Is US oil production still viable at below $30?
Investors know all too well the fallout currently taking place in the energy markets. With crude tumbling below $30 per barrel, investors are bracing for the prospect of a series of bankruptcies of small, highly indebted drillers. That is because at such low prices, the economics of oil drilling, particularly in onshore fields, are untenable.
Three of the major U.S. producing oil fields are the Permian Basin, the Eagle Ford shale, and the deep-water Gulf of Mexico. Each region has its own various levels of profitability, but one thing appears to be certain: with OPEC thus far signaling no willingness whatsoever to cut production and risk ceding market share, the biggest production cuts are likely to come from U.S. oil developments.
This article will discuss the economics behind the key U.S. oil plays, and where the biggest production cuts are likely to come from.
Gulf of Mexico may fare better
The Gulf of Mexico, until recent years, was a very difficult region to explore for and develop oil. Oil deposits are plentiful, but much of the oil is so far down below the surface that it is extremely difficult to get to. However, thanks to advances in drilling technology, the massive supplies in the Gulf are now being tapped into. Many Big Oil firms have made Gulf exploration and production a strategic imperative. For example, Chevron Corporation (NYSE: CVX) is ramping up a major project called Jack/St. Malo in the deep-water Gulf. This project is key to Chevron’s goal to reach 3.1 million barrels per day in total production by 2017. But abnormally high costs threaten the viability of deep-water Gulf drilling, as oil at extremely low depths is not easy to get to. That has made efficiency a priority. Chevron announced in its last quarterly earnings presentation that it improved drilling efficiency by 30 percent at Jack/St. Malo.
Overall, analysts are bearish on Chevron going forward. On a scale of 1.0-5.0, with 1 being strong buy and 5 being strong sell, Chevron earns a 2.3 rating from the research analyst community. Analyst consensus is for earnings to decline 25 percent in 2016. That being said, Macquarie did recently upgrade Chevron to ‘outperform’ from ‘neutral’. Separately, analyst David Rosenberg with Gluskin Sheff recently said “While we may not have yet reached a bottom, the fact of the matter is that this drop in the oil price, in the context of its bubbly predecessors, seems rather long in the tooth.”
The Gulf of Mexico is a critical region for domestic production. In fact, Gulf of Mexico federal offshore oil production accounts for 17 percent of total U.S. crude oil production. This makes the Gulf ripe for production cuts if the oil industry enacts a meaningful supply response to low commodity prices. The good news is that because of the long length of time to bring Gulf of Mexico projects from planning to start-up, the drop in the price of oil is not likely to impact projects there this year.
The EIA does not expect production to dip at all over the remainder of 2016. Projects currently in very early stages face risk of postponement, but projects nearing completion are not expected to be affected. The U.S. Energy Information reports that 13 major projects are expected to start up in 2015 and 2016 combined. As a result, it appears operating conditions in the Gulf of Mexico remain satisfactory, at least in the near-term.
Onshore shale fields are the most vulnerable
Of the major oil producing areas of the U.S., the onshore shale plays appear to be the most vulnerable to major slowdowns due to the crash in oil and gas prices. The onshore shale fields are bearing the brunt of the massive drawdown in weekly rigs, and that trend is likely to continue given the less-than-optimal economics.
The first disadvantage to onshore drilling is that these oil fields tend to have steeper rates of decline and shorter life spans. Whereas offshore deep-water wells can produce for decades, the average onshore well declines significantly after its first few years of full production. The other significant disadvantage to onshore drilling is that there simply isn’t nearly as much oil onshore as there is offshore. Industry research indicates there is potentially 48 billion barrels of undiscovered oil in the Gulf of Mexico, compared to just 13 billion barrels of undiscovered oil onshore.
This is borne out in the weekly rig count issued by oilfield services firm Baker Hughes (NYSE: BHI). The most recent tally states that Gulf of Mexico rigs have declined by 47 percent in the past year, although last week the Gulf actually added 2 more rigs, an 8 percent week-over-week increase. It seems rig activity in the Gulf is picking up slightly, due to the attractive nature of the oil fields there. Meanwhile, onshore fields continue to shed rigs. Last week’s total of 635 land rigs was down by 5.5 percent from the previous week. Over the past year, land rigs have declined by 62 percent.
Consider the steep decline in production in the Eagle Ford. Last month, production there totaled 1.1 million barrels per day, respectively. In the same month last year, production exceeded 1.6 million barrels at the Eagle Ford shale. In the Permian Basin, legacy oil production is down by more than 80,000 barrels per day, the steepest decline rate at any point in the past decade.
Going forward, as commodity prices continue to fall, this trend should only continue. Investors should look for the major producers in the onshore regions to keep cutting capital spending to shore up balance sheets. The next step in the process would be to reduce production to get costs in-line with the commodity price environment.
Companies to Watch
Chevron: Chevron is a major producer in the Gulf of Mexico. The Jack/St. Malo development is projected to have a 30-year planned production life, and current technologies are expected to produce more than 500 million oil-equivalent barrels.
Pioneer Natural Resources (NYSE: PXD): Pioneer has a huge presence in some of the premier oil and gas producing fields in the United States, including the Permian Basin and the Eagle Ford Shale. The company has a total resource potential of more than 11 billion barrels of oil equivalents. Consensus analyst estimate is a ‘buy’ rating with a $162 median price target, which represents 45 percent upside potential.
EOG Resources (NYSE: EOG): EOG Resources is the largest crude oil producer in the Eagle Ford region, after a massive expansion in oil production. EOG’s oil production grew at a 40 percent compound annual rate from 2010-2014. The company may have to make difficult decisions on production in this low-price climate. Consensus rating is a ‘buy’ with a $87 median price target, which represents 40 percent upside potential.
Bob Ciura is an independent equity analyst. Since 2012, his work has focused on fundamental investment analysis of publicly-traded companies in the energy, technology, and consumer goods industries. Bob has a Bachelor's degree in Finance and an MBA in Finance.