27 Jan Part 5 of the Prolonged Pandemic Series
As it stands, a prolonged pandemic stretching across 2021 is likely to lead to significant consolidation and concentration in the domestic oil and gas industry. What could change that?
A. Capital flight leads to new financing mechanism
The present private equity model that has driven so much of the growth in private (i.e. non-publicly traded) oil and gas exploration is a critical step in the long evolution of oil and gas financing. Whereas this model arose to serve an acute void left by traditional forms of capital – banks and private individuals – the present accelerating retreat of now-traditional forms of capital is creating space for further evolution in financial models.
In crisis comes opportunity, and as the debate over what the ‘new’ business model for E&P should be, creative capital providers have the opportunity to create a space for themselves in the discussion. This creative capital coupled with operational excellence could find a way to thrive in $40 oil.
B. Technological innovation significantly bends cost curve
As discussed, the exponential pace of technological efficiencies has led many to speculate that there is little left to achieve with the present production model absent a technological step-change. However, there is ample precedent industry for technological revolution borne out of necessity. One need look no further than the advent and wide-spread adoption of horizontal drilling and hydraulic fracture stimulation that has unlocked previously unimagined potential in terms of reserves from ‘tight’ reservoirs.
If necessity is the mother of invention, then the present price environment would seem to ripe for driving exponential technological advancement. What is more, with the markets more accepting of if not outright demanding that operators engage in single-digit growth rates and maintenance operations, more internal investment can be routed to technological innovation and experimentation as opposed to merely putting more drain hole in the ground.
There is precedent in recent history, as the extreme demands for technological innovation driven by the wars in Iraq and Afghanistan have provided significant technological advancement. For instance, satellite imagery developed to track assets and threats on the battlefield is now being made available in the oil and gas industry to track development in advance of what can be discerned from public filings. Whereas companies would once employ ‘oil scouts’ to surreptitiously (at times) find out what the competition was up to, commercially available satellite imagery has enabled competitors to develop a real-time map of development in-basin.
Recently, Shell has made public the drilling of a U-shaped lateral in the Permian Basin. Whereas traditional shale wells are drilled down to the productive zone and out laterally as far as possible, Shell drilled a single horizontal well that essentially turned 180 degrees and proceeded back towards the drilling rig. Long story short, this well design was enacted out of necessity in the face of losing the well in question due to subsurface issues encountered during drilling. That is, it had been theorized internally for some time but was not planned in advance. While there is not enough public data to make industry-wide generalizations, reports from the ‘horseshoe well’ indicate significant improvement in recoverable hydrocarbons.
Finally, the adoption of AI and quantum computing is largely in its infancy within the oil and gas space. Because so much of what actually occurs ‘downhole’ is unknown, operators rely to a large extent on modeling to determine likely outcomes, or to draw conclusions from certain established outcomes. The increased application of AI and quantum computing will allow operators to utilize and correlate vastly greater data sets to unlock. As market pressure increases the need for a competitive edge and general access costs are lowered, the democratization of data should expand the possible frontiers of change that presently appear to be stymied by the physical limits of our existing technology.
C. Overshoot from dramatic drop in drilling leads to supply crunch, which whipsaws price sharply upward
According to the most recent Baker Hughes reports, there are 65-70% fewer oil and gas drilling rigs operating in the United States than this time last year. As previously discussed, the bulk of these rigs are targeting unconventional formations through horizontal wells that must be fracture stimulated to produce. These unconventional wells typically exhibit flush production for 6-18 months, after which time they enter into a steep production volume decline before flattening out into the long tail of terminal decline.
The constant need to replace this flush production to maintain overall production volumes and thus cash flow is what is referred to as the shale treadmill. Should drilling and completions decline for any meaningful period of time, then there will be a corresponding drop in production volumes approximately 12 months later.
When viewed against this backdrop, it is clear that drilling and completions are a leading indicator of domestic supply. Thus, a 65-70% decline in drilling activity today is very likely to produce a commensurate sudden and drastic decrease in domestic supply approximately one year from now. Anything close to a 67% decline in US production occurring in an approximate 12-month time frame has the potential to roil markets and drive prices sharply upward.