Trouble in Saudi Arabia

Jim Brown
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The best laid plans of mice and men sometimes go astray.

Prices drifted back down to $60 on Thursday but surged $2 after the employment report on Friday. Prices held at $62 over the weekend despite news that the Saudi Aramco IPO had been pushed out as much as a year because of valuation problems. Saudi wants a $2 trillion valuation and they only want to sell a 5% stake. That is turning into a challenge because the group of advisors they have consulted are struggling to come up with that valuation. Saudi officials reportedly told UK officials the IPO would likely be shelved until 2019 "at the earliest."

Saudi Arabia was happy to go along with the production cuts to reduce inventory levels and raise prices because that made their oil in the ground worth a lot more money. With oil stubbornly refusing to move over $65 and the cooperation on the production cuts likely to fade in late June, the chances for higher prices are fading.

We could see $65-$75 by the end of the year but Saudi would like to see $85 or higher to bump up their valuations. With every day that passes their reserves decline by 11 million barrels. If the IPO is pushed out to mid 2019 that means reserves decline by more than 4 billion barrels. As long as they are discovering new reserves they can offset some of that but most of Saudi's oil was discovered decades ago because they are conventional reserves and easy to spot even with primitive acoustic methods.

Another challenge with the IPO is that Saudi Aramco is a state owned company. In a state where things can change at the whim of the king, that is a troubling problem for investors. Financials, reserves, production and technological challenges have always been a state secret. Nobody even knows which wells are producing, which have an extremely high water cut and which are kept operating just to keep up appearances. The late Matt Simmons wrote a book a decade ago claiming the Saudi oil kingdom was a house of cards and if the truth was known, it would collapse. Quite a few analysts have said they could not advise their clients to invest in the IPO. With a lack of interest, the Saudi king may be thinking about abandoning the process. A Reuters analyst, Jack Kemp, believes the IPO will never happen.

In the U.S. oil production rose a whopping 86,000 bpd last week to 10.369 million bpd. Production is surging without a material increase in the rig count. The the last four weeks there has been an average net gain of 2.5 rigs per week. Last week there was actually a decline of 4 oil rigs and spike of 7 gas rigs.

Platts said recent surveys suggested producers were going to maintain production growth but at a reasonable rate. They were no longer chasing production at the expense of profitability. This has been the mantra for the last six months but very few analysts actually expect them to follow through on it once oil prices hit $65. Apparently, they are restraining the urge to splurge.

Inventories at Cushing hit a new low for this cycle at 28.2 million barrels. The exports are continuing at a near record pace and that is depleting those inventories. Imports hit a 5-week high at 8.0 mmbpd and gasoline demand surged to 9.276 mmbpd, up 416,000 bpd over the prior week. Refiner utilization is holding at the lows for the year as the maintenance cycle gets underway.

The CEO of Pioneer Natural Resources (PXD) spoke at CeraWeek and pointed out that 20% of global capex spending is in the Permian. The rig count has risen from 156 to 434 over the last two years. The IEA expects Permian production to double by 2023. Exxon's XTO energy subsidiary plans to expand its rig count in the area over the next three years by 65% and tripling its production from the Permian.

Devon Energy (DVN) said it authorized a $1 billion stock buyback (6% of outstanding shares) and raised its dividend by 33% to 8 cents. The company is selling some Texas assets for $553 million.

Chevron, the largest producer of LNG in Australia, said they expect a global shortage of LNG by 2025. This should come as a shock to most readers since there was a global glut over the prior three years and several projects were cancelled or shelved because of the expected low prices. This has put producers behind the demand curse. China and Japan are ramping up demand very quickly as they try to clean up their air. China's dependence on coal has created major polution problems and the government is on a major push to clean up the air by switching to natural gas.

Chevron has around 100 Tcf of gas offshore Australia and two of the largest LNG plants in the world. This will be a major gold mine for Chevron since they have no further capex expense on those plants. It is all gravy from now on. China imported record levels of LNG in January and demand is expected to continue rising. Chevron said global demand by 2035 could be 600 million metric tonnes per year and supply could be only around half of that amount. Gas prices are going up.

Shell (RDS.a) said in February it would take $200 billion in infrastructure spending in LNG to meet demand by 2030. The cancellation of projects after 2014 is going to cause a lack of supply in the early 2020s until new projects under consideration today can be brought online.

In the U.S. gas demand for LNG is roughly 3 Bcf per day. Over the next two years that will rise to 12-13 Bcf per day and that will put upward pressure on local gas prices. Analysts believe supply is available although it is not currently being produced. The majority of gas from various shale fields is still being flared (burned off at the well head) because there are no pipelines or processing facilities to transport it away from the fields.

Analysts are scratching their heads over recent developments at several major oil companies. The CEO of BP said mature oil fields with existing wells actually produced more oil in 2017 than in prior years. He said in his 39 years in the industry he has never seen or heard of a negative decline rate. That means existing wells suddenly began producing more oil than expected. He is not alone. Shell and the country of Norway also reported a slower decline in production in legacy wells and nobody has an explanation. Wells in Norway declined at a 9.3% rate in 2017 compared to a 18% annual rate in the early 2000s.

To explain this a little better, an average conventional legacy well may decline about 7% per year. Each well differs but this is an example. After years at this rate, wells suddenly slowed their decline to only 4% or 5% in 2017 and in multiple countries. They are still declining because oil is a finite resource but they were declining at a slower rate. The average decline rate in 2017 was 5.7% as reported by the IEA. That is the lowest rate in more than a decade.

Engineers pointed to a more stable environment where wells are set to produce at a level rate month after month without any down time and that produces more even underground flows. Starting and stopping production due to above ground problems can slow flows because the oil thickens when it is not moving.

According to the IEA, fields in decline produced about 51 million bpd in 2017. If you apply that 5.7% average decline rate that means we are losing 2.9 million bpd per year from those fields. If we round it to 3 million that means those fields will produce 48 mmbpd in 2018, 45 mmbpd in 2019, 42 mmbpd in 2020, etc, not allowing for the smaller baseline for calculation each year.

Some industry officials point to the added incentive by producers to reduce decline rates. At $100 oil they did not have as much incentive because money was flowing freely. At $50 oil, they have a great incentive to produce as much as possible from each well. Therefore, they spend more time and money to develop enhanced recovery techniques to prolong production.

The only constant in this equation is that oil production will always decline. It is a scientific fact that you can only extract the oil that is in the ground under your well. There is not any new oil being created and once that first barrel is produced the supply will forever be reduced. If there is only one million barrels under your well, you can improve recovery rates for years into the future but you will never get all one million barrels out of the ground. You can improve methods to extract more but there is a finite limit.

Oil will trade over $100 a barrel in the future. It may not be for several years but it will trade over that level again as depletion eventually wins the race against production.

Jim Brown

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