The Permian basin blues

They've got the Permian Basin blues. Nothing they can do. Orders rigs when prices were high and so they drill a hole and let it die.

While the rig counts rise, it is slowing the profits for shale operators and the cost of production is going up. Baker Hughes reported that drillers added just two oil rigs and during the last four weeks rig additions were the lowest since November. Smaller shale firms are feeling the pain and the economics in the shale patch will cause the reporting agencies to once again lower the U.S. oil production forecast.The Energy Department on Tuesday lowered its forecast of U.S. oil production next year by 1% in what may be the beginning of a trend.

This weekend the Houston Chronicle wrote that small Permian shale producers are beginning to feel the impact of the recent slide in oil prices, warning they could postpone exploration and production plans, slow hiring and spend less on oil field services that underpin thousands of jobs in Houston area. The Chronicle says that even as larger companies plow full speed ahead in the nearby Permian Basin, these smaller, privately held firms are sending up the first signals that the industry's recovery may be losing steam as oil prices remain stubbornly below $50.00 a barrel. Many oil producers had expected prices to reach about $55 a barrel by mid-2017 and built budgets around the expectation; now, with prices near $45, they are adjusting.

The Houston Chronicle reports that Eagle Energy Inc., a small Canadian oil company that drills in Texas and has offices in Houston, recently said it plans to cut jobs, executive compensation and other costs as oil prices languish far lower than the firm expected. They also quote Jack Byrd, president of Byrd Operating Co., a small producer in Midland, who said oil prices slid far below levels needed for his company to expand operations, so instead, his firm has sold off some unprofitable property, steered away from drilling ventures with other companies and has avoided borrowing. "We're back in a holding pattern at these lower prices," said Byrd. "We won't do any work that's not absolutely necessary, and we won't spend any money we don't have to. It has to make economic sense."

The Chronicle also reports that small oil producers tend to be more sensitive to falling prices because they don't have the same access as larger competitors to capital through stock and bond markets to cushion the blow. Most of their capital comes from the oil they sell. And because of their smaller size, they struggle to negotiate the same discounts that oil field service firms give to larger companies. Still, the larger companies eventually might face the same pressures to scale back, analysts said. It's a great read.

At the same time costs are rising. John Kemp, a Reuters market analyst, wrote that U.S. oil and gas exploration and production companies are paying more to hire drilling rigs as the number of rigs still idle after the slump declines. He reports that drilling costs were up by 8% in June 2017 compared with their recent low in November 2016, according to preliminary data from the U.S. Bureau of Labor Statistics published on Thursday. Kemp says that the rise in drilling costs has barely started to reverse the previous 34% decline reported between March 2014 and November 2016, but it does mark an important turning point in the oilfield services costs cycle.

Drilling costs have been rising year-on-year since March and in June were almost 3% higher than in the corresponding month a year earlier. Kemp says that services costs are cyclical and follow changes in the rig count with a lag of a few months, but so far cost increases have been very modest compared with the resurgence in drilling activity. The number of active rigs has more than doubled over the last year, according to oilfield services company Baker Hughes, while costs have risen by less than 3%.

What we are seeing is the economics of shale come into question. The boasts that shale could be profitable in the $20-handle and $30-handle has been put to the challenge and it is clear that at this point, it is not the case. While shale oil is a global game changer it is still very sensitive to price. This means that shale will pull back just as prices start to rise. Due to the lag time on wells, the price will have to rise significantly to stop what will be a slowing trend in U.S. oil rig additions and oil rig completions.

This comes at a time when we saw more strong demand news out of China. Reuters reports that in a sign of strong demand, data on Monday showed refineries in China increased crude output in June to the second highest on record. OPEC is hoping higher demand in the second half will get rid of excess inventories.

And OPEC is right it probably will. U.S. inventories are falling at a record pace and that trend will continue. Demand is king and we will see supply fall globally at an accelerated pace in the months ahead.