09 Dec Part 2 of the Prolonged Pandemic Series
1. Depressed demand leads to a stagnating price.
Despite historic demand destruction both in terms of speed and scope, oil prices have stabilized at approximately 70% of their previous levels from 2019. As stated previously, the coronavirus has not materially impacted the supply side of the oil and gas equation (subject to the wildcard discussed below). This leaves demand as the key driver of price; because supply is constant in the near term, price will stagnate proportionate to demand. Should the pandemic carry on through 2021, price will remain correspondingly depressed as well.
Restated, until people are back on airplanes, back in offices (whatever that looks like), and back in stadiums (indicative of a return to pre-Covid consumption patterns), oil prices should remain correspondingly depressed and range-bound in the high-30s to low 40s.
2. A stagnated price will lead to continued depressed drilling activity.
The primary driver of the United States oil and gas industry from 2005-present has been shale – also known as unconventional – development. Due to unconventionals’ relative dominance of the domestic oil and gas landscape, we’ll limit our discussion to the impacts of the coronavirus on this sector of the exploration and production industry.
While technological change will always continue to bend the cost-curve, it is generally accepted that barring a step-change in technology, shale development needs an oil price above $60bbl to make economic sense. This is a gross generalization and ignores many region-specific factors that contribute to the ‘break-even’ such as price differentials, takeaway capacity, relative acquisition cost, rig cost, etc. These variables vary wildly amongst regions, and even within the same geographic area.
That being said, it has also been widely posited that the period from 2016 to 2019 saw such a focus on improving operational efficiencies that the near-term ability to bend the cost curve further is insignificant.
At $40bbl, the vast majority of shale wells are uneconomic. This means that the only unconventional wells being drilled are those that are unavoidable and that operators are limiting their drilling activity to the minimum viable amount. The reported US horizontal drilling rig count reflects this, have dropped an approximate 70% year over year.
2021 is presently trending heavily towards operators moving into what has been referred to as ‘maintenance mode,’ meaning that CapEx is geared primarily towards generating free cash flow from existing assets. A prolonged pandemic through 2021 and into 2022 should deepen this commitment to maintaining the status quo over production growth.