Who Will Win The Oil Wars? US Shale, OPEC Or Consumers?

In less than a decade, the U.S. shale oil revolution has brought consumers worldwide billions of dollars in savings, driving down the price of gasoline, fuel oil, air travel, plastics and countless other household budget items.

Before a fresh supply of shale oil drove U.S. crude output to records in 2013 and 2014, U.S. benchmark oil often traded above $100 per barrel. Then came the price war. Prices dived more than 75%, to near $26 per barrel, in the 20 months through February last year, as producers worldwide pumped at record levels in a battle for market share.

Now the contest between shale’s still-emerging revolution and the old-school keepers of global oil price controls has entered a critical new phase. A vulnerable agreement between Saudi Arabia and Russia is attempting to hold down global oil supplies and bolster prices into the $50 to $55 per barrel range. Shale oil producers in the U.S., anxious for a recovery and operating with no pretense of balancing supply and demand, pose a clear threat to OPEC’s goal.

Trading underscored those concerns over the past week, driving West Texas Intermediate oil down 4% for the week through Friday afternoon, despite data for a second week showing surprisingly heavy withdrawals from U.S. inventories.

Shale oil producers have learned to cut costs and extract more oil with less gear and smaller work crews. At the prices sought by OPEC, industry experts project a new shale production boom, one large enough to possibly outstrip the rise in global demand growth and push oil back below $50 — possibly far below.

That is a promising prospect for much of the global economy, which benefits when oil, gasoline and natural gas prices remain low. But not so for the oil trades. The outlook presents a conundrum to investors working to assess whether to place bets on estimates for a sharp recovery to profitability this year among U.S exploration and production companies, or on the very different prospects presented by the below-$50 price scenario.

In oil, $50 is not a magic number above which all or most producers suddenly become profitable, says Richard Mason, chief technical officer with Hart Energy, a Houston researcher and publisher. But it does tend to mark a technical level above which industry confidence rises.

“It’s a spectrum,” he said, “but that 50 marker seems to have a psychological effect.”

When oil holds above $50, stocks like Pioneer Natural Resources (PXD), EOG Resources (EOG) and Continental Resources (CLR) become attractive. The companies ramp up production. Revenue and profits may grow. All three companies are among the long list of E&P names for which consensus views, based on oil at or above $50, call for significant rebounds in earnings this year.

When oil remains below $50, investor attention turns to refiners like Phillips 66 (PSX), Valero Energy (VLO) and Marathon Petroleum (MPC), as well as chemical plays and other stocks that benefit from cheap oil.

Russia Joins OPEC

If there was any question about U.S. shale’s impact, it was answered when Russia emerged as a working member of the Organization of Petroleum Exporting Countries, starting with a production-cap agreement early last year.

“Russia and Saudi Arabia have nothing in common except for oil prices,” said Fariborz Ghadar, director of Pennsylvania State University’s Center for Global Business Studies. “When it comes to oil price coordination, they’ve grown closer together.”

Russia and Saudi Arabia have vied for the role of top global oil producer in the past two years as U.S. production retreated with the price collapse. Russia overtook Saudi Arabia last year as the leading energy vendor to China.

But Russia’s cooperation revived Saudi-led OPEC’s influence over global supply and pricing. In February 2016, Russia and a group of OPEC oil ministers tentatively agreed to freeze oil production at then-robust levels. Russia’s participation was just enough to bolster oil traders’ confidence. The pact chalked off the low point of oil’s 20-month decline and launched a 96% price rally over the next four months.

In November, Russia signed on to an OPEC production agreement, and the group enacted a three-month cutback, beginning in January. On May 25, Russia agreed to OPEC’s extension of those cuts to March 2018.

Is it too strong to say that Russia has become a de facto member of OPEC?

“No, it isn’t,” Ghadar said. “They are acting more a member of OPEC than most of the OPEC members.”

Shale Gets A Turbo-Boost

What happens next is likely to depend largely on how U.S. shale oil producers behave.

The Energy Information Administration estimates U.S. oil production this year will increase 300,000 bpd, to a total of 9.3 million barrels per day. For 2018, it projects another 700,000 barrels per day of new supply, raising U.S. daily output to around 10 million barrels. Saudi Arabia averaged 10.5 million barrels per day in 2016. Russia sucked up 10.96 mbpd for the year, topping out at 11.2 million barrels in December.

But new shale-production techniques make predictions difficult.

One big advance, says Mason at Hart Energy, is keeping hydraulic fracturing events close to the wellbore, rather than employing massive, more wide-ranging fracks.

Fracks formerly reached out 100 feet or so and generated recovery of 6% to 9% of oil in place, Mason says. “But fracks now are reaching out only around 25 feet, and what we’re getting there is probably 20% or better,” he said.

Advances in directional drilling, geo-steering, better bits and more sophisticated down-hole communication are allowing drillers to turn out of a vertical well and exploit thinner layers of oil-rich rock.

“That becomes very important when we look at the stacked plays, like in the Permian Basin, where we might have from four to 13 horizons potentially that can communicate or produce oil,” said Mason, who published the closely watched Land Rig Newsletter for 17 years.

The result: Fewer rigs and smaller frack crews can now produce more growth.

Mason warns that this does not necessarily mean the industry has driven down its breakeven price per barrel of oil to the sub-$45 and sub-$40 levels that some producers have claimed.

“I’m just talking about the technology,” he said. “The economics is a different story.”

Field surveys on both the services and the exploration-and-production sides of the business generally come back with prices near $55 per barrel, where things really start to look economically attractive.

“We just did a piece on the Eagle Ford,” a massive shale play in south central Texas, “and the price people needed there, on average, was $56,” he said.

As a result, even at $50 to $55 oil, the industry remains in a kind of a twilight zone, Mason says. The price level is good, but it’s not quite good enough to be economically viable immediately.

“You still see a lot of really big companies out there that we would classify as among the better operators, and they still show negative quarterly returns,” he said.

Watch The Borrowing Base

In any case, OPEC appears to be targeting oil in the $50 to $55 range, and spending plans are clearly ticking higher among a growing number of independent shale producers. Among the big integrated oil companies, Exxon Mobil (XOM), Chevron (CVX) and Royal Dutch Shell (RDSA) have announced $10 billion in combined spending on U.S. shale projects this year.

That means rising supplies will be rolling onto the market. But, unless prices crash, there is scant hope that producers will attempt to limit supply to the rise in demand.

“They can’t do it at all,” Mason said. “Everybody’s self-interest precludes any type of cooperation at all to try to hold supply back.”

The bottom line: The rising supply of shale oil likely will overpower rising demand, and OPEC’s $50 floor will cave. Welcome to the next cycle.

The industry has changed since the 2014 price plunge. More than 240 U.S. exploration, production and services companies declared bankruptcies after oil prices fell in 2014. The shakeout left the surviving companies better situated to handle another downturn, according to Matt Ferris, partner with energy bankruptcy specialist Haynes & Boone.

The number of new bankruptcies tapered off entering 2017, as shown in Haynes & Boone’s Oil Patch Bankruptcy Monitor reports. But circumstances vary. Services companies, which do not have the more easily liquidated acreage assets that E&Ps do, continue to report bankruptcies and restructurings at an undiminished rate.

Oil-services prices recover more slowly than oil prices in the industry cycle, adding more pressure to services companies. And this time around, production advances likely mean less demand for services crews and drilling rigs.

Ferris says about 1 in 4 companies remain at risk of a decrease to their borrowing base, which limits their credit access. A dive in prices back below $50 for an extended period of time could increase the number of at-risk companies — a red flag that the industry may be due for more shakeouts.

Demand Set To Rise For Sand, Rail

A couple of bright spots stand out for investors. Keep an eye out for exploration and production companies reporting rising profits, particularly those that have outrun their hedged production contracts. They could be showing signs they’ve reached the sub-$50 breakeven points that some in the industry have claimed. But be cautious. They could also be companies simply cleared of debt by bankruptcies.

In oil services and many types of equipment, demand looks likely to remain weak.

But one segment seems poised for high demand: what the industry calls proppant, the majority of which is called fracking sand.

“Right now, sand has been the most inexpensive thing you can use to dramatically increase your production,” Mason said. He explained that multiple horizontal, or lateral, legs are drilled radiating outward from each vertical well.

“We are literally putting a trainload of sand per lateral in the ground,” he said. “And when I talk about a trainload, I’m talking about 100 cars of sand.”

That puts a focus on names like U.S. Silica Holdings (SLCA), Hi-Crush Partners (HCLP), Emerge Energy Services (EMES) and Fairmont Santrol Holdings (FMSA).

At a hundred carloads per well leg, railroads are also key beneficiaries — but only if Saudi Arabia and Russia can push oil prices to $50 or above for a sustained period.

The market is skeptical. Since the May 25 agreement, West Texas Intermediate oil dived back below $50 and is trading near $48 a barrel. That’s held the pressure steady on the shale-heavy Oil & Gas-U.S. Exploration and Production industry group, which languished at a weak No. 190 ranking on Thursday, among the 197 industries tracked by IBD.

From the consumer’s point of view, the lower the better. Every $10 decrease in oil prices translates to a 25 cent-per-gallon cut in gasoline prices, according to Beth Ann Bovino, U.S. chief economist for S&P Global Ratings. The same cut in oil prices also produces an increase of around 30 basis points in consumer purchasing power.

“The lower gasoline prices go, the more confident people feel,” Bovino said. “When things become cheaper, people buy the bigger car or, instead of driving to their local beach, they drive all the way down to Florida.”

IBD