Bear Market in Energy

Jim Brown
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Equity investors continue to fret over the potential for 3-5% declines.

Energy investors could kill for only a 3-5% decline. Energy stocks are down 20%, 30% even 50% as the sector struggles with a bear market. There is no light at the end of our tunnel. Every report, every analysis, every price tick simply increases the pain.

OPEC has been ineffective in supporting prices in a favorable range but I would hate to see where prices would be today without their production cuts. We could be looking at $30 oil prices.

Prices dipped last week to $46.50 on the current contract and this is before the driving season demand evaporates 3 weeks from now. I am hoping all the driving to and from eclipse viewing sights give us another week of significant inventory declines before the demand ends and refiners begin to switch over to winter blend fuels. That 60 day maintenance period slows demand for oil and inventories will rise again until we are well into the winter heating oil cycle.

The IEA warned again that OPEC must continue the production cuts through 2018 or the inventory levels would return to their highs. They warned the market that OPEC is losing its grip on producers and compliance is going to continue to slip. The IEA's Neil Atkinson, head of oil markets, warned OPEC is going to have to dig in for the long haul and at least extend the cuts through 2018.

The latest production numbers show OPEC at 32.8 mmbpd, which is currently higher than demand for OPEC oil. That means inventories are already growing again. "If OPEC wants to keep oil prices in the $50-$60s they need to keep a lid on supply for several more years" according to Sarah Emerson, an energy principal ad ESAI. With July's production the highest in 2017, there is little to no chance they will be able to maintain compliance through December and zero chance they can extend it through 2018.

What the OPEC production cuts accomplished was a short-term rise over $50. That allowed U.S. shale producers to hedge 2017 and much of 2018 production at those levels and nor a drop back to $40 is not going to be as painful. That means U.S. production is not going to decline as much as OPEC would hope if prices fall again. Essentially, OPEC threw the U.S. shale producers a lifeline that allowed them to continue drilling at a moderate pace through 2018. OPEC would have been better off to have flooded the market with crude, kept prices under $50 and flushed out the weak producers.

We all know OPEC could force $75 oil by the end of September if they just slashed production further. That would allow them to produce less oil but make the same amount of money. Why Saudi Arabia cannot convince the cartel countries of this fact is a mystery. Greed causes irrational thinking.

There is another factor that showed up in the recent earnings. Producers are reporting a higher gas to oil ratio in their production. As they changed their production methods for closer and longer laterals and massive amounts of sand, the ratio of production changed. The amount of gas being produced rose and the amount of oil declined. This was a problem for revenue since gas is cheaper and it is a problem for future production because producing the gas lowers the reservoir pressures, which means the length in time and volume of future production is going to slow.

In the race to produce as much oil as possible in the shortest amount of time, they have caused a new problem that will impact them in the years ahead. Fortunately, producers can immediately change their production methods to prevent this in future wells and that means lower initial production rates but the wells will produce longer.

The rapid rise in decline rates is slowing the net production increases. The EIA said the monthly production decline in the Permian had risen from 100,000 bpd in 2016 to 154,000 bpd in 2017. That means they are expecting a net increase in production in August of only 64,000 bpd even though new production is expected to total 218,000 bpd.

The active rig counts have declined over the last 6 weeks by an average of 1 rig per week. Over the prior 25 weeks they rose an average of 11.72 rigs per week. The producers understand the problem and realize that prices are going to crash again in September. They are reducing costs and electing to slow the rate of production increases.

This is causing another problem in the service side of the business. In Q2 multiple vendors reported less sand being used to frac wells. After an 18 month period of cramming as much sand as possible into the fracs, the spike in gas production instead of oil, has changed the calculations for sand input. Halliburton said producers are demanding less sand for that reason but also because of cost.

The cost of sand is expected to rise 62% in 2017 to average $47 a ton. This spike alone was increasing the cost to complete a well by 15%. Halliburton said sand volumes fell in Q2 for the first time in over a year. They expect another 2.5% decline in Q3. Supplier Smart Sand (SND) said they shipped less sand in Q2 and the first decline since the oil crash.

Producers are constantly testing new completion profiles including sand amounts and type, chemical additives, length of laterals, distance between fracs, etc. Anadarko said new well designs in Colorado had increased oil and gas production by 35% and they used less sand.

With the sand suppliers frantically adding capacity in expectations for continued growth in active rigs and completed wells, this is suddenly a roadblock to their profitability. Multiple new facilities are expected to come online later this year and in early 2018. If the demand for sand is suddenly going to slow again, this could cause them significant problems. The only good news is that producers hedged production through 2018 and that means they will need to continue drilling new wells, even if it is at a slower than expected pace.

Despite all the negativity, the EIA said U.S. shale production would top 6.0 million bpd in August and 6.15 million bpd in September. Output from the Permian is expected to top 2.6 million bpd in September.

In the U.S. crude inventories declined -8.9 million barrels last week and the 7th consecutive weekly decline. Over those 7 weeks, inventory levels have fallen -42.7 million barrels. The decline last week was the largest since September 2016. I suspect refiners were loading up the distribution system with gasoline ahead of the eclipse weekend. With up to 100 million people driving 3-5 hours each way to watch the eclipse, there was a lot of gasoline burned. With Labor Day less than two weeks away, they should maintain that high level of gasoline production.

Oil rigs in the Gulf are at a two-year low but that does not mean producers are no longer interested. In the recent round of government bidding for Gulf blocks, the big cap names were still buying leases.

Chevron was the high bidder on 15 blocks at $27.92 million.
Shell was high bidder on 19 blocks at $25.1 million.
Exxon, yes they still drill in deep water, bid $20.39 million on seven blocks.
Total SA paid $16.8 million for six high bids.
Anadarko spent $10.6 million on 10 blocks.

Shell is getting closer to completing the massive Appomattox project. Their production platform left South Korea on its way to Texas for installation of the remaining equipment and testing. The platform has been under construction for two years and Shall claims the project will be profitable at $50 oil. That would be a major breakthrough if they can accomplish that. The project is in 7,200 feet of water 80 miles off the coast of Louisiana. Maximum production is expected to be 175,000 bpd.

The EIA is expecting the start of production from 7 new fields in the Gulf in 2017/2018 and the Appomattox is not listed on that schedule because it may not start until early 2019. The new fields are Horn of Mountain Deep, Son of Bluto 2, Amethyst, Atlantis North, Stampede-Knotty Head, Stampede-Pony and Otis. Three of those fields were discovered prior to 2007. That is how long it takes to get first production out of a deepwater field.

The bottom line to this commentary is that oil prices are not going higher anytime soon. Globally, we have seen nearly $1.5 trillion in oil projects cancelled or deferred over the last three years. Eventually, that will cause a shortage of oil because of lack of investment. With demand rising an average of 1.5 million bpd every year, we will see a point where demand catches up to production again and prices will rise. The rise in prices will trigger more investment and 3-5 years later production will increase and the cycle repeat. Temporarily, over the next 18 months, we should see low oil prices and low gasoline prices. That will encourage additional demand and spur economic growth. Low oil prices are great as long as you are not an energy investor.

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  Active Rigs

Active drilling rigs fell -3 to 946 for the week ended on Friday 8/18. Oil rigs fell -5 for the week to 763. Active gas rigs rose +1 to 182. Active rigs peaked at a high of 1,931 in September 2014. Active offshore rigs declined -1 to 16 after peaking at 61 in 2014.

Oil Inventories Week Ended 8/11/17

Crude inventories fell -8.9 million barrels to 466.5 million. This was the 7th consecutive week of declines totaling 42.7 million barrels. The historic high at 543.4 million was on April 29th, 2016.

Refinery utilization declined from 96.3% to 96.2% as refiners begin flood the distribution system with gasoline prior to Labor Day.

U.S. production rose +79,000 bpd to 9.502 mbpd. That is a decline of 108,000 bpd from the peak in 2015 of 9.61 mbpd.

Cushing inventories rose 600,000 barrels to 57.0 million.

Gasoline inventories were flat at 231.1 million and should continue to be volatile over the coming weeks as summer driving peaks and then ends after Labor Day.

Distillate inventories rose 700,000 barrels to 148.4 million barrels.

Details in the graphic are for the week ended August 11th. All numbers are not available until the Friday of the following week. In the graphic below, green represents a recent high and yellow a recent low.

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