The world of oil is very different than it was even a decade ago—having gone from resource scarcity to resource abundance. The industry's business model needs to change to keep up, says Senior Energy Analyst Dimitry Dayen.
The dynamic of shale
Supply dynamics in the energy sector are changing, because shale oil is transforming the global supply landscape. The macro-change that shale brought to the industry is that the U.S. has gone from being a marginal producer to a swing producer and that has effectively reshuffled the global cost curve.
U.S. exploration & production (E&P) companies are the most economically sensitive producers, effectively spending 100% of their cash flows—or more—on production. When I started in this industry, we used to call them checkbook drillers, because they just spend whatever they get in the bank.
So, the current price signal from the market to the North American E&Ps is that the declining price of oil means cash flows have now declined a lot. The response is to moderate spending. These companies are price takers, they have no control over the price of their commodity, they can only control their own cash outlays. And we’re already seeing that. Cash flows have declined. The rig count has started to come down.
Industry on a treadmill
One really interesting feature of shale is that it is a very high decline-rate asset. By decline rate, I mean how far does production decline in the 12 months after it is brought online. Consider what happens if you drill a well and it comes on really strong, and then 12 months later it’s down by 60 to 70 percent of its original production. When you stack a lot of these years on top of each other, you have an industry that has an average decline rate of 35 to 40 percent, which is very high.
If these companies stop spending money 12 months from now, they’ll have 35 percent less oil production. Just to compare that decline rate to the rest of the world, the total average decline rate for the globe is about six percent. It’s a big differential and a very material issue.
In effect, you have to increase activity every single year by double digits if you’re going to continue to grow at the pace you’ve been growing. And rough math is such that if activity is flat in ’19 over ’18, production growth will probably be cut somewhere in half.
The world has changed
Before the shale revolution, the world was actually kind of straightforward for energy. Prices went up and down, driven by supply and demand, but the overall concern was peak oil—where is supply going to come from. Companies were incentivized, and delivered value, through exploration—you have to go and find oil. It’s hard to get. You didn’t know where it was going to come from.
As a producer, it didn’t matter if you were outspending. Value was created because you bought acreage for very little money, or no money, and you found oil on it. And once you struck oil, it’s really, really valuable and now you better get out there and drill it really quick, bring that net asset value forward, produce your resources, sell it, and go find the next resource, because the resource you just found is only going to last you 5 - 7 years because there’s not a lot of inventory. You delivered value through the drill bit, through the exploration.
That has changed. You don’t deliver value through exploration anymore. With the advent of shale, we have repeatable inventory to an extent. There is still geological risk, but generally speaking it’s more repeatable. And companies now don’t have just three or five or seven years of inventory. In some cases, they have 30, 40 or 50 years of inventory. And the buildup of that inventory has already been reflected in the values of these stocks.
A mind shift is needed
So for companies that have good resources, it’s all about production. The market is not asking, “Where are you going to get more oil?” In fact, it doesn’t want more money spent finding more resource if you already have a lot. Instead it wants to know how companies can monetize this resource over a long period of time, with a cost structure that makes sense and that creates value for shareholders.
It’s almost like an industrial company. You don’t care how many widgets an industrial company makes necessarily, but whether they have good profit margins, good returns on capital and good cash flows and that they are making those widgets economically. That’s the way this industry needs to shift.
And when commodity prices go up, you don’t chase and spend all your money making more widgets, making more barrels. You pace yourself at a level which makes sense relative to the size of your resource so that you have the right level of inventory, you have the right scale, you have the right corporate structure, the right balance sheet, so that you can monetize this resource and try and benefit your shareholders in a very, very logical way.
And when oil prices rise, and you have more cash, you can return more cash to shareholders. And when they fall you have less cash and you’ll be returning less cash to shareholders. And we’re seeing some companies that have done this successfully, but a mind shift needs to occur in these organizations that to their credit have grown production successfully and gotten value for kind of 30 years going into the shale revolution. But the world’s just different now. It’s gone from resource scarcity to resource abundance, and the business model has to keep up.
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