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Ty’s Take For Week Ending 8-5-16

While I normally focus on where the price of oil is going, what I am more interested in this week is the fundamental question so important to all of us to help plan our business and know when this downturn will end: what price does it take for drilling to resume and when does service pricing recover (i.e. when do we all stop the agony)? I wrote about this issue a few weeks ago, and I largely remain behind my original opinion. But this week we got a host of new information from Big Oil Execs about their predictions and plans.

In creating the article on Earnings, I reviewed hundreds of pages of transcripts from the various earnings calls (thank you to www.seekingalpha.com for all of your hard work transcribing the earnings calls). And while each company has their own opinion as to market conditions and what they foresee happening, I did glean a bit of insight and can tell you that there seems to be at least an undercurrent of consensus. I know the article on earnings is long and tedious, but I do strongly encourage you to read it to help develop your own opinion.

First, it struck me that almost all of the major oil companies are, over the mid-term (say end of this year through middle of next year) bullish on oil. Anadarko CEO R.A. Walker called $60.00 a barrel oil by end of the year, or early next year. BP never technically gave a prediction, but given that they continually spoke of $50-55/bbl I believe that is their prediction. And both BP and Anadarko reiterated their belief that oil markets will move into balance in the second half of this year. More importantly, while the supply side was definitely mentioned, all of the Executives seemed to be focused on a demand side recovery: that is with supply decreasing but demand driving the recovery (which is good for us because it probably means a more sustained recovery).

Second, it is interesting to note that many of the companies are already adding rigs or planning on adding rigs. BP had taken their rig count in the lower 48 down to 1, and they are currently operating 3-4. They intend to be at 5-10 by the end of the year. In my mind, this certainly supports my theory below that we will see an activity increase this year. In the Permian, Exxon plans to go from six rigs to ten rigs by the end of the year. Similarly, both Chesapeake and Apache intend to add rigs at or near $50.00 per barrel.

Third, the other thing that struck me was how low the cost of production in the Permian and other U.S. basins is compared to just a few years ago peak. BP said their production costs lowered 33% from 2012 overall per barrel (across all areas). Exxon noted a 70% reduction in Permian unit development costs over the past two years – resulting in the Permian being economical and the Bakken yielding a 10% rate of return at just $40.00 per barrel. For Pioneer to say they can drill horizontal in the Permian as cheap as a conventional well in Saudi Arabia is mind-boggling to me and speaks to the changes we have seen. While that is certainly the lowest cost we heard from any Company, nevertheless, all echoed sentiments of being profitable as low as $30.00 per barrel in certain areas.

Most companies left CAPEX for 2017 at the same level as 2016 and did not increase their guidance which is of great concern to me. This could truly signal that they intend to take a very conservative approach, which might make some sense given the current lending environment, and they believe the market remains too volatile to call at this point. But remember, these are just their projections: they reflect reality only in their current state and in intention. As the situation on the ground resolves, they are free to revise those numbers up or down.

But I do have an alternative theory. Anadarko and Hess both indicated they would not seek to add meaningful activity until oil is at $60.00. And the other CEOS somewhat echoed that sentiment. But in reading the transcripts, as a lawyer would read it, I found all of the executives to be a bit coy in their answers. I believe this is not only intentional, I believe it is smart. I believe each one does not want their competitor to know when they are going to jump in. That might create a race to jump in first before everyone else does which might then crater the market again. No one wants everyone to start drilling like crazy at $50.00 again - that just insures the recovery will last 30 seconds, and then we will have two more bad years. While I do believe $50.00 a barrel is enough to stimulate some activity it will not be a full on recovery. Therefore, I think everyone is being a bit secretive intentionally. I predict you will see a more significant uptick in activity over $50.00 than would be apparent from reading the Earnings Reports. I do think we will need 6-8 weeks of sustained $50.00 or more per barrel to see significant activity – which will result in a partial recovery. And I believe we will see significant recovery when oil is above $60.00 as the danger of oil dropping so much that swing production becomes unprofitable is greatly diminished – especially as this will be, at least in part, abe demand based recovery rather than a supply based recovery.

The problem though, is when will oilfield service companies like Schlumberger benefit. At one point, their CEO was quoted as saying the recovery for the service industry would lag 3-4 months behind. This makes sense. However, he indicated subsequently in his earnings call that Schlumberger would begin renegotiating pricing concessions given during the downturn. Not the position of someone who is scared that recovery isn’t within eyesight.

The major oil company execs asked about this seemed to refute the notion. Some outright said that there was such a surplus of supply for oilfield services that it would be a while before they would have to give in to demands for higher prices. Others took a more moderate approach basically arguing as follow: look, we are partners. For this to work, we have to keep drilling costs down otherwise we will be right back where we started – it will be too expensive to drill in the current environment and everyone loses. We did our part, so the argument goes, by making systematic changes in our company, we need the service companies to cooperate.

That is a pragmatic approach and awfully hard to argue against. What I basically see happening is a period where activity levels recover for service companies, but profit margins do not (or at least not significantly). Demand for equipment (and those of us who depend on that demand) will see an increase in activity. So will the service companies. But we will be asked to continue some pricing concessions. Of course, in the end it does not matter who is right from a pragmatic perspective, it is a free market and free market forces will prevail and decide for us.

In the coming weeks, I will again give you my take for the price of oil, and we may have some fun. Stay tuned.

And finally, what do you all think? I write this every week so you know what I think, but I love hearing you all’s opinions. I encourage all of you to email me your thoughts on this column!

By: Ty Chapman

Five Star Metals, Inc.

Raising the Bar for Customer Service and Quality

Twitter: @FSM_TY

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