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A Ponderosa Market Outlook Report
CHALLENGE
THE
OF
ABUNDANCE
OVERVIEW
Copyright © 2015 Ponderosa Advisors, LLC. All Rights Reserved.
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303.309.4078
May 2015
INTRODUCTION
INTRODUCTION
Events of the past several months have been unsettling for the oil and gas industry
and its investors. Global crude markets have moved from being undersupplied to being
oversupplied. US oil prices (WTI) fell by 60% from June 2014 to March 2015, dropping
from $107/bbl to $43/bbl. Prices have since rebounded to $60/bbl despite continued
oversupply and persistent bearish signals in the market. This price pressure and volatility is the result of an all-too-familiar pattern: high prices stimulate innovative exploration, which results in rapid production growth outpacing demand, followed by a price
correction. It happened in the natural gas market in 2008-2010, in the NGL market in
2011-2012, and now the crude market. Each of these commodities was once thought to
be scarce but is now abundant. Current market dynamics raise several questions: Is the
oversupply situation a short-term phenomenon or is it symptomatic of a longer-term
industry transformation? How will oversupply in the crude market impact the natural
gas or NGL market? Which producers and midstream companies are well-positioned to
cope with the new environment? Ponderosa Energy, a unit of Ponderosa Advisors LLC,
deploys proprietary, data-driven, integrated analytics to understand this new market
paradigm and provide answers to pressing industry questions in its Ponderosa Market
Outlook report series.
OBJECTIVE
The Challenge of Abundance is the first release in our Market Outlook series and
provides subscribers with the insight and information needed to monitor the market and
react proactively to changing fundamentals. The report provides Ponderosa’s integrated
view of crude oil, natural gas and NGL production and price forecasts through 2020,
and examines current market dynamics that underpin Ponderosa’s pricing scenarios.
This initial report establishes baseline forecasts and the analytical framework that will
drive future reports. Extensive forecast reports will be published twice yearly, in May
and October, with market commentary and focused fundamentals analysis published
bi-monthly. Shorter market alerts will be published as warranted.
ROAD MAP TO THE REPORT
The Challenge of Abundance report includes detail on supply and demand fundamentals for crude oil, natural gas and NGLs markets, from both a global and US perspective.
It is organized as follows:
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THE CHALLENGE OF ABUNDANCE
May 2015
▶▶ Executive Summary highlighting the major takeaways from this report.
▶▶ Introduction noting the key themes and context for the analysis.
▶▶ The main body of the report, which presents Ponderosa’s view of the international crude balance, domestic fundamentals for crude oil, natural gas and
NGLs, and our forecast of production and prices through 2020. The report also
notes key things to watch for in energy markets across the next six months and
the risks associated with our analysis.
Additional supporting Appendices provide detailed analysis and supporting data for
the report. They include:
▶▶ US Basin Detail – Information and analysis of production trends for the major
US producing basins, including the Williston, Anadarko, Eagle Ford, Permian,
Northeast (Marcellus and Utica), Denver-Julesburg and Powder River, along
with other Rockies’ regional plays. The analysis is based on Ponderosa’s proprietary Production Model for crude oil, natural gas and NGLs.
▶▶ US Refining and Crude Oil Quality – A discussion of US refineries and the
importance of crude quality as it relates to demand, using Ponderosa’s proprietary North American Refinery Model.
▶▶ Transportation – Detail on transport options, economics and takeaway capacity
from various oil and natural gas US production basins.
▶▶ Prices – A technical analysis of historical US crude oil and natural gas prices
and Ponderosa’s near-term price forecasts.
▶▶ Hedging Analysis / Producer Guidance – A look at hedging strategies and
producer guidance for this year.
▶▶ US Natural Gas Demand – Consumption trends for the US broken out by
sector, including power burn, residential/commercial, industrial, transportation, exports to Mexico, and exports of LNG.
ABOUT PONDEROSA ENERGY
Ponderosa Energy, part of Ponderosa Advisors, LLC, is a boutique advisory
firm leveraging state-of-the-art databases and analytical tools to provide our
clients with detailed market intelligence for investment in crude oil, natural
gas and NGL markets. Located on the top floor of the 621 Tower in downtown
Denver, our client list includes private equity firms, E&Ps, midstream operators, utilities, hedge funds, major manufacturers and foreign investment firms.
For information about purchasing this report, a subscription to the Ponderosa
Market Outlook series, and other Ponderosa products and services, contact
Harry Brookby, Director of Sales, at hbrookby@ponderosa-advisors.com or
call 303.309.4078.
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OVERVIEW
OVERVIEW
The rapid fall of crude oil prices since last summer, along with continued
weakness in natural gas and NGL markets, has been an eye-opener for
investors in oil and gas. The lens through which we should view today’s
markets is fundamentally different from the past. Abundance has
replaced scarcity as the principal market driver. Low prices for each of
these commodities reflect too much supply relative to demand; the global
crude market is the latest to experience the consequence of growing
supply. US and Canadian oil production growth has overwhelmed
demand and growth trends in other crude producing countries to the
degree that it is depressing prices across the global market. This change
has profound implications: global production levels are now directly
shaped by market price signals, not government action. Understanding
the underlying fundamentals, rather than solely focusing on geopolitical
and macroeconomic risk, is necessary to succeed in today’s markets.
US
and
Canadian
oil production
means that growth
is now occurring in
markets where price
signals drive market
activity, not OPEC.
The analysis in The Challenge of Abundance reflects this new reality. The report will
present Ponderosa’s production and price forecasts, view of demand trends through
2020, and explain how our methodology drives our conclusions. We will address international crude market trends, key dynamics in the US market and the major US production basins that are shaping prices, and review the US natural gas and NGL markets and
how they are impacted by the domestic and global crude oil markets.
Figure 1: In most US basins, the value of a well is defined by the price of crude oil.
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THE CHALLENGE OF ABUNDANCE
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KEY TAKEAWAYS
US is in an era of oil and natural gas abundance. Rapid growth
»» The
in US production is just the latest in a series of events where first
natural gas, then NGLs, and now crude oil production overtakes the
nation’s consumptive ability and drives down prices. Though the US
crude market is more connected to global market fundamentals than
natural gas and NGLs, the dynamic is the same.
and production of these three hydrocarbon commodities
»» Price
is interconnected. Typical wells in most major US basins produce a
mixture of oil, natural gas and NGLs, and their relative proportions
determine the ultimate value and economics of each well. The current
low-price environment for crude also depresses oil exploration and
drilling, which in turn results in lower associated natural gas and NGL
production. By the same token, higher prices for natural gas stimulate
oil and NGL production.
crude oil and natural gas production will continue to
»» US
grow, but the pace of growth will slow until demand
arrives to support prices. Ponderosa believes the crude
market is in a “pain
period” that could
last three years, in
which prices will be
sufficiently depressed
to limit supply growth.
While US crude oil
production averaged
about 5.3 MMb/d in
2010 and increased
by 77% by the end of 2014, average daily output will grow just 27%
from 2015 to 2020. Limited growth in domestic consumption means
exports of natural gas and also crude oil are critical for markets to
absorb the increased supply, given US refinery limitations.
drilling will be pushed out of most basins due to poor
»» Marginal
economics. The industry will stabilize around larger, better-financed
producers, and significant consolidation is a given.
crude and refineries are not created equal. The value of a specific
»» Allbarrel
is based on the volumes and values of products that a specific
refiner can make from it. The changing barrel composition being
consumed in the US refining complex as a result of the shale oil boom
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OVERVIEW
will continue to impact refining margins and thus the price a refiner is
willing to pay for a specific barrel.
US light crude production grows, the relative value of all crude
»» Asstreams
will change, and increased crude-on-crude competition
among domestic barrels will impact prices all the way back to the wellhead. Expect condensate and lighter crudes to incur significant
price penalties, and heavier crudes will earn price premiums.
growth in the Marcellus and Utica plays in the Northeast is
»» Production
reshaping the natural gas industry, changing traditional supply patterns
and pressuring production in traditional supply basins, such as the
Rockies. Expect a re-emergence of basis differentials with impacts
on production economics and infrastructure viability.
and natural gas remain commodity businesses, but they are now
»» Oil
technology-driven businesses requiring new mindsets and operating
models. Technology improvements on productivity and cost will
continue to evolve. The impact: more production will be economic
at lower prices.
back to the future. Similar to the 1990s, when supply last exceeded
»» It’s
demand, increased emphasis must be placed on marketing production. We are in a protracted buyer’s market, and suppliers must be
proactive and creative if they are going to receive any kind of price
premium. Expect a re-emergence of the independent marketing
company.
SNEAK PEEK – AN EXCERPT FROM THE REPORT
Ponderosa built its production model to analyze four tiers of complexity when looking
at production economics across US basins. First, we model basin averages – in general,
this tells us which basins have the best economics on average and lends insight into infrastructure risk and opportunities and regional pricing dynamics. Next, we look at the field
or formation level, which sheds light on the type curve variance within a basin and intrabasin dynamics such as varying well economics and advantageous drilling locations. The
third tier is at the producer level within a basin. This analysis answers the question of
which producers are better at what they do than their peers and allows us to incorporate
and assess producer guidance plans. The fourth analytical framework is to tier production within a producer’s basin-wide portfolio, based on economics. This degree of granular analysis allows us to identify where sweet spots are located and how producers stack
up to their peers, as well as the longevity and viability of their drilling programs.
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THE CHALLENGE OF ABUNDANCE
May 2015
Figure 2: The Eagleville and Sugarkane areas of the Eagle Ford provide good returns even with crude oil prices
below $55 and with natural gas below $4.
This initial report of Ponderosa’s Market Outlook service addresses several factors that
complicate an understanding of US crude production growth, including:
The Interconnectedness of Oil, Natural Gas and NGLs
A key feature of the US market is the interconnectedness among natural gas, crude and
NGL markets. They once were connected by their value per MMBtu; today they are
linked by their contribution to revenue produced when a well is drilled.
The relative value of crude, natural, and NGLs to production revenue varies greatly
across US production basins. Figure 1 illustrates this variance, and indicates that the
value of a well in most of the major basins is more dependent on oil and NGL prices
than on the price of natural gas. Despite crude and NGLs providing key contributions
to the overall economics of a well, the gas component is still significant, so much so that
in many places, it is the only reason that wells are viable at current crude prices. This
highlights the complexity of understanding production in the US – while it appears
that producers may target a specific commodity, all the hydrocarbons in the production
stream matter and materially impact economics, balance sheets, and producer behavior.
Parts of the Marcellus and the entire Haynesville play are the exceptions; dry natural
gas production in these areas dwarfs condensate or NGL production, and in those areas
natural gas prices dominate wellhead economics.
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OVERVIEW
Figure 3: A look at IRRs in the Williston breaks down returns across three tiers of wells.
Even within a basin, variance in the ratio of oil volumes to gas volumes produced
from a well determines the overall rate of return and competitiveness of drilling in
different fields and formations. This variance means that economics in some areas are
more sensitive to crude price fluctuations, and others are more sensitive to changing
gas prices. Figure 2 illustrates the point using examples from the Eagle Ford in Texas.
We have integrated NGL prices into the analysis shown in the chart by indexing ethane
to the natural gas price and the remaining NGL products to crude prices. The graphic
shows the combination of natural gas and crude oil prices that yield a 10% internal
rate of return on the drilling and completion investment. Note that only four fields,
Briscoe Ranch, DeWitt, Sugarkane and Eagleville, achieve a minimum average 10% rate
of return at current prices. The steeper the line in the chart, the more sensitive the field
is to gas prices, and the flatter the line, the more sensitive it is to crude prices.
Sweet Spots Drive Growth
Returns are not consistent across a basin, and often are not consistent even within wells
drilled by the same producer in the same region. To better understand and illustrate the
variance, Ponderosa examined wells drilled by 10 prominent producers in the Williston
Basin (Figure 3). The wells drilled each year by each producer were divided into three
equal groups: Tier 1 contains the third of the wells with the highest initial production
rates (IPs). Tier 3 contains the third of wells with the worst IP rates. Tier 2 includes the
middle third of wells.
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THE CHALLENGE OF ABUNDANCE
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Figure 4: Eagle Ford wells have a wide range of breakevens across the basin.
The figure shows the average breakeven price and IRR for each producer by well tier.
Tier 1 wells for all producers showed the lowest average regional breakeven prices, and
about 60% of all production came from those wells. All wells in Tier 1 generated IRRs
above 20%, a common investment decision threshold. Tier 3 wells, generally located
on the fringes of plays, had very weak returns, in all but one case generating a negative
return.
US Crude Price Resiliency
Due to the interconnectedness of oil, natural gas and NGLs, and the existence of sweet
spots, many fields within US basins can produce crude oil at sub-$50/bbl prices and
natural gas below $3.00/MMBtu. Figure 4 shows the wells drilled to date in the Eagle
Ford color-coded by their estimated breakeven cost. Orange to red wells have the lowest
breakeven costs (red is sub-$40), while blue wells have costs in excess of $60. Looking at
all the wells that were drilled when the US active rig count stood at 2,140 (the average rig
count when crude prices were above $90/bbl), and then normalizing that level to represent 100%, at $50/bbl about 64% of the rig fleet wells drilled at $90 are still economic.
Crude prices must fall substantially below $50/bbl in order to curtail growth. This analysis assumes a natural gas price of $2.75/MMBtu.
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OVERVIEW
METHODOLOGY AND APPROACH
Ponderosa’s approach will have several underlying tenets:
1.Proper assessment of events in the oil, natural gas or NGL markets requires
analysis of all three markets simultaneously. At present, about two-thirds
of the natural gas produced in the US comes from a well that also produces
either oil or natural gas liquids. Looking at the price environments of all three
commodities independently is a prerequisite for understanding and explaining
exploration decisions.
2.Innovation is a key factor driving the market. Whether it is new drill bit
design, new fracking techniques or other operational approaches, producers
are getting more with less. The oil and natural gas markets are still fundamentally commodity markets, but in many ways have become technology-driven
markets. Accordingly, Ponderosa’s reports will pay close attention to the impact
of innovation on operating costs.
3.Today’s domestic oil and natural gas markets are most accurately understood
by looking at the lowest level of available data. Whether it is understanding
production, transportation, processing, or demand trends, our Market Outlook
service will employ data-driven bottoms-up analysis, eschewing general equilibrium or other top-down macro models.
4.Price formulation in the oil and natural gas industries is complex. For the
oil industry there are at least three sets of market dynamics that are important:
▶▶ The global balance between supply and demand, which among other
things implicitly means global macroeconomic trends.
▶▶ The US and North American supply and demand balance. As US and
Canadian production rises to a level that saturates the market currently
satisfied by imports, North American oil will face crude-on-crude
competition and North American prices may separate from global
prices.
▶▶ Crude quality will increasingly define regional differentials from
WTI, the US benchmark, or other North American prices. The US
is producing lighter and lighter oil, yet there are limits on how much
the nation can consume with our currently available refinery structure. Natural gas prices are somewhat less complex. Weather obviously
plays the most important role, though the North American supply and
demand balance is also important. Several factors will alter the current
dynamic, including power generation technology changes, new petrochemical and other industrial demand sources, and exports. This report
and subsequent Market Outlook reports will monitor activities that
encompass all these dynamics based as much as possible on granular
data analysis.
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