Dan Reed

Reports of Energy Industry’s Death are Greatly Exaggerated

Sam Clemens, better known by his pen name, Mark Twain, is credited with having said “Reports of my death have been greatly exaggerated,” or something very near that.

Those predicting the demise of the U.S. shale oil and gas industry in the wake of the dramatic drop in oil prices that began last summer should learn the back story behind what is perhaps the most famous and enduring of Clements’ many quotes.

Don’t Be Fooled by Dropping Prices

Yes, prices remain off more than 50 percent or so from their peak in the summer of 2014. And yes, that has imposed a great deal of pain across the industry. According to the closely watched Baker Hughes rig count, the number of rigs in active pursuit of oil as of March 27 was 1048, down 42 percent from the peak of 1,809 in October. That’s translated into thousands of lost jobs throughout the energy industry, especially at the oil field services level of the industry. It also has pushed highly leveraged companies and those that had not effectively controlled their operating costs into the bankruptcy danger zone.

But the industry as a whole remains amazingly resilient. And while there’s great variation on a company-by-company, industry-segment-by-industry-segment and play-by-play basis, reports of the industry’s death have been just as off-base as those reports about Twain’s passing. And for similar reasons.

It’s hard for us to imagine today, when every upper-level elementary school student knows that Mark Twain’s real name was Samuel Langhorne Clemens, that bit of information was not widely known in his day. It’s not that he sought to keep it a secret (after his early success under the Twain name, Clemens was quite open about the name issue but recognized the value of the Mark Twain brand and continued to use it).

Rather, information didn’t spread very rapidly or widely in those days. So, it was somewhat understandable that, when his cousin James Ross Clemens fell seriously ill in London, that news of Cousin James’ illness led to rumors, and eventually incorrect news reports, that the famous Mark Twain was near death, or already dead.

Today, in light of the dramatic drop in oil prices, it’s easy to understand how those not intimately familiar with the energy industry could assume that it is on its last leg. But, as was the case with the erroneous reports of Twain’s death, it’s simply not true. In fact, there’s a growing argument that the significant segments of the energy industry have already adapted and are poised for a comeback, with the only questions being how long will it be before that comeback begins, and how big of a comeback will it be.

Here’s why:

Lower operating costs. The big drop in energy prices has had the beneficial effect of forcing inefficiencies out of the market. Prior to the price drop, the exploration world was working under a long-standing and difficult to resolve set of operating inefficiencies. It’s the hallmark of a boom that when prices are high and demand is equal to or exceeds production capacity that the cost of production will rise. Prior to the price drop exploration companies, in effect, were bidding the hourly price of rigs and other services. No more. By many estimations drilling costs are down more than 30 percent per well. That helps explain why U.S. production continues to grow despite the dramatic drop in the rig count. Exploration companies are achieving significant efficiencies on the order of 25 percent that are allowing them to do more with less and to significantly offset the impact of lower market prices.

Exploration is not a cookie cutter business. The cost of drilling in the Bakken play in the Dakotas is higher than the cost of drilling in South Texas’ Eagle Ford play. Accordingly, companies that are more active in the Eagle Ford are doing better than those that are more exposed to the Bakken.

Companies can’t shrink their way to profits. Unless they have zero debt, energy companies must continue production to generate the cash flow they need to cover interest payments and other obligations. That gives them time either to ride out the downturn, to find new sources of backing capital or both.

Mineral rights contracts are use-it-or-lose-it deals. If companies don’t drill within a certain time frame, they lose the rights to drill on leased land and their up-front investment in those leases. So they are incentivized to keep drilling, at least a little bit. And, given the technology and economics of horizontal drilling, if they have to drill one well to keep a lease deal alive, it makes more sense to drill lots of wells on that same lease.

They’re already on the hook for transportation costs. By themselves, sunk costs never justify spending more money on a bad project. But if producers expect to remain in business long-term, it’s best they not burn their bridges with the trail and pipeline companies with which they already have long-term oil and gas transportation contracts.

The costs of keeping active well producing are much lower than drilling new wells. It rarely makes economic sense to just cap a producing well. Continued production at low cost softens the blow of reduced exploration and fewer finds, at least in the short- to mid-terms.

Forecasts are rarely right. Sadly, economic forecasts for both the energy market and the macroeconomic are rarely correct beyond the 12-18 month time frame. There’s nearly always some unforeseen and unforeseeable event or series of events that changes things entirely. Thus, energy companies that can keep their costs down, find operating efficiencies, locate new capital and stay in the game know they are positioning themselves for the next growth opportunity.

Global instability favors a return to higher energy prices. Whether it’s heightened threats of, or the actual outbreak of, war in the Middle East, a decision by the Saudis to reign in their production or huge new demand from a booming third world, chances are something will happen in the global geo-political and/or economic world that will push energy prices higher again. Exactly when and how high remain hard to predict, but predicting a return to higher prices in general does not qualify as going out on a limb.

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