Guest gainsaying by David Middleton
U.S. Oil Production Is Headed For A Quick Decline
By Philip Verleger – Mar 11, 2019
The most recent forecasts published by the US Energy Information Administration show US oil production increasing steadily. The February Short-Term Energy Outlook sees the output from US wells rising from 11.9 million barrels per day at the end of 2018 to 13.5 million barrels per day by the end of 2020. Most other forecasters agree.
Thus, it may come as a surprise to learn that production at the end of 2020 may have actually decreased from December’s 11.9 million barrels per day level to between 11.3 and 11.5 million barrels per day. This lower figure represents the production level that should be expected given the financial activity of the independent firms behind the shale output surge.
The coming decline will occur mostly in the areas that have produced the most growth over the last five years: the Bakken, Eagle Ford, Haynesville, Julesburg, and Permian basins. The production drop will occur because the firms operating there have been forced by monetary constraints to cut back on drilling. The recent reduction in debt and equity issuance by these firms assure the output decline.
These firms will also enter into hedges as soon as the size of their new discoveries is delineated. The futures sales will likely occur when wells are completed and before they are fracked to ensure the company can cover costs and perhaps profit, even if prices fall.
Maybe I’m just being picky…
The coming decline will occur mostly in the areas that have produced the most growth over the last five years: the Bakken, Eagle Ford, Haynesville, Julesburg, and Permian basins.
The Bakken, Eagle Ford and Haynesville aren’t basins. They are located in basins. The Haynesville is primarily a gas play. The “Julesburg” is generally referred to as the D-J or Denver-Julesburg Basin.
These firms will also enter into hedges as soon as the size of their new discoveries is delineated.
Shale players generally don’t make discoveries. They’re called resource plays for a reason.
The futures sales will likely occur when wells are completed and before they are fracked…
What happens if you frac a well that’s already been completed? You frack up the completion. Frac’ing is part of the completion procedure. So-called “DUC” wells, the wells that have been drilled, but not yet frac’ed haven’t been completed. DUC stands for “drilled uncompleted.”
Am I being picky? Or are those points pertinent to Dr. Verlenger’s prediction? It is possible that he was just simplifying the language. And he wasn’t necessarily calling the Bakken, Eagle Ford and Haynesville basins. But the Haynesville is a gas play, a fairly dry gas play, with only about 0.25 bbl of condensate yield per million cubic feet of natural gas produced.
Dr. Verleger appears to be a brilliant, highly educated person. He has a PhD from MIT, served on President Ford’s Council of Economic Advisers and ran the Office of Energy Policy at the US Treasury during the Carter administration… But, does he know anything about oil?
I don’t have time to check every prediction he has ever made, but this was the first one I found on the Internet…
September 28, 2009
Oil market “teetering on the edge,” warns Verleger
Are oil prices about to take a dive? Analyst Philip Verleger thinks so. “The oil market is teetering on the edge,” Verleger said in a report. “Prices will fall sharply absent immediate and dramatic action.”
Citing poor refinery margins, Verleger argued that producers need to cut crude production. “Some country or combination of countries needs to reduce output two million barrels per day,” he said. “The cuts should take effect October 1, 2009.”
Because margins are so poor, demand for crude will sink, and prices will not hold in the $65-75/barrel range cited by technicians.
Dr. Verleger was sort of correct. Prices did “not hold in the $65-75/barrel range cited by technicians.” They rose above that range for the next five years, fell below it for four years, traded in the range for about a year, fell below it again and appear to be rising back to it. The average price for WTI (West Texas Intermediate) since September 28, 2009 has been $73.84/bbl.
Dr. Verlenger’s current prediction is based on hedging activity…
The decrease in open interest anticipated the future drop in production. In our view, drilling firms that were forced to curtail activity also curtailed sales of future production, understanding that they would produce less.
These declines were mirrored by a drop in the short position of swap dealers—the financial institutions that write bespoke hedging instruments to producers. The reduction in hedging in 2014 and 2015 led to the later decrease in production.
The same phenomenon is occurring today. Total open interest has fallen by twenty percent, as can be seen from the figure. Swap dealer short positions have also contracted. The message is clear: producers are hedging less, and they are hedging less because they expect to produce less.
Hedging is price-driven. Oil companies layer-on hedges while prices are rising, not based on anticipated production increases. When prices drop, oil companies spend less money, drill less wells and production declines. The puropse of hedging is to protect the bottom line from falling prices
What Is Hedging?
The best way to understand hedging is to think of it as insurance. When people decide to hedge, they are insuring themselves against a negative event. This doesn’t prevent a negative event from happening, but if it does happen and you’re properly hedged, the impact of the event is reduced. So, hedging occurs almost everywhere, and we see it everyday. For example, if you buy homeowner’s insurance, you are hedging yourself against fires, break-ins or other unforeseen disasters.
Layering-on hedges when prices are falling is kind of like trying to buy homeowners insurance while the fire department is hosing down your house.
The greatest risk with hedging is that you can miss out on some upside. A lot of oil companies missed out on $70 oil last year because they layered-on hedges too quickly when prices were rising.
Devon Energy Corp shares were down 2.7 percent at $43.78, Chesapeake Energy Corp was down 6.6 percent at $4.41 and Anadarko Petroleum Corp was down 5.2 percent at $69.34 on Wednesday afternoon after they reported earnings per share below analyst expectations.
U.S. shale production has surged in the last two years, buoying overall U.S. oil output to a record of about 11 million barrels per day.
Oil producers use hedges as an insurance contract to lock in a future selling price for production.
Many shale producers hedged second-quarter production at about $55 a barrel, which backfired as U.S. crude climbed to more than $70 a barrel last quarter, the highest level since 2014.
Certainly if prices drop below $50/bbl for a prolonged period of time, Dr. Verlenger’s prediction of a decline in US crude oil production will very likely be correct. If prices rise into the $60-80/bbl range, his prediction will very likely be wrong. It all boils down to predicting oil prices and most oil price predictions are wrong the moment they’re made.
As Jude Clemente wrote:
I have learned a very simple truth during my 15-year career in the energy business: one of two things usually happens when you make seriously bold predictions, especially for the longer term.
When the time comes to answer for being wrong, either you are not around to have to respond, or the critics will have forgotten that you ever made the prediction in the first place.
Or as more elegantly stated by Lawrence “Yogi” Berra and possibly some obscure physicist…
“It’s tough to make predictions, especially about the future.”