Oil Industry About To Be Burned Again By Fall In Oil Prices

Tyler Durden's picture

Submitted by Arthur Berman via OilPrice.com,

The current oil-price rally is over.

U.S. rig counts have surged as oil prices sink. Capital is driving the oil markets and it enables bad behavior by producers. That is why oil prices will stay low.

The oil-price rally that began in February is over. Prices rose from $26 per barrel to $51 by early June and are now below $42 (Figure 1). If they fall through $40, the next likely support level is at $36 per barrel.

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Figure 1. The current oil-price rally is over. Source: EIA, Wall Street Journal and Labyrinth Consulting Services, Inc.

Capital Drives The Oil Market and Prices

Most people think that fundamentals–supply and demand–drive the oil market but capital drives the market and oil prices.

More than anything, rig count reflects capital flow. Many believe that oil prices drive the rig count but it is really capital flow that drives rig count and production and that affects oil prices.

When oil prices fall and oil-price volatility increases, the floodgates of capital open. Every genius-investor wants to buy low and sell high. Rig count rises with fresh capital, production increases and oil prices fall (Figure 2). The weekly change in tight oil horizontal rig count is the leading indicator of capital expenditures. Price trends roughly follow the inverse path.

Figure 2. Capital flows drive the oil market. Source: EIA, CBOE, Bloomberg and Labyrinth Consulting Services, Inc.

When oil prices were around $100 per barrel in mid-2014, oil-price volatility was low. When prices fell below $90 per barrel in October 2014, oil-price volatility began to increase. When prices bottomed below $46 in January 2015, volatility peaked. Correctly believing that a price floor had been reached, investors poured capital into the markets and oil companies were flush with money to start drilling again. Prices rose to $60 per barrel by May 2015.

As drilling proceeded, oil-prices began to fall as market confidence in a price recovery faded. In July 2015, prices began to fall. As they fell to near $40 per barrel by late August, price volatility increased again. Investors saw another price floor and opened their wallets.

Prices rose 18 percent to more than $48 by early October but by then, confidence in a price recovery again faded with increased drilling and global economic concerns about Chinese growth and oil demand. Oil prices fell below $30 in late January 2016 and by mid-February, oil-price volatility reached its highest level since the Financial Collapse in November 2008.

Once again, investors saw a price floor and the floodgates of capital opened. Pioneer and Diamondback raised almost $1.5 billion in share offerings in January 2016, probably the darkest time for oil markets since 1998.

In the first half of 2016, more capital has flowed to E&P companies than during 2013, the previous record year when oil prices were more than $100 per barrel and the tight oil boom was in full bloom (Figure 3).

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Figure 3. U.S. E&P companies have sold more stock so far this year than in the whole of the record year of 2013, when oil averaged almost $100 a barrel. Source: Bloomberg.

Rig Count Surges and Oil Prices Fall

During the current price rally, prices increased from $26 in mid-February to more than $51 per barrel by early June. Meanwhile, the rig count change rate has exploded (Figure 2). Predictably, oil prices have fallen below $42 per barrel as hopes for a price recovery fade once again. This repeating process qualifies under the standard definition of insanity – namely, continuing to do the same thing that got you in trouble before. Related: Oil Extends Losses As EIA Reports Filling Inventories

66 land rigs and 47 tight oil horizontal rigs have been added since early June (Figures 4 and 5). Last week, prices were crashing but 18 rigs were added, the biggest increase in almost 2 years.

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Figure 4. Rig count has increased as oil prices have fallen. Source: Baker Hughes, EIA and Labyrinth Consulting Services, Inc.

Those added rigs, however, resulted from decisions and a process that began weeks or even months ago. After a company decides to add a rig, negotiations follow. More time passes between signing a contract and a rig showing up on location. Empirically, there is about a 5-week lag between changes in price trends and a response in rig count (Figure 5).

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Figure 5. Changes in rig count lag price-trend changes by about five weeks. Source: Baker Hughes, EIA and Labyrinth Consulting Services, Inc.

Who Are Those Guys?

Which companies are adding rigs and do their financial results support more drilling at these oil prices?

About 60 percent of rigs added in the tight oil plays during the last few months are in the Permian basin where there are currently 145 rigs operating (Figure 6). The rest of the new drilling is fairly evenly spread among the Bakken, Eagle Ford, Niobrara, Mississippi Lime and Granite Wash plays.

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Figure 6. Permian basin rig count: 145 rigs despite low oil prices. Source: Drilling Info and Labyrinth Consulting Services, Inc.

The most active operators in the 3 most-productive plays–the Permian, Bakken and Eagle Ford–are shown in the table below.

Table 1. Leading tight oil rig operators for the week ending July 22, 2016. Source: Drilling Info and Labyrinth Consulting Services, Inc.

In the Permian basin, Concho Oil & Gas currently operates 15 rigs, Pioneer Natural Resources operates 12 rigs, and Energen operates 8. Apache, Chevron and XTO each operate 6 rigs, and Anadarko and Endeavor each operate 5. Cimarex, Diamondback, EOG and Parsley all operate 4 rigs.

The most active operator in the Eagle Ford play is EOG with 5 rigs. EOG is followed by Chesapeake and Marathon each with 3 rigs. In the Bakken, Continental Resources is the leading operator with 5 rigs. Hess operates 4 rigs, Whiting operates 3 and Oasis, 2 rigs.

So how are these operators doing financially?

Terribly, despite preposterous stories of technology gains, costs approaching zero, and single-well EURs of 1 million barrels of oil equivalent.

Figure 7 shows the main rig operators in the Permian, Bakken and Eagle Ford plays. These companies spent an average of 4 times as much as they earned in the first quarter of 2016. And it’s been going on for years. Imagine doing that yourself.

Among Permian operators, Parsley spent more than 10 times cash flow and Energen, more than 6. Pioneer and Chevron spent 5 times more than they earned. Anadarko had negative cash from operations meaning that it didn’t even earn enough to pay for well operations.

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Figure 7. Tight oil companies spend 4 times more than they earn. Source: Google Finance and Labyrinth Consulting Services, Inc.

EOG leads the drilling in the Eagle Ford play and only spends twice what it earns–among the best of a bad lot. Marathon, on the other hand, outspends earnings by more than 6-to-1 and ConocoPhillips is not much better at more than 4-to-1. Like Anadarko, Chesapeake has negative cash from operations and, therefore, does not appear in Figure 4.

In the Bakken play, Hess cannot even pay for well operations from its cash flow yet operates 5 rigs. Continental Resources leads Bakken drilling and has a respectable capex-to-cash flow ratio only spending $1.30 for every dollar it earns. Whiting outspends cash flow by almost 6-to-1 and Oasis has negative cash from operations.

The debt picture is equally grim.

It would take top tight oil rig operators an average of 10 years to pay off debt if all cash earned from oil and gas sales were exclusively for that purpose based on first quarter 2016 financial data–in other words, no drilling, no salaries, no nothing except debt payments (Figure 8). That’s way above standard tolerance for this critical measure of bank risk which is now about 4:1 but before 2012, it was closer to 2:1.

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Figure 8. Tight oil companies would take 10 years to off debt using all cash from operations. Source: Google Finance and Labyrinth Consulting Services, Inc.

In the Permian basin, most operators have a debt-to-cash flow ratio of about 6:1 or 7:1. Chevron and Pioneer are much higher at 9.3:1 and 8.2:1, respectively. It would take Apache 8 years to pay off its debt and 7.4 years for Concho. Cimarex is somewhat lower at 4.4 years and not surprisingly XTO (ExxonMobil) is at 2.2 years. 

In the Eagle Ford play, EOG has more debt than it could pay off in 6 years and Marathon has a stunning debt-to-cash flow ratio of almost 25! Conoco is not far behind at almost 18-to-one.

In the Bakken play, Continental would need 6 years to pay off its debt but Whiting leads all major tight oil players with a debt-to-cash flow ratio of 29-to-1!

Meanwhile, these companies tell investors tall tales of fantastic rates of return even at low oil prices that clearly do not pass even a superficial fact check using Google Finance or Yahoo Finance. Why would any rational investor give money to most of these companies?

Short-Term Price Spikes In a Few Years

There is an important difference between oil supply and reserves. Supply is available on demand and reserves require long-term, capital-intensive investment to develop.

Tight oil is really a supply project because reserves can become supply one well at a time. Tight oil development can be turned on or off at will as prices rise and fall because at-risk capital is incremental–basically the cost of the number of wells in a rig contract.

While tight oil supply has overwhelmed markets in recent years, remaining reserves are relatively small–a few tens of billions of barrels–compared with true reserve projects like conventional and deep-water oil or oil sands that involve hundreds of billions of barrels. True reserve projects have been largely deferred because of uncertainty about how long low prices will continue.

The insane cycling of oil prices will continue as long as tight oil production keeps the market in a supply surplus. At some time in the next few years, the market will go into deficit as deferred investment in reserve projects comes back to haunt us. Then, inventories will finally be drawn down to 5-year average levels and prices will probably spike.

If that happens, it is likely that prices may go well above $90 per barrel. This may last for a year or somewhat longer based on what occurred in 1979-1981 (27 months), 2007-2008 (13 months) and 2010-2014 (48 months) when prices were more than $90 per barrel. Then, demand destruction will set in and prices will fall. Because the global economy is so much weaker now than during those past periods of high oil prices, I suspect that it will only take a few months to a year before prices fall hard.

Lower Prices Ahead

The current oil-price rally led many to believe that a full price recovery was underway. But inventories have been too large for that to happen short of epic supply interruptions. Current OECD inventories stand at 3.1 billion barrels and untold millions of barrels in places like China and Russia that do not report storage volumes.

In mid-April, I cautioned:

Two previous price rallies ended badly because they had little basis in market-balance fundamentals. The current rally will probably fail for the same reason.

You don’t have to be a genius to figure this stuff out. Attention to data and recent history is all it takes.

So, why do producers misread price signals so badly and act in ways that lower prices and hurt their own businesses?

They can’t help themselves. Give them money and they will spend it. That’s what E&P companies do.

The cost of credit dictates the precedence of cash flow over common sense even as more debt and the growing burden of debt service dictate even more production to meet new cash flow demands.

It is a vicious cycle that cannot be broken unless the capital stays away. That has not happened because other options for similar yields at acceptable levels of risk cannot be found. And so it continues.

The longer companies continue to produce at a loss and make absurd claims that they are making money at low prices, the more that investors believe them. The market graciously obliges by shorting oil prices.

I see no graceful way out of all of this.

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RadioFlyer's picture
RadioFlyer (not verified) Jul 28, 2016 8:16 AM

Time for a rumor of a production cut from bumfuckistan or an explosion.

Dubaibanker's picture

More demand destruction.....Bring it on!!!

2,700 employees just lost their jobs in Singapore today.....in the oil trading and shipping sector....while Singapore lost a listed company as well as lot of tax revenues and commercial as well as residential real estate demand.

Entire top management abandoned the company, like rats leaving a sinking ship! LOL

Swiber files for liquidation as top management quit

LawsofPhysics's picture

Demand destruction? What product of real value did these 2,700 useless fucking paper-pushers provide again?


I still see 8+ billion people competing for the very real resources required to maintain a high standard of living!!!!

There is plenty of real demand out there.

scraping_by's picture

You're counting heads when the important number is the dollars in their pockets. Globalist pressure on wages has impovrished everyone, especially the rich Westerners every business counts on to be their market. And there's only so much a few uberwealthy can buy.

LawsofPhysics's picture

When fraud is the status quo, possession is the fucking law.  This will become the case for all industries that deliver a real product or provide a real service.  Eventually, the producers will simply say "fuck you" and stop producing, regardless of how much fiat you offer them.

Global Weimar motherfuckers.

RadioFlyer's picture
RadioFlyer (not verified) LawsofPhysics Jul 28, 2016 8:32 AM

Global Weiner is right

the grateful unemployed's picture

which is why the fed can't follow an incrementalist rate hike policy. investors can connect the dots, and suppliers will hold back supply to get better prices at a later date. the fed has done a good job of obfuscating the inflation picture. (and squeezing the hedge fund shorts who were buying and storing oil - talk about the house of pain) lately the inflation bond market has been pricing in the inflation surprise. from a traders perspective its the 30yr TIPs which have been catching a bid, but perhaps even that window has closed. which brings us back to price controls, which the government tried in the 70s, then they figured out if they controlled interest rates they controlled the entire world, so watch for interest rate shock, there are already signs.

LawsofPhysics's picture

So, your bet is that interest rates will climb regardless of what the Fed does?  Please go on...

This is not the 70's, not by a long shot.  I venture that WWIII will happen first.

the grateful unemployed's picture

one example recently on the first of each month the Money Market fund managers have been accessing the feds discount window to maintain their NAV. this results in a temporary bump in rates, the process is exactly repetitive of the feds first rate hike, using the reverse repo. in this case the MMs come to them. so for a few days a month we have a fed rate hike.

the second issue is the US credit rating. if the rating goes down, investors will demand higher interest rates. the Trump suggestion of defaulting may be enough to trigger a lower credit rating. and third rates should be higher anyway, so its not a black swan event its the fed delaying the inevitable.

and fourth there is some reason to believe that helicopter money is coming to consumers. how would you do that? i mean would you say to Congress, figure out who gets what? yeah, right. or you could deliberately inspire high inflation, (by simply counting it correctly) in order to pay consumers who depend on COLAs more money. the government may actually start looking for inflation under every rock and counting it. and fifth if you do raise rates savers benefit from the interest their money earns and those saves become consumers. that appears to me to be especially obvious, though funding government gets more difficult, by accounts the fed could drop 1.5T from its balance sheet without changing interest rates. monetize the additional cost of the government doing business.

in simple terms you turn the switch the other way and let that pent up demand come out.

marcel tjoeng's picture

you're referring to Tesla (not the car)


so, what exactly happened to his working model again?



LawsofPhysics's picture

Good analysis but you are ignoring the fact that for producers/manufacturers, serious inflation is already here.  IMO we are simply coming to the same end game that the Soviet Union experienced.  We are simply coming at it from a different angle.

Iam_Silverman's picture

"in simple terms you turn the switch the other way and let that pent up demand come out."

Like when gasoline prices dropped drastically?  I'm not sure all of that money made its way back into the general economy like they predicted it would.  Consumers are fickle and hard to predict.  Human nature doesn't always follow the economic models postulated by the learned ones.

Indelible Scars's picture

Heh. Won't happen. It's called money and there will always, always be someone that will provide the product that produces it. Besides, what is with this shit that the price of all goods, services or commodities must rise continually? Everything is finite with the exception of space and there's at least some argument regarding that. Unless all boats rise at the same rate with the tide there will be a plateau at which each product must locate. The world is flooded with oil and I think most know that the fairly recent past run up to $150 was a total scam, real value must reflect real conditions. I know, many people hate logic.

RandomAnglican's picture

I can confirm the capital chasing oil.  I own some modest Permian rights, and every few weeks, I get calls asking to buy this or that from me.

the grateful unemployed's picture

the largest consumer of gasoline is the US military?

LawsofPhysics's picture

Precisely why "parking" the US military at home would further destroy oil "prices".  Can't have that kind of peace now can we.

the grateful unemployed's picture

yes but what if those US military units are active duty? just saying (posse commitatus)

LawsofPhysics's picture

So what if they are?  I am former ARMY AMMED.  I can think of a shitload of productive things these people could be doing stateside. If we really want to save this country we need to seriously re-consider how our captial and resources are deployed.


Iam_Silverman's picture

"I can think of a shitload of productive things these people could be doing stateside."

I vote for border security patrols!

S Spade's picture

you got a hard on for the military or what?  it's a drop in the bucket relative to the public at large...

heck, our public schools likely use more...the wheels on the bus go round and round...

Cloud9.5's picture

The thing I missed in the peak oil scenario was that there would be more gasoline and diesel available at lower prices during the decline.  I failed to grasp demand destruction brought on by economic contraction.


Think about this for a moment.  You are the wizard sitting behind the curtain.  One of your underlings rushes in and screams we are running out of cheap oil. With a mouse click you bring on line expensive oil.  Collapse is delayed.  Another underling rushes in and says we cannot fund social security another mouse click and collapse is delayed.  Yet another underling rushes in and yells the major banks are failing again.  With another mouse click you recapitalize the banks.  Collapse is delayed.  Others come screaming in the territories are insolvent and collapsing, major cities are insolvent and collapsing, states are insolvent and collapsing, pension funds are insolvent and collapsing.  Simple mouse clicks will arrest all of these ongoing collapses.   What would you do?

LawsofPhysics's picture

What the majority of them are doing.  Click the mouse while building/buying a well-fortified planatation in Barbados.  I know several VC guys, these are not stupid people, they know what is coming.

Iam_Silverman's picture

"Simple mouse clicks will arrest all of these ongoing collapses.   What would you do?"

Damn!  Another trick question.  Are you running Windows XP or 10?  That could make a difference.

Publicus's picture

When you print money, you can use that money to increase supply. This is why we see no inflation despite money printing.

The next step is to print money to fund jobs and government. There is no need for any tax nor any debt.

LawsofPhysics's picture

No inflation?  Healthcare?  Rent? Education?  Electricity?

You are a disingenuous cunt,  is that you Hillary?

Add to that LOW to NO WAGE growth.

Dapper Dan's picture

In most cases if there is no production from an oil/gas lease for over 60 days, the lease may be lost under the The habendum Clause.  

The Habendum clause of an oil and gas lease sets forth the duration of the lease.  Under the habendum clause of the lease, the lessee is typically granted a fixed “primary term” and an additional “secondary term.”  Extension of the lease into the secondary term is usually conditioned upon the lessee’s actual production of oil and gas.


Iam_Silverman's picture

"Extension of the lease into the secondary term is usually conditioned upon the lessee’s actual production of oil and gas."

Yup, the language "Held By Production" was a boilerplate part of the Producers 88 form for years.

Embrey's picture

The paradigm that changed is world demand due to the economic/financial chickens coming home to roost.
People like to complain that oil is expensive. A barrel of oil is 42 gallons. At $84 dollars a barrel, oil is $2/gallon. That's $0.50/ quart. That's $0.125/cup. Compare this to any other liquid product you buy. You can't even get milk out of a cows teets for that cheap and you don't have to spend $7.5MM to get at that same milk cow.

Oil is and has always been cheap.

When you buy gasoline, a large % of your retail price is tax. Yet it is the oil industry that is called price gougers. Bullshit.

Do you know why solar, wind, etc cannot compete with crude? Because Mother Nature has provided us with a more efficient battery than we have been able to produce. And it's not even close. Crude is a storage of energy that is storable, portable, etc.

The only source of energy that will someday compete with crude is the sun. The problem is that humans haven't been able to harness/store that energy at a competitive price. You want to know who will be the first quadrillionaire? The person who provides the market with electricity waves that need zero physical transmission infrastructure. Just pull power out of the air like a radio signal. When we can access power out of the air, oil will be obsolete as a power source.

LawsofPhysics's picture

FLUX is the real issue.  We burn a tremendous amount of consumable calories in order to simply make fertillizer to feed people.  The issue is how fast can you access more calories to consume and keep this going.

Let me be clear, with a population of 8+ billion that is still growing exponentially, only one thing is certain, standards of living around the world will continue to drop.

The math and physics is what it is.

Embrey's picture

You are speaking globally and I am speaking micro regarding the oil business. Apples and oranges.

Speaking globally, petroleum is the reason why there has been such a population explosion. Fertilizer is a biproduct. So are more global, efficient markets fueled by our ability to get products to market. And so on.

Do I think that the advances in food production and quality of life that have been made possible as a result of petroleum are infinite? No. Petroleum at a target cost is finite.

Peak oil hypothesized that oil was more limited than it really is. But, there is a very limited amount of crude available at $30. However, at $60 there is a plethora of crude.

If petroleum was infinite, would exponential growth allow for 100,000,000,000 people to inhabit planet earth? I don't think we'll get to 9,000,000,000 before famine, pestilence and/or war auto corrects the the problem.

Born2Bwired's picture

According to what I've read Tesla did this in 1931 with an electric car... JP Morgan dropped support for Tesla when he could not meter energy. 

Embrey's picture

Are you telling me Tesla could invent wireless energy transmission/reception but he couldn't invent a meter to measure how much energy was used?


user2011's picture

Any moment now, there will be a cable about opec production cut rumor to save the day.... I doubt there will be any cut because no middle eastern countries want to lose market share and American shale oil is not interested in slowing down their production either. Downward spiral continues.

Catullus's picture

If I see 3 more of these articles, then I'll know it's a bottom.

No mention of the forward curve for oil. I spend money for production later. They can't make money at $40, but 2018 forward marks for oil are in the $50s. And 2017 forwards were in the $50s just 7 trading days ago.

Add to this: gold/oil ratio is +30:1. Oil and oil producers are a huge buy on this pullback.

It's like buying a mining company that's already producing.

liquid150's picture

I usually assume that by the time ZH publishes an article about a trend, the trend is essentially over.

Youri Carma's picture

Good piece from Arthur Berman and exactly how I envisioned it: "Most people think that fundamentals–supply and demand–drive the oil market but capital drives the market and oil prices."