US oil growth in H2/19 despite declining US oil rigs. The US oil production growth story has been excellent in H2/19. The EIA estimates US oil production has just hit new record 12.9 mmb/d [LINK], which is up ~0.8 mmb/d since May. Yet this has happened in a period of accelerating decline in US oil rigs. There were 800 US oil rigs at May 31, but that is now down to 668 US oil rigs. So how did US oil growth happen? No question part of it is likely due to continued improvement in well rates and faster drilling times (more wells per rig) by many operators. But the biggest reason is that the large drawdown in DUCs from the surplus (rainy day fund) has allowed US oil completions to stay high despite declining US oil rigs count. There were 732 DUCS drawn down from June 1 thru Oct 31. This is significant as there were only two months since Jan 1, 2017 that had a monthly decline in DUCs. If we treat these 732 DUCs as the one time oil supply burst and assume each DUC added ~1,000 b/d of oil IP30 in the month following completion with an average annual 1st year decline of 60%, we estimate the drawdown of DUCs will add ~645,000 of oil production by year end 2019.
US Oil Rigs, MoM Changes In DUCs, Completions and Oil Production
But soon the surplus (rainy day fund) of DUCs will be gone and DUCs will be down to normal levels. There will always be some sort of normal level of DUCs that are needed to allow operators to smoothly plan operations from drilling through completion and first production especially as the US has moved to shale/tight oil resource plays. DUCs won’t go to zero. As everyone has described, drilling, completing and tieing in wells has become much like a manufacturing process. And like any manufacturing process, they want to run it at consistent levels throughout all stages to maximize efficiency and operational capacity. That means there always has to be a certain normal level of DUCs that work hand in hand with the new oil wells being drilled to keep a steady input to the operator’s drilling, completion and tieing in operations. And that the normal level is higher than a few years ago due to the increasing percentage of pad drilling where multiple wells are drilled and completed at the same time. Raymond James also highlighted that this surplus (rainy day fund) of DUCS will soon be gone. They wrote “that we are fast approaching the critical “normal level” of DUC inventories (shown by the red line). In fact, should DUC draws and completions continue at their trailing-three moth rate (shown by the dotted blue line), DUCs will reach critically low levels by February of 2019”. Their timing assumption exclude any EIA DUCs over 2 years old (approx. 15% of total EIA DUCs) as they filter only for “real” DUCs. But once the surplus (rainy day fund) of DUCs is gone, it means that the operators then have to set a lower rate of drilling, completion and tie-in operations to sync up with their level of oil rigs alone without the benefit of a surplus DUC inventory.
The issue doesn’t change, but we expect some of the older DUCs will be completed. One of the comments we heard on the Raymond James DUC views is that they were being overly pessimistic by excluding 15% of the DUCs from their filter to get to “real” DUCs. We agree with Raymond James that there will be many DUCs that will never be completed as there will have been many wells that were drilled and the rock quality wouldn’t justify the costs of fracking/completion. However, we probably wouldn’t have eliminated all DUCs >2 years old, but the reality is that if we only eliminated half (ie. 7.5% instead of 15%) of the DUCs, it wouldn’t change the issue and conclusion – the surplus (rainy day fund) of DUCs to draw on will be gone very soon maybe not by Feb, but perhaps a couple months later. The issue of a soon to be depleted surplus (rainy day fund) DUCs inventory will be gone soon. Our Sept 15, 2019 Energy Tidbits memo noted an EIA interesting EIA Sept 10 brief [LINK] “Time between drilling and first production has little effect on oil well production” that noted there really isn’t a difference between DUCs that were only 1 year old or 3 – 4 yrs old and that we shouldn’t assume, at least for the Bakken, that all older Bakken DUCs aren’t any good because they haven’t been completed as of yet. Regardless, it doesn’t change the issue of running out of surplus DUCs to draw on, it just perhaps delays it by a couple months.
EIA Comparison of Bakken Wells Performance By Yrs To Complete
At the same time, Permian growth is facing the challenge of increasing PDP decline rates. Yesterday, we tweeted [LINK] our thanks to Wood Mackenzie for an excellent webcast “Benchmarking Permian PDP Decline Rates” that had the slide deck titled “here today, gone tomorrow – getting ahead of 2020 PDP decline rates and their impact on operator revenue”. Their slide deck and comment highlighted the challenge for most Permian producers to show YoY growth under a scenario of 2020 activity levels similar to 2019 activity levels. Wood Mackenzie said “Expectation of these companies today is that they will rein in spending at least to a point of cash flow neutrality, if not generating modest cash flow while also growing or at least holding flat production volumes. There is a magic number between 40% and 42% decline rate. That makes it above that, above that decline rate, it makes it very difficult if an operator were to have an identical year, were to drill the same number of wells in roughly the same locations next year as this year to hold production flat. that’s the magic number”. Wood Mackenzie didn’t provide an overall Permian average PDP decline rate, but overall, it is probably similar to the BTU Analytics estimate in the high 30’s that we included in our outlook webcast.
Permian Operators PDP Decline Rates
Crude Oil Decline vs Production By Region
A US oil plateau is likely coming in H1/2020 if refreshed capex budgets can’t increase US oil drilling to levels to maintain the higher US oil production base driven by the one time supply burst from DUCs drawdown? We don’t think US oil rigs will ramp up in Q1/2020 as quickly and as much as they did in Q1/17 with the lack of equity issues. Earlier, we noted that the average MoM reduction in DUCs was 146, but that Sept was 204 DUCs drawdown and Oct was 225 DUCs drawdown. The Permian is the primary oil play and, using the EIA Drilling Productivity Report database, the EIA estimates Permian oil rigs were able to drill 1.2 wells per rig per month. If we use this 1.2x factor on an overall US basis, it means we would need to see oil rigs increase by 122 rigs to replace the average 146 DUCs drawdown, and by 188 oil rigs to replace the 225 DUCs drawdown in Oct. This compares to the 132 decline in US oil rigs from May 31 to Nov 29. US oil rigs should immediately increase in Jan with refreshed budgets, but we doubt anyone expects to see the US oil rig count immediately return to June levels. In 2017, we saw US oil rigs increase steadily by 247 oil rigs from Q4/16 thru Q2/17. But referring to the equity issuance graph earlier, producers were able to access equity markets in 2016 and 2017. That’s not the case in 2019 when there have been zero equity issues in Q4/19 to date. Its why we don’t see US oil rigs jumping up immediately to the levels needed to replace the big one time drawdown in DUCs. The advantage for markets with the surplus (rainy day fund) of DUCs soon to be gone, it makes the focus simple – how fast and how much are US oil rigs increasing? Because if they are not, its hard, especially with increasing base decline rates, to see a math scenario that leads to strong YoY growth in US oil from Dec 31, 2019 to Dec 31, 2020. Rather, we believe that, absent a big quick increase in US oil rigs, the likely scenario is US oil reaching a plateau in H1/2020 and essentially zero incremental US oil growth from exit 2019 to exit 2020. If we don’t get big increases in US oil rigs, we don’t see how the US can keep growing from the record oil production that was lifted up by the one time supply burst from the big drawdown in the surplus DUCs. This means we expect to see US oil production to reset at a slightly lower level and then return to a sustained period of much smaller growth rates based on US producers living within cash flow. This plateau may not wipe out the current global oil surplus in 2020, but it certainly dramatically shifts the global supply picture leaving 2020. And as we highlighted in our webcast, we expect the investor tone to oil to dramatically improve once markets realize US oil growth won’t satisfy global oil demand growth by itself.
US Oil Rigs Increases/Decreases In H1/17, H1/18, and H1/19
It is looking like former Saudi energy minister al Falih was right about the Permian – production would plateau years earlier than expected. On July 3, 2019, we posted a blog “A Big Plus To Post 2020 Oil If Saudi Is Even Directionally Right That Permian Plateau Is “In A Year Or Two Years or Four Years” to highlight then Saudi energy minister al Falih’s comments on CNBC early that morning because no one, at that time, was calling for the Permian to potentially plateau in a year. Al Falih said “There will be a plateau for these unconventional resources in the US, the Permian being one of them. is it in a year, or two years or four years, I don’t know but certainly its not indefinitely.” No one was then calling for Permian plateau (peak oil) in a year or two and not likely 4. Maybe most assumed it was just musings from al Falih. But we thought it was more than musings because Saudi Arabia has been taking a different tactic this time than their normal strategy to get market share – increase oil production, crash oil prices, ruin growth prospects for other oil basins. They want solid oil prices and an increasing oil market share. And this time, we thought al Falih’s comments suggested they believe that, they can regain market share, by letting US shale play out. At that time, we said If Saudi Arabia is even directionally right in Permian reaching plateau (peak oil), it means that Permian and US oil is going to hit peak oil probably at least a few years earlier than expected. This will be very bullish to oil post 2020. Based on what is playing out in the past two months, it looks like al Falih may be right.