Arguably the biggest catalyst for the surge in crude, in addition to the technical move which started off with a vicious short squeeze into the NYMEX close last Friday, was last week's record drop in the Baker Hughes rig count to 1,223, down from 1,609 just three months earlier. That, coupled with the ever louder reports of majors and all other energy companies cutting CapEx, has led some to believe that the supply imbalance is finally starting to normalize, and that production in the coming months will sharply drop off. However, as Morgan Stanley's Adam Longson explains, that is not nearly the case.
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Here are his big picture thoughts on what the recent rig count drop relaly means:
The devil is in the details: The market is likely too excited about falling rig counts. Even after the natural gas experience, the market fails to appreciate that the relationship between rig count and production can be deceptive. Headline rig count declines may look impressive, but as we look at the data, much of the drop in oil rig count has come in low yielding vertical/directional rigs – i.e. the low-hanging fruit. Even within horizontal rigs, much of the decline has come in lower performing plays or lower tier counties within high quality plays. In some cases, we’ve seen a reallocation of rigs between counties within plays. This was particularly prominent in Midland last week. The most productive rigs will likely remain as long as possible, esp where hedges are in place, until redeterminations or cash flow issues force additional cuts. However, there are some positives. Some good rigs are being lost with the bad, and rail costs are forcing declines in high quality Bakken counties.
And here is the drill down, as well as his five key concerns abou why the market is misinterpreting the rig data, and why "small crude oil rallies can occur, but are likely limited and unsustainable."
A deeper look at oil rig count changes paints a different picture.
The US oil rig count has fallen from a peak of 1,609 for the week of Oct 10, 2014 to 1,223 last week. This drop of 386 rigs (24%) coupled with a 94 rig (7%) WoW decline created excitement among some bulls that a turn would come sooner. However, the experience in natural gas from 2011-14 should give investors pause about a falling oil rig count translating to significant production cuts. We don’t expect the same magnitude of efficiency gains, but mix shifts both within and across plays and rigs suggest activity will not slow nearly as much as headline counts suggest.
Five key concerns about rig counts and production.
1. Capex cuts come in waves, and the pace of drop may not be sustained. Many producers are implementing the first round of capex cuts for 2015, which can come quickly. Once plans are in place, there is a risk that the rig count decline may decelerate or stop until the next round of capex cuts are announced.
2. Thus far, lower performing vertical and directional rigs have been cut more than horizontal. Despite starting from a much smaller base, the vertical+directional rig count has fallen 202 (41%) vs. only 184 (16%) for horizontal oil rigs. In a more extreme example of this shift, the Permian horizontal oil rig count is equivalent to where it was when the US oil rig count peaked back in Oct (albeit it has decline marginally from its peak in Dec.
3. The average IP and production from vertical and directional rigs is much lower. In terms of contribution to oil production, the lower quality vertical rigs have initial production rates (IPs) that are just a fraction of horizontal wells. As an example, in the Permian Delaware, horizontal oil IPs can average nearly 500 b/d (with some counties much higher). In comparison, the average vertical and directional oil IPs are closer to 80 b/d. Hence, it may take 5-10 vertical or directional rigs to equal the production impact of a single horizontal rig.
4. Horizontal rigs fell more last week, but from low quality plays - consistent with the trend since Oct. Of the 94 rig decline last week, 66 came from horizontal rigs. While this is more helpful, the reality is that 46 of the decline came outside the three most prolific plays (the Bakken, Permian and Eagle Ford). In fact, of the 186 decline in horizontal oil rigs since Oct, 122 have come outside the Big 3 plays. Moreover, 33 of the 61 decline in the Big 3 since Oct has come from the Bakken where high rail costs are adding to the stress. The source of the decline is important because on average these other horizontal plays have ½ the IP rate of the Big 3, and often far less. Relative to the higher quality acreage in the Big 3 shale plays, other parts of the US can be as little as 10-25% of the average horizontal oil IP.
5. Even within plays, IPs can vary dramatically. Real analysis should be done at the county level given clear opportunities for high grading the portfolio within plays. Not every producers has the opportunity to shift from lower quality to the highest quality given geographic ownerships, which can create some noise in the data. However, when we look within plays, we see enormous gaps between the lowest and highest quality wells, as well as the average and top 25% of wells drilled. Within a play, the variance in IP rates across counties can be shockingly high, providing producers an opportunity to shift rigs in the portfolio. We have already seen evidence of this high grading occurring with rigs still increasing in some counties.
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His conclusion: look at the Permian: "The Permian, which was a big focus in this week’s numbers, offers an example of many of the above issues. Much was made of the drop in the Permian rig count (25 rigs). However, 16 of the drop came from vertical and directional rigs. Moreover, among the horizontal rigs, there was clear evidence of a shift towards more productive counties, especially in the Midland. The best counties generally saw rig counts increase or had rigs shuffled around between acreage. In the Midland, all of the decline came in much less productive counties, while the best count (Midland) saw rigs increase."
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