The Fuse

Permania Isn’t a Panacea for the Long Term

by Matt Piotrowski | April 14, 2017

Expectations surrounding the Permian Basin have grown considerably over the years. And with good reason. Output there has doubled since early this decade, companies are pouring resources into the area, and costs have declined sharply. There is only upside for now in the Permian. “The Permian has undergone an 18-month transformation that has seen the region go from a hub of potential to the hottest basin on the planet,” said Benjamin Shattuck, Principal Upstream Analyst at Wood Mackenzie in a recent note. Pioneer’s Scott Sheffield, comparing the Permian to Saudi Arabia’s gigantic Ghawar field, said the basin could reach 8-10 million barrels per day (mbd) a decade from now. If this outlook is realized, the long-term bearish case for the oil market may hold. With growth around 800,000 b/d to 1 mbd per year, this one basin could meet an overwhelming majority of demand increases for the foreseeable future.

But the Permian, as strong as it is, may not be the long-term savior for oil markets that some think it is.

With so much focus on OPEC cuts and shale growth as of late, declines at existing fields, both conventional and unconventional, and the extra stimulus that low prices has given to demand mean that a supply-demand gap will eventually form, even if the rosiest scenario pans out in West Texas.

“What we’re going to see in the next few years is how far we can stretch shale production,” Carl Larry of Oil Outlooks & Opinions told The Fuse. “Unconventionals have pretty extreme decline rates. We’ll soon be talking about a ‘deterioration factor’ instead of looking at how high production can grow.”

“Unconventionals have pretty extreme decline rates. We’ll soon be talking about a ‘deterioration factor’ instead of looking at how high production can grow.”

The U.S. Energy Information Administration (EIA), in the reference case for its latest long-term outlook, sees the Dakotas declining sharply through the latter part of this decade before rebounding, with production in the Southwest (dominated by the Permian) stabilizing in the early 2020s and just gradually rising after that (see below).

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It’s not just concerns about fall-offs in shale, but conventional non-OPEC fields have rising decline rates, which have likely increased even more during the period of under-investment of the last few years. Bank of America Merrill Lynch said that decline rates for conventional fields outside of OPEC have risen this decade from 4.87 percent to 5 percent.

This decline rate translates into almost 3 mbd of new supply needed just to offset declines, an amount that the Permian can’t, of course, counterbalance on its own. Moreover, mature wells, as a result of limited investment during the low price environment, could experience decline rates of 10-12 percent, according to Rystad, putting more strain on supply growth outside of U.S. shale, and specifically West Texas.

But low prices have stifled capex, while producers in Russia, Africa, South America, the Middle East, Canada, Asia, and the North Sea are all dealing with a host of issues, whether political, economic, or geological. “The U.S. is the best place to carry out oil projects,” Davide Tabarelli of Nomisma Energia in Italy told The Fuse. “It has the capital, the service sector, the expertise, the infrastructure, the technology, the right regulatory environment. Outside the U.S., though, there’s political instability and high costs for conventional projects that will keep development from happening.”

After two years of global capital spending declining, it will pick up only modestly in 2017, presaging a tighter market, particularly since larger conventional projects, which take a longer period to ramp up, are being delayed or scrapped.

barclays

The direction of demand is, as always, up in the air, given the uncertainty surrounding numerous factors underpinning growth, such as a strengthening global economy. But it’s clear that after growth of 1.7 mbd last year and 1.3 mbd in 2017, according to IEA estimates, increases of more than 1 mbd are likely over the next five years. Against this backdrop, the Permian isn’t even enough to meet growth in demand, much less offset declines.

So, even if you assume the Permian grows by the most optimistic scenario of about 1 mbd over the next decade, the world will still need at least 3-3.5 mbd of other new supply per year to accommodate demand growth and offset declines during that timeframe.

Financial constraints

To be sure, the Permian holds great promise, as evidenced by the rig count rising by 154 since last May to 270 and $32 billion in M&A transactions taking place during the same period, according to Woodmac. Furthermore, plays require $55 per barrel to be fully developed, but can be profitable in the mid-$30s, down from $70 a few years ago. “Stacked pay potential offers the promise of lengthy drilling programs that can usher a company well into the 2020s,” Woodmac says.

The shale boom has been stoked by easy credit, but that could come under strain now that rates are rising.

Permian growth, combined with better-than-expected growth in non-OPEC producers and OPEC output increases if the group returns to a pump-at-will strategy, could very well keep a global imbalance from occurring and prices from spiking. Nevertheless, a lot has to go right for the Permian, and any other shale basin, to continue to disrupt the global market and remain on a sharp trajectory upward that some like Pioneer’s Sheffield forecast. Worries about physical factors—such as decline rates and building infrastructure to keep up with supply growth—could hinder output, but financial factors are also concerning, not least of all rising interest rates. The shale boom has been stoked by easy credit, but that could come under strain now that rates are rising. On top of that, labor and service sector costs are on the rise now that activity has picked up at a brisk pace. Analysts have said that cost inflation could be the biggest challenge ahead for shale producers now that prices have risen and drilling has rebounded sharply. “We could see break-evens jump considerably,” said Larry of Oil Outlooks & Opinions. There’s also the irony of too much oil in the short run—helped by the Permian do doubt—driving down prices, which in turn would once again slow activity and by extension production growth.

The Permian will be the most closely watched production area in the coming years (except for maybe OPEC heavyweight Saudi Arabia, of course), but it shouldn’t be seen as the panacea to cap prices over the longer term. The global oil market has to deal with a lot of other trends outside West Texas that may cause a supply gap and price spike down the road.

 

 

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