Peak Rigs

Jim Brown
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Schlumberger said capex spending in North America was declining and the rig counts prove it.

The active rigs in the US declined -15 last week to 913 and that was the lowest since May 26th. The cycle peak was 958 on July 28th. We have lost 27 rigs in just the last three weeks. Last week saw a drop of 7 oil rigs and 8 gas rigs.

Schlumberger said producers are pulling back on capex spending with the outlook for oil still very uncertain. Drilling expenses have been rising as rig activity increased. That pushed the breakeven prices higher and reduced profits.

Since the initial rebound for WTI in early 2016, prices have vacillated between $44-$54 and drillers are struggling to make ends meet. The generally accepted cost of production in the Permian was around $27 in Q2. That has risen slightly because of higher sand costs and higher servicing costs as the rig activity rose. When oil prices did not rise despite the OPEC cuts, the outlook for prices has begun to fade. Goldman is not expecting prices over $57 until 2019 with the potential for a return to $45 in the coming months.

The instability in Kurdistan over the last couple of weeks has put a bid under prices but as the Iraqi government continues to seize control of the fields and pipelines, the expectations for production outages are fading. On Saturday Iraq gave control of Kurdistan's main pipeline to Russia's Rosneft. The company is planning on boosting its investments in the region to $3.5 billion and increasing pipeline volume from 600,000 to 950,000 bpd. Over the last several weeks volume had declined to 200,000 bpd as fields were shut down as a precaution when the Iraqi army began to invade Kurdistan. As Iraq regains full control the oil and full production and export resumes, oil prices will fade. Iraq has sent an urgent request to BP to takeover development in the Kirkuk oil fields. BP is expected to send in teams in the coming weeks to develop a plan to rapidly boost production.

US inventories are set to decline as companies export more WTI to Europe. Since the 40-year ban on exports was lifted in 2015 the pace of exports has been increasing. Europe wants out superlight shale oil to produce gasoline without all the environmental issues in the refining process. They are also buying our superlight oil to mix with heavy oil from the Middle East to simplify the refining of the heavy oil. According to Tom Kloza of the Oil Price Information service, US exports could rise to 15-20 million barrels per week. With Brent prices $3-$4 over WTI, oil from the US is actually cheaper as a waterborne crude. Kloza and the OPIS expects WTI to remain in the $47-$51 range for the rest of 2017 and then weaken in early 2018 as inventory levels begin to build again. Kloza said we are not likely to see $60 oil again until 2019.

The IEA warned in its latest monthly report that global inventory builds, rising non-OPEC production and sluggish demand growth could weigh on oil prices in 2018. They said 3 of 4 quarters in 2018 could be "roughly" in balance as long as OPEC does not end the production cuts at the end of March and weather conditions remain normal. For the first quarter of 2018 they expect inventories to rise by 800,000 bpd and that assumes the 1.8 million bpd cut remains in force. For the rest of the year non-OPEC production is expected to grow at roughly the same pace as demand growth so inventories will remain high with no declines. This report was another reason US producers are slowing development activity. There is no light at the end of the tunnel.

The IEA warned that global inventories were declining much slower than expected when the major OPEC producers agreed to cut production. They are becoming frustrated at the lack of movement and their decreased cash flow from the cuts. The IEA expects OPEC and Russia to announce an extension of the cuts after the November 30th OPEC meeting. They cannot afford to wait until the end of March to make the announcement because the market is too worried the cuts could end and prices plummet. They have to relieve the pessimism at the November meeting.

The IEA said demand growth in 2017 is on track for 1.6 million bpd and that will decline slightly to 1.4 mmbpd in 2018 due to technology improvements in electric/hybrid cars and mileage increases in internal combustion vehicles. Global supply rose 90,000 bpd in September to 97.5 million bpd.

Pioneer Natural Resources (PXD) said they would quadruple exports in 2018. They shipped three 500,000 barrel cargoes in Q3 and will ship four in Q4. This number is expected to rise to 13 by October 2018. CEO Tim Dove said all the increase in US shale production in 2018 would be exported. Pioneer expects to quadruple production over the next ten years as well.

The Vitol CEO warned that US shale production increases in 2018 could force the price of Brent down to $45 with exports a major factor. David Knapp, CEE at Energy Intelligence warned there was a new peak coming. He said production from the Eagle Ford would peak as all the prime drilling locations were completed. He said the Permian will not peak for several years and it could be a decade before production would begin to decline. Production in the Permian was 2.2 mmbpd at the start of 2017 and has risen to 2.7 mmbpd. It is expected to rise to 3.3 mmbpd by the end of 2018. The Pioneer CEO said they have 20,000-35,000 wells to drill on their existing Permian acreage and they are on pace to drill 250 a year, giving them decades of reserves left. Of course the offset to that is the rapid pace of declines in existing wells. That means they have to create 300,000 bpd of new production every year to offset the 200,000 bpd of declines in existing wells. This is the production treadmill that never stops and continually increases in intensity as shareholders demand production increases.

US shale production totals about 6.2 mmbpd with total production about 9.55 mmbpd in September. That is expected to exceed 10.0 mmbpd in 2018. Production declined last week because of the Gulf shutdowns when Hurricane Nate blew through the oil patch. This will rebound quickly over the next two weeks.

OPEC is not buying the slowing demand theory. The secretary general said last week, "We expect demand to pass 100 mmbpd in 2020 and reach 111 mmbpd by 2040. We see no peak in oil demand for the foreseeable future." Time will tell. With airline growth exploding by thousands of planes a year and Boeing expecting to sell 29,530 jets over the next 20 years, mostly to Asia, the demand for oil will continue to increase. Unless they find a way to create a battery powered plane, the demand for jet fuel will continue to rise. That will offset any decline of gasoline as a civilian motor fuel.

Our problem today is that oil is stuck in a range and energy equities are also range bound until at least the November 30th OPEC meeting. Once we know for sure they are going to extend the cuts, we could see equities firm. However, Q3 earnings for energy companies are not expected to be strong because oil prices were under $50 for the entire quarter. Costs rose and prices were weak. That could cause new declines in some of the producers.

Until a trend develops there is nothing for us to do. The service companies are fading as the rig count declines. Production companies are fading on fears oil prices are going to head back to the high $40s. We need to be ready to buy a dip if we do get a decent decline in crude prices. The next chance for a potential rebound in prices is Q2-2018. It is really frustrating for us but put yourself as CEO of some of these shale producers. It has got to be really frustrating for them because they have debt payments coming due and revenues are not rising.

There will eventually be another oil boom. The decline in investment over the last four years means production will decline in the coming years. We are just not there yet. The shale boom is offsetting the declines in conventional oil and deepwater drilling. Two years ago, there were nearly 60 active rigs in the Gulf. Today there are 20. That means future Gulf production is going to slow and when the next boom comes it will take a decade to restart Gulf production. Everything in the Gulf takes 5-7 years to go from exploration to initial production and 10 years to full production. Nobody will start new projects of any size until prices are back over $75 and stable.

The wild card in this story is the potential turmoil in the Middle East. If Iran and Saudi Arabia start shooting at each other or the US manages to impact oil exports from Iran as part of the nuclear problem, prices could rocket higher.

Jim Brown

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