Oil and Gas

OPEC harmony and shale reality

RIYADH — As oil prices have been on a recovery path, the general consensus seems to be a continued increase in US shale production to record levels, according to a report by Al Rajhi Capital on Oil markets. While this may be the case, the report observes that despite rising prices most firms under its study are still in losses with no signs of improvement and average ROA is still a measly 0.8% on account of higher capex and leverage. Moreover, in Q3, the average operating cost per barrel has broadly remained the same without any efficiency gains.

The shale firms have been exuberantly investing even as the price per barrel required (currently $64/barrel) to meet cash flow requirements has only been increasing. Even when capex declines, we are unlikely to see any sustained drop in cash flow required per barrel due to drop in production due to the nature of shale production and rising interest expenses. Hedging benefit was negligible in Q3 2017. Overall, the report does not see this sustainable for long.

OPEC’s dynamic strategy.

We sense more unity among OPEC members as well as Non-OPEC allies to take a collective decision which will especially help to manage the market balance and any potential risks, namely

a) uncertainty in production outside OPEC, mainly Shale production and

b) Chinese demand for oil. Therefore, though following the extension of current production cut agreement till December 2018 — shale producers may gain more market share in 2018 — OPEC might devise a new strategy (which may not only just be capping production) so as to manage an oil price optimal enough for the existing fields to continue production but rebalance the market.

OPEC is closely monitoring US inventory level for future action. Though US commercial inventories have declined by over 100m barrels in 2017, it is still higher than 2014 levels. Given that average global consumption was 93.6m b/d in 2014, and is likely to increase to 100.1m b/d in 2018 and 101.8m b/d in 2019, the optimal level of inventories to meet surge in demand or untoward disruption in supply required could be higher in general. However, even as oil inventories are declining we would expect the level to further decline before OPEC takes a call on further action.

Compliance status improves: Based on OPEC’s secondary sources production data of 11 producers (ex-Equatorial Guinea), average OPEC compliance improved to ~130% in December. Nigeria (being exempt from cuts) continued to increase its output for the second straight month, offsetting the decline in production from Saudi Arabia and Venezuela. This has resulted in a net rise in overall production for the OPEC members in December. Meanwhile, non-OPEC members have also marginally increased production, reaching a compliance level of 96% by November (as per IEA data).

Demand: The oil demand is likely to pick up in the near to medium term on the back of improving global economic activity. OPEC has recently raised its oil demand forecast in its January 2018 report, reinforcing our view. Trailing twelve month (TTM) vehicle sales grew 3.5% y-o-y at the end of Q3 2017. Vehicle sales continue to be driven by emerging markets (EM), primarily by China (7.7% TTM y-o-y growth).

Shale health check up

1. Shale profits and stock performance: We observe that despite rising crude prices, most of US shale firms under our study were still in losses till Q3 2017 with no signs of improvement and average ROA was still a measly 0.8% on account of higher capex and leverage. At the same time, the stock performance of all these companies (under our sample) also reflected the weak earnings performance, posting negative returns during the 9M 2017. Whiting Petroleum and Oasis Petroleum shares plunged by ~55% and ~40%, respectively, while Concho Resources witnessed a minor decline of ~1%.

2. “Cash required” per barrel to meet expenses & capex requirements is increasing despite stable operating efficiencies. The average operating cost per barrel (based on our sample companies and our methodology) increased in Q3 2017. However, excluding one company (Pioneer natural Resources) from our analysis, which witnessed a steep increase in operating cost per barrel, the average operating cost remained almost stable.

3. Cash required to meet expenses increased Despite largely stable operating efficiencies of US shale producers, our calculations show that “Cash required per barrel” (Operating costs + depreciation + interest expense + tax

expense + capex on drilling and exploration activities) continued to increase for the

third consecutive quarter, reaching to $64/bbl in Q3 2017 from $63/bbl in Q2 2017, primarily on account of the increased capex (~17% q-o-q rise).

Within the Permian basin, Diamondback Energy, which is pure play Permian shale producer, has still one of the lowest requirements of cash per barrel of $53/bbl, while Energen Corp. and RSP Permian need $65/bbl and $66/bbl, respectively to start generating positive free cash flows.

4. Hedging benefit negligible in Q3 2017. A look at the US shale producer’s average hedged realization indicates a decline in gains in Q3 2017 compared to Q2 2017 ($1.0/bbl vs. $1.8/bbl), which is miniscule, in our view. This compares meekly with the numbers for FY15 and FY16 at 15/bbl and $9/bbl, respectively. Despite recovery in oil prices, it is unlikely to see a significant improvement in hedging benefits in the near-term, as most of the US shale producers have already hedged their part of production at lower than the current market prices. However, if oil prices sustain at the current level, US shale producers could start increasing their hedging positions at higher rate, which would help them to surpass 10.5mb/d volume at the end of this year.

5. Shale producers raising debt to fund their capex programs, which could weaken their own financial health in case of decline in oil prices amid rising US production. After bottoming out in the H2 2016, capital expenditure by the shale producers in our study has remained on an upward trend in 2017, primarily due to recovery in oil price post the OPEC agreement. We note that the increased capital expenditure puts the shale producers deeper in debt, reflecting from rising total debt for these companies.

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