Wednesday, February 04, 2015

Oil Stocks May Be A Big Win In 2015
[Editor: This is good news for the shareholders of SAW Pipe (which is widely used in the energy sector for the transportation of oil and gas) companies like Jindal Saw Ltd (Rs.80.20), whose products are also used in the oil and gas sector]
Feb. 3, 2015:  The basics of oil production are pretty simple - companies drill a well and if they find oils they put it on stream. The major capital costs are upfront, and production follows for years to come. 

The variable costs of production are relatively low, and royalties and taxes are usually tied to selling prices and are variable costs. 

As a result, once a well is producing oil companies are loathe to shut it in since even at low prices the well is very likely to produce positive cash flows. 

Production is highest when the well is first placed into production and tends to decline each year thereafter, a phenomenon often called the "droop" or "decline rate".

In shale oil production basins like the Bakken, the "decline rate" is pretty steep.

Summary
  • U.S. production of oil is still rising and may continue to rise for a while yet.
  • But the drop in capital expenditures and a sharp decline in the rig count point to lower production by year end.
  • In the Bakken and Eagle Ford alone, production could drop by as much as 1,250,000 barrels a day according to a TD Bank analysis.
  • The industry has reacted swiftly to lower prices and the recovery should emerge by the fall.
  • Now may be time to add to oils.
Oil sands production has a different set of dynamics more like mining. Capital costs are large and spread between the upfront costs and maintenance, and operating costs tend to be relatively high. At low oil prices, it may not make sense to continue to mine. Like metal mines, putting an oil sands mining project on care and maintenance at very low prices might make sense, although I don't recall such an event happening.

United States field production of oil today is 9.1 million barrels a day according to EIA. If no one drilled another well, it would decline possibly by as much 60% annually for new shale wells and perhaps 5% to 10% for wells that have been on production for several years. Across the industry, it is reasonable to assume a decline rate of 37% for the purposes of illustration, although the real figure varies widely by operator and by oil field.

The United States entered 2014 with oil production at about 8.1 million barrels a day. That means that without additional drilling, 8.1 million barrels a day would fall to 5.1 million barrels a day if all capital spending ground to a halt, using the 37% decline rate assumption to make the point.

United States capital expenditures for exploration and development totaled close to $250 billion in 2014, but my guess is that $100 billion of that went to natural gas drilling.

Now we are in 2015 and the base production level is 9.1 million barrels a day. At a 37% decline rate, production would fall to 5.7 million barrels a day without new capital spending. Capital efficiencies improve in industry downturns with rig operators charging lower day rates to keep busy in many cases.

Assuming a 20% improvement and using a $30,000 capital efficiency, capital expenditures in 2015 of $102 billion are needed to stand still. While the industry has announced plenty of cutbacks in spending, I think it is likely the industry will spend enough to more or less hold production at the 9.1 million barrel a day mark or perhaps slightly lower if WTI prices stay below $50 and capital cutbacks exceed $50 billion in the U.S. in 2015.

As it stands, oil production continues to grow in key regions - e.g., Bakken.

The point is that no one should expect an immediate dramatic fall in U.S. production. Higher prices will require greater consumption worldwide. Fortunately for oil investors, the U.S. consumption of oil continues to grow as the U.S. economy expands with imports growing from 6,856,000 barrels a day in the first week of January to 7,422,000 barrels a day in the week of January 23, according to EIA data. Those data are quite volatile and it is too early to predict a trend other than to say that in an expanding economy oil consumption tends to rise.


Looking out a few quarters, the glut may turn to shortage. TD Securities estimates that oil production in Eagle Ford could drop from over 1,500,000 barrels a day to about 750,000 barrels a day by year end based on an assessment of the rapid drop in rig count in the area.

TD sees the possibility of a drop of as much as 500,000 barrels a day of production from the Bakken using similar logic.

The fact is that the rapid drop in oil prices has seen a dramatic drop in capital expenditures for the energy industry already.

A big part of that reduction is a steep decline in the rig count across the U.S. oil patch.

Investors should expect quite a ride for the next couple of quarters and quite a few false starts before the oil price starts to show stability or give clear indications of a recovery. That will please traders but frustrate those who try to call the bottom.


Looking out a year or eighteen months, if the world economy does not slow and the pace of capital cutbacks continues globally, prices seem certain to recover and oil stocks should reward patient money. There is no need to heap risk on risk, so I will stick to quality names with solid balance sheets.

Note: The above are only excerpts from the main article on the website: Seeking Alpha

Courtesy: Seeking Alpha
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