Grant's Interest Rate Observer:  More Upside for Oil?

What if the supply glut that has bedeviled energy markets since 2014 is less severe than commonly believed?  That central question was placed under the spotlight by researchers at the Massachusetts Institute of Technology. The Energy Information Administration, they argue, has overshot its future production forecasts by attributing technological advances to recent output increases, rather than producers first drilling their most productive acreage due to the low price of oil.  Bloomberg has the details:

 

“The EIA is assuming that productivity of individual wells will continue to rise as a result of improvements in technology,” said Justin B. Montgomery, a researcher at the Massachusetts Institute of Technology and one of the study’s authors. “This compounds year after year, like interest, so the further out in the future the wells are drilled, the more that they are being overestimated.”

 

Margaret Coleman, the EIA’s leader of oil, gas and biofuels exploration and production analysis, said in an email “the study raises valid points” and the administration is looking to give its estimates a tighter focus. 

 

While government supply forecasts come under scrutiny, the current rate of production decline looks to be much faster than widely understood, if a recent analysis from the Boston Consulting Group’s Jamie Webster is on the beam.  Webster explained his thesis in the Petroleum Economist on Nov. 16:

 

Decline rates shrank in the initial phases of the price slump, as companies sought to keep existing production as high as possible by streamlining maintenance and focusing capital. Offsetting a field’s or well’s decline is, after all, often the cheapest barrel a company can bring to market. It was a way producers battened down the hatches to try to [outlast] what was at first thought to be short-lived price weakness.

 

As the notion that prices would stay “lower for longer” took hold, those temporary effects were undercut by the sharp drop in capex. The result was an increase in the decline rate. Rystad [Energy] estimated that 2016 had the highest decline rate of the past 25 years. It’s likely to get worse, too, as the recent deep spending cuts steepen the decline curve for the next two years. Furthermore, we can expect a long-term structural increase in the decline rate, simply because – in the absence of many new fields being developed – the average age of the producing ones is now trending upward. In 2017, we assessed the decline rate at 9+%, equating to about 8.8m [barrels a day]. That’s five times greater than the demand increment for 2017.

 

The questions over the prospects of domestic output growth come following yesterday’s agreement by the Organization for Petroleum Exporting Countries, along with Russia, to maintain their previously agreed upon supply cuts - which were scheduled to expire in March - through the end of 2018. 

 

Things may likewise be (finally) looking up for the drillers if a recent transaction between Transocean (NYSE: RIG) and DEA Norge in the North Sea for work beginning in mid-2019 is any indication.  According to analysts at Johnson Rice, the implied day rate for the contract came to $200,000, well above the existing contracted day rate of $180,000 for a North Sea contract on the rig, which runs through February of 2018. 

 

The price of oil has made a furtive rebound, with West Texas Intermediate crude trading towards the upper end of its two-year trading range near $58 per barrel.  WTI remains far below its 2010-2014 average of $91 per barrel, however.  Grant’s, which has proffered a kind word for the prospects of Texas Tea and an array of associated securities on a few recent occasions (Nov. 3: “Not the FANGs,” March 10: “Laddered oil play” and March 25, 2016: “Investment value – ‘on,’” among others), continues to expect good things from the energy patch.