Energy Markets: There Will be Winners and Losers

We are ardent believers that the recent decline in the price of oil is temporary given continued demand growth (which will likely only accelerate at lower prices) and our expectation that worldwide supply will decline at current prices; in short, we expect that the supply/demand balance will shift leading to higher pricing.

Much of the incremental worldwide supply growth that we have seen over the past several years has been tied to growth in U.S. production, predominantly the U.S. shale regions.  Looking at these shale producers, we’ve seen reported decline rates upwards of 70% in the first year for many of these companies.  For instance here’s a look at the legacy production of two major U.S. shale basins, Bakken and Eagle Ford, where we are not only seeing huge legacy declines, but current new production not keeping up with these declines.1

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Capital had been readily flowing up until now to fund the treadmill of constant capital reinvestment needed to keep up production, but what happens when the capital inflow stalls and investors wake up to the fundamentals of the businesses?  We expect these dynamics will not only lead to a decline in U.S. production, but may ultimately lead to a number of producers who won’t be able to weather the storm.

With a larger and larger portion of U.S. oil production coming from shale producers who have these far greater decline rates than conventional oil producers, the total U.S. production decline rate has now more than doubled in the last five years, putting it at all-time highs.2

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This at a time when we are also seeing massive declines in rig counts.3

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So together we believe this has large implications for U.S. production going forward.  We will continue to see a record amount of production needing to be replaced over time due to these natural decline rates, all the while capital investment to replace this production will be stymied and rig counts, an indication of future production, have fallen off a cliff, leading to a meaningful drop in U.S. oil production.4

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Where does that leave us?  If much of the incremental supply growth worldwide has come from the U.S., but that U.S. production will be declining, then the supply and demand balance will see a shift and thus we would expect to see a rebound in oil prices.  Though we caution investors this may well take several quarters to play out.

So at face value, this should mean that the energy sector is an attractive area to be positioned as we wait for that rebound—we may see some continued near-term volatility but in the longer-term, energy names are bound to go up, right?  But not so fast.  While we are long-term energy bulls, there were certainly be winners and losers as these dynamics play out.

As noted above, we have our concerns not only about the longevity of shale production, but to the viability of many of the companies themselves.  First of all, many of these shale producers did not generate free cash flow at prices nearly twice what they are today.  Oil and gas production is a capital intensive business, so with the severe decline rates and less capital now readily available to regain that production, as well as the lower prices received for what is produced, we expect this may well lead to the lack of funds available to service the debt loads of many of these companies. In sort, we expect these dynamics may lead to a spike in default rates.  And it isn’t only the shale producers that we see as vulnerable, but also the oil and gas service companies that will be hit as rig counts and production declines.