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The Permian basin has been grabbing headlines for the past few
years, as operators have rejuvenated the area by exploited its
massive resources of shale and tight oil. Indeed, the performance
has been impressive:
Even during the worst parts of the downturn, Permian oil
production showed quarter-on-quarter growth, never declining.
Peak well production in the unconventional plays rose by 125%
in the past five years.
PV10 WTI breakeven prices fell from about $75 in 2014 to less
than $40 today.
Each month Permian production sets a new record, approaching
six million barrels per day by the end of 2020.
This explosive growth justifiably created the notion that the
Permian will continue its meteoric ascent and dominate global
markets. Yet a careful look "under-neath the hood" shows a system
with important constraints that make the region vulnerable to lower
oil prices than headlines suggest.
To understand how low prices can impact the play, it is helpful
to break down the system into the two parts that determine oil
output.
Base Decline
Simply put, for any given year, base decline equals the volumetric
decline from January to December for all wells brought onstream
before the first of the year. As shown in Figure 1, that figure was
slightly over 110 million barrels per day (mb/d) for the Permian in
2013. This decline was very shallow because the base of historical
wells was composed of older wells on the flat part of their
decline. In the Permian, extensive enhanced oil recovery operations
(waterfloods and CO2 floods, for example) have low output per well,
but do not decline rapidly.
Today, the situation has changed dramatically mostly due to
shale. Individual shale wells deliver very high production
immediately, but they decline from this peak by 65% to 75% in the
first year. Being hyperbolic, that first-year decline rate becomes
increasingly shallow over time. Thus, growth in output via shale
from 2013 to 2016 was relatively easy, since it involved adding
high initial-rate wells on top of a slowly declining, conventional
base.
However, now that shales are dominating the base of production,
the "treadmill" has accelerated dramatically. We expect base
decline in 2020 to be almost 2,000 mb/d - nearly 20 times the 2013
figure. Importantly, base declines in any year are largely fixed
and predictable.
Wedge Volumes
The second part of production is the output from new wells that
operators bring onstream over the course of the year - the "wedge."
The equation is simple: if wedge volume exceeds base decline,
output grows. If operators cannot match the decline, output
falls.
A myriad of factors influences the extent of wedge volumes.
Think of it this way: wedge volumes equal the amount of capital
invested in new wells multiplied by capital productivity (the
average production generated by each dollar spent).
In the Permian, capital efficiency rose dramatically between
2013 and 2017. This explains why operators were able to compensate
for falling capital investment levels in 2015 and 2016 to maintain
production. the Permian was able to remain resilient despite
dropping level of investment.
Looking closer, improved capital efficiency was driven by the
compound effect of five simultaneous well improvements:
The single largest factor was that oilfield service costs
plummeted as evaporating demand reduced fleet utilization of rigs
and pressure pumping.
Operators became much more efficient as a relentless focus on
improving logistics and cutting costs bore fruit.
Companies focused on only the best parts of their acreage,
worked by their best people.
Lateral lengths extended, creating efficiencies in both
drilling and completion.
Companies were able to perform better analysis and apply
lessons learned to extract more oil and gas per foot of lateral,
largely through the increased use of proppant to complete
wells.
All of these factors are real, but a look at the current data,
however, shows that the impact of each factor has diminished or
stopped. This is a natural part of the maturation process for a
basin and is to be expected. In fact, in some cases, such as
oilfield service pricing, 2018 experienced a reversal of gains as
modest inflation took hold.
Thus, unless a new technology or technique emerges, Permian
productivity has likely moved from a period of breakthrough gains
from 2014 to 2017 to very incremental gains. Economics are
world-beating, but they are not likely to improve.
As a result, wedge volume is therefore highly dependent on the
sheer amount of capital invested in new wells. More capital drives
high growth and less capital reduces near-term growth. This stands
in contrast to much of the conventional oil industry where capital
investments do not impact production for many years due to long
leads times.
Two factors determine the amount of capital that will companies
will invest:
Prices: The primary source of capital spending
is cash flow from operations. Rising prices allow operators to
spend more, stimulating growth. Falling prices reduce cash flow,
forcing companies to cut back on spending or seek access to
external capital through debt, equity, or other infusion.
Cash/capital balances - Historically,
shale-oriented exploration and production companies relied heavily
on borrowing to maintain capital invest-ment levels in times of low
prices.
In the past two years, however, equity markets demonstrated less
tolerance for adding debt or equity to fund growth. Instead, they
are demanding that companies live within cash flow - or even return
cash to shareholders. This is an important change in thinking about
the growth of the Permian: each dollar returned to shareholders is
not invested into a new well, eroding wedge volumes and reducing
growth.
With lower prices and increased demand for reinvestment
restraint combined with the rising base decline rate, it's clear
why low prices are likely to succeed in blunting the momentum of
the Permian. Although the region boasts extremely high capital
efficiency and the ability to attract external capital despite
lower oil prices, a downshift to a lower gear seems inevitable in
2019.
We also can draw lessons about the longer-term performance of the
system. Low prices definitely have an impact, but not because they
make individual wells uneconomical. Rather, low prices limit the
total capital available for reinvestment by reducing budgets.
Volatility may compound the problem by encouraging companies to
budget conservatively (no one likes to retrench on spending or
growth plans).
These undrilled wells remain in inventory, however, ready to
come online whenever capital becomes available. This deep inventory
of locations offers companies riskless flexibility and optionality.
Sooner or later, they are likely to contribute to supply and may
drive growth surges such as that seen in 2018.
As the market understands how the shale asset functions, this
ability of the Permian (and US shale in general) to respond quickly
to oil price changes may lead to reduced oil price volatility, as
supply relieves tightening markets and vice versa. It is only when
the inventory of the most productive acreage exhausts itself -
after 2025, in our view - that the Permian encounters structural
obstacles to growth.
Posted 28 March 2019 by Raoul LeBlanc, Vice President, Energy, IHS Markit