It no doubt feels like a new paradigm for oil investors with the price of oil falling 72 per cent since 2014, the second-largest peak-to-trough decline in more than 30 years.
Many are pointing fingers at the Organization of the Petroleum Exporting Countries for the monster wave of oil now hitting the markets, but it really all started with U.S. shale producers.
Many forget that deep oil-price declines are soon followed by some sizable recoveries
Following the 2008 financial crisis, ultra-low interest rates, three rounds of quantitative easing in the U.S. and a risk-on atmosphere provided vast amounts of capital (both debt and equity) to U.S. producers, who quickly put it to work drilling and fracking.
As a result, more than four million barrels per day of production was added at a time when there just wasn’t enough demand globally. Not surprisingly, the Saudis and their fellow OPEC members lost patience along with market share, and responded in kind by bringing on an additional 1.5 million barrels per day from mid-2014 through to mid-2015.
The price of oil quickly responded to the supply-demand imbalance of approximately two million barrels per day.
Unfortunately, just when you thought it couldn’t get any worse, Iran is about to hit the market with an immediate 500,000 barrels of oil now that its sanctions were lifted on Saturday.
In the midst of such a mighty storm, it’s very hard to imagine that it will eventually come to an end, especially when the primary focus at the moment is just on surviving the onslaught.
But we believe the clouds will eventually break since the sheer magnitude and duration of oil’s ongoing pricing collapse will eventually self-correct, as will the current supply-demand imbalance, perhaps even sooner than many expect.
The solution will likely come from where the problem began — U.S. shale producers.
Having covered the industry as a sell-side analyst, I’ve seen my fair share of reservoir models and production profiles. Shale wells have what is termed a hyperbolic decline curve, meaning they have upwards of a 75-per-cent decline rate in production in the first one to two years before they stabilize at substantially lower levels. They require continual drilling and a lot of capital reinvestment just to keep production flat, let alone grow it.
Capital markets closed for business early last year and debt markets quickly followed suit, so these producers have had to rely on rapidly falling cash flows to continue drilling wells.
The average U.S. producer was using more 80 per cent of its cash flow just to service interest payments when oil was at US$50 a barrel. Imagine the situation at US$29 a barrel, or even negative oil prices for North Dakota Sour crude.
As well, the rig count has fallen nearly 70 per cent, with most of the drop occurring in early 2015, so we really have yet to see the lag impact on oil production.
When that impact comes, both the speed and magnitude of the fall in production may surprise many and there will be little that can be done to stop it given the massive staffing cuts at North American service and production companies and a quickly aging and under-maintained fleet of service and production equipment.