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Editor's note: An original version of this article appeared in the December 2017 edition of Oil and Gas Investor magazine.
Each autumn, as the leaves begin to fall, executives start to collect data points, studies and projections from multiple sources, gathering acorns of insight ahead of the new fiscal year. After poring over reports to feed data into their internal models, they adjust their spreadsheets and scenarios.
There are no definitive answers, but CEOs seek strong signposts upon which to plan their 2018 budgets and production goals. These involve looking at oil and gas supply and demand, how much OPEC members will produce, geopolitical tensions such as in the Middle East, China’s oil demand and what the U.S. government may do to alter fiscal and regulatory schemes.
One of the most closely watched factors is the direction of U.S. oil production. Will it flatten or rise in 2018 to prolong a global supply glut? Pundits wonder: Will there be a supply gap if large international projects do not get the green light?
“The interesting tension going forward is the one between firming oil prices, on the one hand, and new-found capital discipline amongst E&Ps, on the other,” Bill Herbert, head of energy research at Simmons & Co. International, a Piper Jaffray company, wrote while reporting on Halliburton Co.’s third-quarter conference call.
Eric Otto, managing director at research firm The Rapidan Energy Group LLC, echoed that thought. He told Investor, “We think $45 WTI [West Texas Intermediate] is the dividing line in the capital returns vs. growth debate: Pressure on oil-weighted shale producers to prioritize capital returns increases below $45, but dissipates above $45.
“But even in a sub-$45 environment, not all oil-weighted shale producers can rapidly and materially alter their business models to pursue capital efficiency over growth, primarily due to leverage constraints.”
The key question for all: What would cause the price of oil to rise to a sustainable $55 or $60 per barrel (bbl)? The motto for every company until that day arrives may be “Stay lean and mean in 2018.” Meanwhile, here are some factors to consider.
Oil prices
A poll of 15 investment banks conducted by The Wall Street Journal expected WTI to average $50 next year, but answers vary widely. All expressed concerns that the oversupply of oil will continue into 2018. U.S. shale production and bloated global inventories are the two biggest factors.
RBC Dominion Securities Inc. upped its call on WTI to $51/bbl in 2018, but said oil likely will be rangebound between $45 and $55, rising to average $54 in 2019.
In October, Wells Fargo Securities LLC senior analyst Roger Read revised the firm’s estimate to $49.49/bbl for 2017. He also projected the price to be flat at $49.25 for 2018 and rising slightly to $51 in 2019, up from his previous projections of $47.73, $47.52 and $50, respectively.
A Barclays report noted that commodity prices can diverge from their fundamentally justified fair value for many reasons, including if media reports and analysts repeatedly use easily identifiable phrases such as “supply glut,” “lower for longer” and so on. These can adversely influence market sentiment, it wrote.
“The rebalancing is fragile and could reverse … even if OPEC extends its policy through year-end 2018,” Barclays reported. “Our most up to date balances suggest supplies will be higher from November to next June, reaching over 100 MMbbl/d for the first time.”
It has WTI ending 2017 averaging $49 and its 2018 forecast is also $49. However, it added, if WTI should rise above $55, U.S. producers will drill and complete wells at a faster pace than they did in late summer. The U.S. oil rig count plateaued in August and had slid by 32 by mid-October.
U.S. oil production
The advent of shale oil production and U.S. oil exports have changed every market dynamic. The U.S. Energy Information Administration (EIA) projects U.S. production from the big five oil plays (Bakken, Eagle Ford, Permian, Powder River and Niobrara) will be 5.9 MMbbl/d this November, rising again throughout next year.
Coincidentally, this number is almost as much as what the entire U.S. produced from all plays in first-quarter 2012, when the shale plays began to take off , and U.S. oil production hit 6 MMbbl/d for the first time in 14 years.
At press time, U.S. oil production was 9.2 MMbbl/d. At $49 WTI, the EIA estimates U.S. daily production could grow by nearly 590,000 bbl in 2018. Tudor, Pickering, Holt & Co. has a rosier forecast of an incremental 927,000, thus estimating total U.S. production will rise to 10.2 MMbbl/d sometime in 2018.
Oil market balance
Oil prices hinge on the supply-demand outlook, but defining that may be a fool’s errand. FBR & Co.’s Benjamin Salisbury noted in a report that, in the past two years, the International Energy Agency (IEA) has raised its OECD oil demand figures 25 times—and lowered them 10.
Some observers say the market will balance soon. Commercial stocks in the developed world have been falling and the market is nearing balance already, the IEA reported in October.
Other observers think this won’t occur until mid-2018; a few postulate not until first-quarter 2019. OPEC’s “Monthly Oil Market Report,” released Oct. 11, said the cartel raised its global demand estimates again, emphasizing a supply deficit coming in 2018 due to the lack of spending on major projects to fill the oil demand gap.
On the other hand, Barclays Investment Bank reported that it expects inventories to build again next year—therefore, it expects WTI to begin 2018 at $53, but to average $49 through 2018.
The Rapidan outlook agreed, seeing the global oil surplus continuing in 2018, despite widespread belief that OPEC and Russia will extend the duration of their production cuts beyond March.
“Once the market focuses on that, the oil price will move down,” Otto said. “Our fundamental outlook for oil remains bearish (risk skewed to the downside) and we expect 2018 Brent will average in the low $40s (with prints in the $30s), barring an unlikely (15%) Saudi decision to cut to 9.5 MMbbl/d or below.”
Barclays tabulated that the current pipeline of upstream projects require 700,000 to 800,000 bbl/d of U.S. tight oil growth in the medium term to match global demand growth of 1.3 MMbbl/d between 2018 and 2020.
“The disagreement between crude trading groups on future price movements underscores the uncertainty over the key drivers of oil supply and demand,” Gaffney, Cline & Associates Ltd. reported in its “Oil & Gas Monitor” in October.
“Growth in consumption has been stronger than expected this year, aiding the recent price gain, but the swiftness of an expansion in U.S. output has also proved hard to predict,” the firm reported.
“A surprise from one of those competing forces in 2018 could tip markets in either direction. Demand is growing, oilfield productivity is declining in the U.S. and further weakening of the dollar may boost commodities. The market has tightened in the last few months, but U.S. shale producers have the ability to drive down prices, just as they did back in 2014.”
FBR Capital Markets & Co. reported, “We believe demand growth, more than supply quotas or rig count reductions, is paramount to restoring market balance for oil inventories.
“Conventional models continue to predict a slowdown in demand growth for 2018 with the IEA projecting just 1.38 MMbbl/d, up 1.4% vs. our 1.7 MMbbl/d, up 1.7%. This demand growth, which we currently estimate to exceed or equal production for the next three quarters, will require draws on oil stockpiles.”
Natural gas macros
Analysts continue to say that there is an overabundance of gas supply that can be economically developed in the U.S. at $3 per million British thermal unit (MMBtu), with that price not changing much through the end of this decade. This outlook is despite increasing exports to Mexico and to LNG buyers.
Scott Hanold at RBC Capital Markets LLC has said more than once that gas prices look rangebound over the next 18 months. “Our base decline rate is 27%, but that is less relevant due to accelerating growth from associated gas driven by oil plays.” Additionally, with production growth in Appalachia resuming in 2018 once new takeaway capacity comes on, any gas demand gains can be offset by incremental gas production.
Wells Fargo Securities LLC recently reported, “With natural gas supply growth well underway and a wave of new pipeline projects set to come online in 2018 and beyond, we view the setup for 2018 and 2019 as challenging.
“As a result, we are lowering our 2017E, 2018E and 2019E natural gas price forecasts to $3.15/MMbtu, $3.06 and $3.06, respectively, down from $3.29, $3.25 and $3.25 per MMBtu, respectively.”
Oilfield service costs
Oilfield service firms have gradually begun hiking their prices, warning that costs along their supply chain have begun to rise again. Wages for rig and frack crews, in particular, will be an inflationary factor in 2018. In surveys, most E&Ps have said they think service costs will rise about 10% overall in 2018, possibly more if the service companies continue to be challenged in hiring—or rehiring—employees as market demand increases.
Insights from oilfield service giants Schlumberger Ltd. and Halliburton are helpful, as they touch every part of the U.S. and global drilling industry. On the company’s third-quarter conference call, Schlumberger chairman and CEO Paal Kibsgaard said the reduction in global oil inventories in the third quarter was “clearly showing that the oil market is now in balance, which is reflected in the upward movement in oil prices over the past month.”
He cautioned, however, that investment appetite for North America land activity “seems to be moderating, driven by a growing focus from E&P companies on financial return and the need to operate within cash flow, rather than the pursuit of production growth.”
Kibsgaard also cited another longer-term trend, namely that spending around the world is at what he called “unprecedented low levels,” raising medium-term global oil supply challenges, thus increasing the urgency for higher investment, a theme echoed by other large service companies as well as by think tanks and consultants such as Wood Mackenzie and Stratas Advisors.
On its conference call, Halliburton president and CEO Jeff Miller said the U.S. frack market is sold out through year-end with visibility into the first part of 2018, and it is encouraged by feedback from customers. It sees continued improvements in pricing and utilization next year, meaning service costs will continue to rise for E&P clients.
Longer term, other trends have been noted.
“The [oilfield service] industry is seeing a significant shift in strategic direction, which is driving capital-markets activities in different directions as well,” Credit Suisse managing director, equity research, Jim Wicklund recently reported.
U.S. land rig contractors are aggregating services and products synergistic with drilling activity, so far mainly directional drilling, running casing and tubing, and equipment rental, “since a flat rig count (with flat pricing and legacy contracts still rolling off) doesn’t provide much of an avenue for growth for a while,” he said.
The pressure pumping industry is seeing the reverse, Wicklund said, “with sand and chemical sales directly to E&P customers, disaggregating the revenue streams relative to 2014, eliminating lower-margin, but very high return, revenues.”
Wicklund noted that much of the consolidation in the industry is happening among lower-market-cap companies, “and, in many cases, recent IPOs that have come out with no debt and [with] public equity. Other than the efforts by land drillers, the established larger-cap companies either don’t have the balance sheets to be active consolidators or are outbid by non-traditional funding sources.”
Last, there is a wave of companies announcing their willingness to be acquired, and 10 to 15 hope to go public if the markets allow.
Capital spend trends
Despite company pledges to the contrary, Wells Fargo analyst Gordon Douthat thinks E&Ps will continue to outspend cash flow in 2018. “While we expect operators to highlight capital discipline and a growth-within-cash-flow message, we believe old habits die hard with E&Ps continuing to outspend in 2018E,” he wrote in a report.
“Our estimated 2018E capital spend is 128% of cash flows, vs. 141% in 2017E and 113% in 2016. Overall, we expect 2018E capex to increase by $3.8 billion over 2017E, or 14% growth year-over-year, and we anticipate a faster pace of cash-flow growth at 26%.”
KeyBanc Capital Markets Inc. analyst David Deckelbaum agreed on the outspend, but not to the same extent, as he tracked 32 public E&Ps in his coverage universe ranging in size from Pioneer Natural Resources Co. to Approach Resources Inc. He predicts the average outspend in 2018 will be just 9.7%—almost half what it’s been this year and indicating more capital discipline.
Another positive sign Deckelbaum cited: In 2017 the debt-to-EBITDA ratio averaged 2.2x for the group, whereas he estimates that in 2018, the ratio will improve to only to 1.7x.
“Ultimately, the oilfield service industry will respond to customers’ needs by deploying additional equipment as required, and [new] crews will naturally advance up the operational learning curve. But U.S. oil production growth in 2018 at or above our current macro forecast of 927,000 bbl/d may be hard to achieve, even if crude oil fundamentals and pricing continue to improve,” he wrote. “In some cases, operators appear to be building their DUC [drilled but uncompleted well] backlog in order to smooth out operational risk heading into 2018 and avoid some of the pitfalls seen over the last two quarters.”
As you can see, there are no clear answers, only scenarios. One can simply look at the Nymex 12-month strip prices, hedge accordingly, and call it good, although most people like to delve a little deeper when it comes to forecasts about commodity prices, and how to manage operations in order to boost the bottom line to a higher number.
We can only hope the ultimate return on capital employed is a number to brag about in investor presentations come next December.
Industry sentiment
Bernstein Research, R.W. Baird & Co. Inc. and the Dallas Federal Reserve Bank gauged industry and investor sentiment in polls in September and October, drawing on a wide cross-section of oil and gas industry participants and buyside analysts.
Bernstein found the three-year price outlook for WTI remains about equally split between people favoring $50 to $60 and those who more optimistically think prices will reach a range of $60 to $70. Some 48% of its respondents thought natural gas prices would be between $2.50 and $3.
The 78 E&P executives who responded to the “Dallas Fed Energy Survey” said, on average, that U.S. production would be 9.9 million barrels per day (MMbbl/d) next year, above the current 9.5 MMbbl/d.
The Baird survey showed that, despite WTI’s recent push above $52, “investor bullishness remains scarce with 80% of respondents expecting $50/bbl to cap WTI for the next three months, and 61% see the $50-to-$60 range to persist long term, up from 56% in our prior [quarterly] survey.”
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