Dear Lord, Please Give Me Just One More Boom…

Hand Putting Check Inside Box for Validated Option

Thank you Minister al-Naimi.

People from the Permian Basin will recognize the title of this post from a bumper sticker popular around here in the 1980s. The whole quote was “Dear Lord, please give me just one more boom and I promise not to screw it up this time…”

Goldman Sachs (everyone’s favorite investment bank) just released a report in which it admitted that as much of half of the debt it issued to energy companies are now junk. Reuters reports that as many as 1/3 of all oil firms face imminent danger of bankruptcy.

In other words, it’s 1986 all over again… which itself was followed by 1998… then 2008. And we screwed it up. Again. Royally.

Really, since the advent of drilling in Texas, each boom is followed almost immediately by each bust – which has the same effect on the region’s business environment. In other words, “high prices sow the seeds of their own destruction” as always.

Moving on, I mentioned last week that one should not put too much stock in the fact that Saudi Arabia accepted terms for an output freeze. Saudi Arabia’s oil minister came to Texas, specifically to agree with me. The markets, never listening to The Wolf Camp, but always listening to Minister al-Naimi, abruptly panicked. The price of WTI lost around 5% yesterday and is already off the mark by over 3% today.

This feels a little like Groundhog Day, but I will say it again – everyone in the world produces as much crude as they possibly can. Companies in Texas will not stop production until they hit bankruptcy court because they absolutely need cash flow. The flip side to that coin is that most of the leases in Texas contain items like “continuous development clauses”, meaning that a company will lose acreage that it does not develop within a certain timeframe – further meaning that, to maintain its present level of reserves, a given company must keep producing. If it starts releasing acreage because it fails to produce, it is only a matter of time before a bank will come calling about its loan. A production company is like a shark, it has to keep swimming to survive.

The same goes for a petrostate like Venezuela, which needs cash to maintain some semblance of order. Saudi Arabia, meanwhile, is concerned with market share – and could care less what the price is today, tomorrow or even six months from now. Iran has been licking its chops for about a decade waiting to dump its crude on the market. Moreover, Iran thinks that it can increase its regional influence by becoming a major player in oil markets – regardless of price. In addition, Iraq has quietly made great strides in restoring its production capacity, and desperately needs cash to continue to stabilize itself.

In short, everyone will keep producing as much as they can – and their capacity to produce is increasing, not decreasing. That means that, despite what the IEA and EIA are telling everyone, production is unlikely to come down much, if at all, anytime in the near future. Sure, American companies may start going out of business. Sure that might affect regional development. But that trend in the US will be more than met by the increased production from other players.

I, for one, am pessimistic that domestic production will collapse. I guess I’m the only person who remembers that these “experts” said the same thing about domestic gas production when the price fell to $2/mcf. I mean they said literally the exact same thing. “The price will fall because people will stop drilling and the decline curves for production on individual wells is so steep.” Sound familiar?

Guess what actually happened. Production of domestic gas increased. This is despite the fact that 60% of gas rigs in the US were idled (and remain idled).

Why is this so? Because of the economy, stupid!

Believe it or not, companies want to survive. The way gas producers survive in a low price environment is by increasing capacity and lowering costs. Which they did… on a large scale. They were able to capture or maximize the most efficient operations, while stimulating extended production from existing sources, all while driving the cost of support services down. The result was a continued downturn in prices for gas products in an environment of stable to increasing production.

What many people seem to miss about pricing commodities, however, is that production is only one part of the equation. You see, everyone cares about proven reserves, too, which is the capacity that a producer has under contract but has yet to develop. In a low price environment, there is an incentive for leveraged companies to increase the value of their known reserves. How does one go about doing this when the prices decline? By increasing amounts of the commodity. In other words, by proving up additional reserves to shore up the total value of its assets.

Unfortunately, this is a short-term strategy. By proving additional reserves, companies increase the amount of total potential supply. In a market with a surplus, increasing the total known supply of said commodity sends bearish signals. It means that any price rises will be met with short-term increases in production – thereby once again lowering the price of the underlying commodity. It’s a vicious cycle… and one that is now and will continue to play out over the next several months.

About Sennoma Civitano

You can trust me. I'm a law-yuh. Oh, and I have a Master's in Public Affairs. I read books. About things.
This entry was posted in Economics, Foreign Policy, Oil & Gas, Oil Prices, Uncategorized and tagged , , , . Bookmark the permalink.

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