Revving up: US oil production in 2017

Feature | 22 May 2017
Oil_Field

US oil production is set to increase in 2017 following a year-on-year decline in 2016, but cost inflation and efficiency gains could put brakes on the output surge before the year is out, says Abhishek Deshpande

In this report, a continuation of our series on the oil and gas sector, we have tried to compare and contrast US upstream fundamentals. This has been done by analysing US crude production and trends in various basins as well as reconciling this against the guidance given by US upstream operators. We have also looked at the financials of companies in our sample to get a wider understanding of the health of the sector. By doing this, we endeavour to provide a detailed outlook of the US upstream sector in the near term.

Based on our productivity model, we expect US oil production to increase year-on-year by 500,000 barrels per day (b/d) in 2017. Extrapolation of the guidance provided by our set of 68 companies indicates a rise in production of 1.1 million b/d in 2017.

Total capital expenditure is set to increase 19.9% year-on-year (yoy) from 2016, by US$13.3bn.

Risk management for 2017 indicates US oil companies are hedged 5% above their 2016 average, at 30%. There are also more 2018 hedges in place relative to the same time last year. However, overall 2018 hedges remain low.

Producers look to benefit from upside in
oil prices through the preference for options-based hedging strategies than swaps, according
to our analysis.

Many companies remain with negative free cash flows and high total debt which could affect their operations in the short term, but we expect the worst of the bankruptcies to be over.

Productivity model

Our production model, based on the productivity of the seven main basins in the lower-48, projects a strong growth outlook for US oil production. When backdated, this closely aligns with the actual yearly change in oil production from
these regions.

Even with a decrease in one rig per basin, monthly production growth will persist due to the increasing levels of productivity assumed. Notably, the case of an increase in one rig per month in each of the seven basins leads to a 2017 production growth of 590,000 b/d. Using this as the basis for our central scenario and factoring in the rest of lower-48 production, along with the other sources of supply as above, we expect US oil production to grow by 500,000 b/d.

The shortcoming of this analysis is in its inability to anticipate accurately the technological gains and at what point of technological curve shale oil is currently. Nevertheless based on past precedence of underestimation of productivity gains from US shale basins, we have used a moderate increase in US shale oil growth in our central scenario.

US upstream

Total US oil production declined yoy by 540,000 b/d in 2016 (and 450,000 b/d on exit rates) while total liquids production (which includes refinery processing gains and natural gas liquids (NGL) production) declined yoy by 300,000 b/d (and 390,000 b/d on exit rates) in the same period. The latest figures for March 2017 show that oil production currently stands at 9.08m b/d, which is a 501,000 b/d increase on the lows of September production levels of 8.57m b/d.

The Baker Hughes US oil rig count stands at 683 as of 14 April 2017, compared to the lows of 316 in May 2016. Including gas rigs, the horizontal rig count has almost doubled since the trough seen in June 2016, signifying how the recent production growth was driven by tight oil production in the lower-48 basins. Vertical and directional rigs continue to remain at depressed levels.

Gulf of Mexico and Alaska

Gulf of Mexico production has continued to maintain its growth trajectory for the last few years, increasing by 92,000 b/d in 2016 (and 124,000 b/d on an exit rate basis) to 1.61m b/d. The production in Alaska has remained stable in 2016 at 490,000 b/d. Gold of Mexico production increased by 133,000 b/d on a yoy basis in 2017Q1 to 1.74m b/d, while Alaska is relatively unchanged at 500,000 b/d.

Lower-48

From the breakdown of the main shale-dominated basins, we can see that Eagle Ford and Bakken were the main sources of the decline from 2014 onwards. Permian has continued to grow albeit at a slightly slower rate. It is also interesting to note how productivity growth (oil production per rig based on new wells) stuttered in late 2015 for Bakken and Permian before resuming their growth trajectory along with other basins. This was primarily driven by the challenging pricing conditions. However, the latest data suggests a slowdown in productivity growth, which could impact the growth outlook for US oil production in 2017 and 2018.

Are we reaching the top of the technological 'S' curve, or is there more mileage to the current improvement in productivity? Many analysts argue that productivity is likely to rise further. We also believe at the same time that
high grading and cost deflation in the past have partially contributed to the improved production growth in recent months, hence break-evens.

Based on scientific literature, the estimated ultimate recovery (EUR) of wells derived has intrinsic shortcomings due to the length of available data series. Well saturation in sweet spots, a consequence of high grading has likely led to interference, where subsequent wells drilled too close to an existing production well could ultimately result in a lower EUR due to the increased interconnectivity of fractures in the shale formation, reducing overall formation pressure. Although the saturation of wells increases short term production volumes, the total recovery, or EUR could be lower.

The impact of legacy production change has lessened for all seven basins put together since the beginning of 2015. Eagle Ford has been the key player in maintaining production from older wells. However, this appears to have reversed as depletion rates in the Permian have increased. The state of Oklahoma has seen production stagnate
in 2016 despite the prolific SCOOP/STACK region within the state supporting production and rig count.

Figure 1: US production (million b/d)

Source: EIA, Natixis

US producers

In addition to our regional production analysis, we have also reviewed the 2017 production guidance provided by a selected group of US oil companies, including oil and condensate production and excluding natural gas liquids (NGLs). Of the 68 companies included in our analysis, eight are investment grade with the rest sub-investment grade. We have further broken down our sample by daily production volume, with 27 companies (the entire investment grade group is included in this category) with production greater than 40,000 b/d and 41 companies with production less than 40,000 b/d.

In order to analyse the full diversity of the US upstream sector, our sample ranges in size from small independents with production as low as 1000 b/d, to integrated majors with production over 500,000 b/d, although only production from US operations has been taken for the purpose of this report.

The overall production guidance in 2016 was found to be more aggressive than the actual production cuts that were made in the year, with overall production declining by 100,000 b/d less than predicted. This can be wholly attributed to companies with less than 40,000 b/d production - this grouping produced more than expected based on initial guidance, with investment grade companies actually increasing production by 5.3% yoy, as opposed to initial guidance of a 2.6% decline. The opposite was true for producers
with more than 40,000 b/d production, for whom the yoy change in production in 2016
was less than expected.

Figure 2: Companies with over 100% yoy capex growth ($USbn)

Source: Company filings

Producer bankruptcies

Total bankruptcies in North America since the beginning of 2015 have risen to 119 oil and gas companies as of February 2017. Out of that number, 70 companies have filed for bankruptcy in 2016 with secured debt at US$20.3bn and unsecured debt at US$36.5bn. Large bankruptcies have continued into early 2017, as indicated by the size of debt, US$2bn secured and US$3.5bn unsecured respectively.

The likes of Vanguard Natural Resources and Memorial Production Partners in the first two months of this year show that, despite the rally in December 2016, prices remain challenging. However, the unprecedented frequency of bankruptcies and size of certain companies entering bankruptcy in 2016H1 is unlikely to be repeated again any time soon, unless there is an unprecedented collapse in oil prices.

With regards to the impact of bankruptcies on production, we have previously talked about certain mechanisms to maintain operations. This meant a lot of US producers (despite filing for Chapter 11) were able to continue operating. For example, one of the larger companies to enter bankruptcy protection, Sandridge Energy, emerged from this in October 2016 after its restructuring proposal was accepted. This highlights the lack of disruption to production in these cases, plus restructuring-driven M&A enables assets to be reallocated efficiently to companies that are able and willing to invest in their focused regions.

Figure 3: Volume of barrels hedged one year ahead, 2017/18 (m b/d)

Source: Company filings, Natixis

Production set to increase

In this report, we were able to analyse and compare the US upstream markets both from a fundamental and companies perspective. It is evident that, based on models and current data available for US shale resources, US production will increase in 2017. This increase in our analysis of US shale basins, conventional and offshore, is close to 500,000 b/d (with exit rates of over 1 million b/d), excluding NGLs production.

Including NGLs we expect US liquids output to rise by 600,000 b/d (1.2m b/d exit rate). In comparison, US company guidance based on a portfolio of 68 companies that we have used suggests a very aggressive growth of over 1.1 million b/d on average for crude alone (which is close to 1.8-2m b/d of exit rates). Although there is alignment in terms of increasing trends, we think companies are slightly over-optimistic on their expected production growth despite the support from hedges.

We believe the potential cost inflation and efficiency gains reaching the top of the S-curve could put brakes on the aggressive rise in US oil output. In terms of timing, it could very well be later in the year by the time such an effect is felt or perhaps in 2018. The producers in our sample have indeed increased their capex this year after two years of aggressive capex reductions. Upstream operators outside of the US remain in wait-and-see-mode, as their capex plans have not increased as much yet.

The hedges of the US producers clearly support increasing production this year but next year remains a big question mark. While year-ahead hedging has been strong relative to what was observed last year, providing a buffer for production if prices remain low, it is still prudent for producers to guarantee more certainty from their cash flows. Particularly if increased production activity pushes up costs and the uncertainties with regards to prices, 2018 hedges could provide support in light of the financial conditions of many of these companies.

This is an extract from the Natixis commodities report, 'US upstream in focus'. It has been reproduced here with Natixis' permission. For the complete report, see www.research.natixis.com

Abhishek Deshpande is chief energy analyst at Natixis. This report was produced in collaboration with Michael Liu

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