The Fuse

Analysts Diverge on the Permian’s Outlook

by Nick Cunningham | September 27, 2017

Expectations for explosive production growth in the Permian may not be realized, according to a new major forecast. This is a sobering outlook, given that the Permian is the hottest shale play and the global oil market will need strong non-OPEC supply growth in the coming years to meet demand and offset OPEC production cuts.

While most analysts see the Permian growing production for the next few years, some suggest that expectations should be tempered.

The U.S. Energy Information Administration (EIA) is assuming output will double by the middle of the next decade, growing from nearly 2.6 million barrels per day (mbd) as of September 2017, to 5 mbd by 2025. Not all analysts are so optimistic. A new report from Wood Mackenzie predicts that the Permian Basin may undershoot market expectations. WoodMac forecasts Permian production peaking at 3.5 mbd in 2021. That stands in sharp contrast to a flurry of separate estimates pointing to robust growth for the foreseeable future, highlighting the uncertainty for future growth in the U.S. Against that backdrop, while most analysts see the Permian growing production for the next few years, some suggest that expectations should be tempered.

Permian frenzy

A number of factors point to troubled waters ahead. WoodMac’s report focused on the drop in well pressure resulting from an aggressive expansion in drilling, which could slow growth. The rig count in the Permian stood at 386 for the week ending on September 22, nearly double from a year earlier. “We’re drilling so many wells and with such tight spacing, should we really expect well number 5,000 to perform like well number 5 did?” said Robert Clarke, a research director at Wood Mackenzie, according to the San Antonio Express-News. His consultancy argues that the best days for a shale basin are typically at the beginning. Simply put, the explosive growth in oil production in the past two years does not portend continued robust increases.

There is already anecdotal evidence that some shale drillers are spacing wells too close together, resulting in “frack hits,” or a sudden drop in well pressure due to wells in close proximity cannibalizing each other. As a result, production from those wells may end up lower than expected.

The high concentration of drilling activity in one region creates other problems. The market for oilfield services in West Texas is increasingly strained, pushing up the price for labor, land, drilling services, and equipment. Estimates on cost inflation vary significantly—Bank of America Merrill Lynch sees the costs of oilfield services increasing by 10 to 15 percent in 2017, but other analysts have costs rising twice as fast.

Cost inflation is bleeding into the sky-high price of real estate in Midland, Texas, a familiar sign of conditions that resemble a bubble. The big question is whether the Permian boom will taper similar to the slowdown in the Bakken and Eagle Ford.

America’s ‘Super Basin’

Not everyone thinks the Permian is destined to slow. While WoodMac argues that the Permian’s best days are numbered, other forecasts argue the drilling boom is just beginning. An exhaustive three-year geological study of 440,000 Permian Basin wells from IHS Markit says the Permian still holds 60 to 70 billion barrels of technically recoverable resources. The study has “significantly changed our understanding of the extent of many formations in the Permian Basin and the potential of those formations to yield additional hydrocarbons,” John Roberts, executive director, global subsurface content operations at IHS Markit, said in a statement.

IHS Markit says the Permian still holds 60 to 70 billion barrels of technically recoverable resources.

“The Permian Basin is America’s super basin in terms of its oil and gas production history,” said Prithiraj Chungkham, director of unconventional resources at IHS Markit and coauthor of the report. “[A] previously undiscussed opportunity for production may be from the tight, non-continuous plays produced through short-lateral wells and low-volume fracking. This offers lower risk, improved upside potential and ultimately, lower recovery costs, which is good news for operators.” The study makes the case that there is immense upside for the Permian and production growth will continue unabated in the medium-to-long term.

permianihs

Cash flow problems

Having large volumes of oil in place is one thing, but extracting those resources for profit is a daunting challenge. To date, a number of shale firms in the Permian are still spending much more cash than they are generating. An August Bloomberg survey of 33 shale E&Ps showed a collective cash burn in recent years that have raised eyebrows. The industry is broadly cash flow negative in the four major U.S. shale oil basins—the Permian, Bakken, Eagle Ford, and Niobrara. Some 14 Permian-focused shale companies spent $11.5 billion more than they took in over the past 12 months. The larger sum of cash burned in the Permian is, at least in part, a function of higher drilling rates. There is, however, a disconnect between the industry’s enormous interest in the Permian and the financial returns companies are seeing.

While that is worrisome for investors, it isn’t necessarily an incurable problem, so long as firms eventually see profitability. However, turning a profit hinges on falling production costs, rising oil prices, a substantial increase in output, or, more likely, a combination of all three. None of those factors are guaranteed—the Permian is already seeing drilling costs on the upswing and a further increase in oil prices is far from certain. Furthermore, reports such as the one from WoodMac suggest that expected gains in output may be less impressive than expected.

The current dynamic of strong growth in the Permian can continue as long as Wall Street remains a favorable ally of shale drillers.

The current dynamic can continue as long as Wall Street remains a favorable ally of shale drillers. Lenders are not running for the exits just yet, but some signs have emerged that their patience with U.S. shale is wearing thin. New equity issuance is on track to reach just $10 billion in 2017, less than a third of the sum from last year, and the lowest total since 2010, according to Bloomberg. In addition, Reuters reported in June that eight prominent hedge funds cut their positions in top shale companies by over $400 million. The divestment was specifically aimed at reducing exposure to Permian-focused firms. Meanwhile, in August, Goldman Sachs said that it fielded inquiries from investors after a raft of poor figures from Permian producers. The investors questioned the wisdom of “positioning across well-owned, perceived high-quality Energy companies.” In other words, there are signs investors are souring on the Permian.

For now, though, Permian production is still rising swiftly—Chevron just announced plans to invest $4 billion in the Permian in 2018, with plans to ramp up production in the basin to 400,000 barrels per day (b/d) over the next few years. The EIA predicts the Permian will add 55,000 b/d in October, reinforcing the shale basin remains one of the most sought after regions for investment from the oil industry.

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