Oil Bull Versus Oil Bear—The Facts; and Other Items That Amuse and Interest Marin Katusa

First, this week’s edition of The Raw Deal has many treats in it, so make sure you give yourself enough time to go through it all.  Also, make sure you whitelist The Raw Deal in your email settings, as next week’s issue will most likely be one of the most controversial pieces I’ve ever written. You definitely won’t want to miss it.

The number-one question I get asked numerous times a day is, “Are you bullish or bearish on oil?” So let’s bring up the some of the main arguments for and against a move in the price of oil.

1. Refinery Runs

Bull:

The latest Petroleum Status Report from the US Energy Information Administration (EIA) showed refinery crude oil inputs increasing by 283,000 barrels per day from a week prior. The increased crude oil runs is a strong bull case for a higher oil price. As refiners come off seasonal maintenance in April 2015, 1 million barrels per day of oil can be added to refining capacity from the lows at the end of February 2015. If oil production growth continues to remain stagnant over the next few months, refiners can add to increased domestic demand, which will put upward pressure on West Texas Intermediate (WTI) prices.

2. Daily Production

Bull:

The week of March 20, 2015 was the last time we heard that oil production increased in the US. Since then, net production has been decreasing. The slight production decline with the added demand from refiners coming online will be a boost for WTI prices into April 2015.

3. Storage Additions

Bear:

Even though production is slowing and refiners are coming online, the demand from US refiners has yet to make net withdrawals from US onshore crude oil storage supply. Remember that we’re still at an 80-year high for crude oil storage at 483.7 million barrels. The storage story has been mixed, with week-over-week decreases and increases. If demand continues to pick up, storage will need to see significant weekly withdrawals to warrant a long-term positive outlook for WTI prices.

4. Spring Breakup

Bull:

Spring breakup is mainly a thing in northern countries; it affects many Canadian drilling operations in Alberta and Saskatchewan, as it does in many parts of Russia. In the winter, the frost on the ground hardens it, which makes the surface very stable for drilling and transport. During the spring, the frost melts and the ground becomes soft, and thus the drilling and logistics become very difficult. We keep in contact with many Canadian producers and have been informed that drilling will likely resume in late May and early June 2015. In the meantime, natural declines in wells will likely slow Canadian crude oil production for the next couple of months, adding to reduced supply and higher WTI prices.

5. Phantom Wells/Fracklog

Bear:

The 3,000-well fracklog drilled by US shale producers hasn’t gone anywhere, and net withdrawals for storage have yet to come to fruition. In the previous edition of The Raw Deal, I mentioned that 150 wells are likely to come online in North Dakota alone because of state regulations on abandoned wells. This means that in North Dakota, 37,500 barrels could be added to production as we enter June 2015, as all producers need to do is drill and frack their phantom wells. Once prices increase to economic levels of production, shale drilling companies are likely to dip into their fracklog inventory and keep WTI prices low for longer.

6. Non-US Shale Producers

Bear:

The tables seemed to be turning as OPEC countries continue to defend their market share in Asia and Europe by increasing production by 811,800 barrels per day at the end of March 2015, according to primary sources. Saudi Arabia itself added 658,800 barrels per day to bring its production to 10.3 million barrels per day, its highest level in three decades. Iraq has fully restored its production back to 3.63 million barrels per day. OPEC added the equivalent of 75% of total Bakken production in North Dakota, which highlights a frustrating market dynamic between world oil supplies that will keep global oil prices low unless OPEC cuts production at its June 2015 meeting.

On April 2, 2015, Iran and the P5 +1 world powers reached a tentative deal on Iran’s nuclear program that would see Iran’s nuclear capacity greatly decrease, and would increase strict monitoring of its nuclear facilities. The final settlement for the deal will be on June 30, 2015 and will likely be accepted by all parties. Although Iran’s Supreme Leader Ayatollah Ali Khamenei has taken a hard line on immediately lifting sanctions, there will likely be some compromise on both sides. If the US Congress is unable to pass the lifting of sanctions and break the nuclear agreement between Iran and the six superpowers, the world will not make US Congressional politics an issue. China, Russia, Germany, the UK, and France will likely lift their countries’ sanctions, and 30 million barrels of Iranian crude will immediately flood the market. As time passes, Iran will add another 500,000–1 million barrels of oil per day as the lifting of sanctions increases Iran’s production capacity.

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K-Man’s Resource Financial Tip of the Week: The Production Type Curve

If you’ve speculated on an oil well, you’ve been where we all have: A company has drilled a well, and we eagerly wait for production results. Will it be a gusher or a duster? The news is finally released, and the headline proudly states that the company is now producing oil… and the stock falls. What happened? How do companies and investors know how much oil is actually good? After all, an oil well in Alberta won’t be the same as one in Iraq. One tool that helps moderate these expectations is something called the “production type curve.”

The production type curve is the production profile of a well located in a specific oil play. To simplify things, it’s essentially the average production rates of all the wells in an area for a specific amount of time: the more wells, the better the representation. They often include well economics, which further temper expectations and are used to compare different oil plays. Let’s look at the type curve of wells in the Hardy Bakken in southeast Saskatchewan.

Source: PDM, Casey Research

For an average cost of $3.5 million, companies that drill in the Hardy Bakken can expect wells in to yield anywhere from 109,000 to 172,800 barrels of oil equivalent for an internal rate of return of 21%–43%. To come back to our first example, let’s say it was a junior explorer and producer that acquired some acreage in the Hardy Bakken play and dropped around $3.5 million to drill its first well. In much anticipation, the company finally releases its initial production rate over 30 days (IP30 rate), which came in at 50 boe/d. While many wells in the Hardy Bakken will have an IP30 in that range, according to the type curve, the average first-year production rate is closer to 100–110 boe/d. Obviously the lower production rate means less oil, and less oil means a lower stock price. Cue the selling.

Now let’s look at a Manitok Energy (MEI.V) as a real-life example, to really pound the concept home.

Manitok drills the Cardium and Manville group in the central plains of Alberta. These formations are oil-rich deposits at fairly shallow depths relative to the Montney and Duvernay formations. One of Manitok’s drilling programs involved tapping the Basal Quartz formation between the Glauconite and Ellerslie formations in the Lower Manville. These horizontal wells have type curves that assume an average initial production rate of up to 250 boe/d.

On October 9, 2014, Manitok released news that it had drilled and produced from the Basal Quartz formation with an initial production rate of 367 boe/d. That sent the stock up for the next two days as investors absorbed the news.

For pure exploration and production (E&P) companies, beating the type curve is important to boost their stock prices. At the point of a type curve beat, investors can choose to take money off the table and enjoy their spoils or bet that the company can continue to beat the averages and settle in for a thrilling ride.

Another emerging use for the type curve is to display the benefits of enhanced oil recovery (EOR). Enhanced oil recovery techniques are used to increase access to existing reservoirs. This means going into already drilled wells and squeezing out more oil. Oil companies are focusing more on EORs than drilling because the current oil environment has forced them to become more efficient. In the Hardy Bakken, water floods are often utilized to increase oil recovery. It’s the process of injecting water into the oil reservoir to increase pressure and stimulate production.

With the application of water floods, the estimated ultimate recovery of a Hardy Bakken well increases 67%, from 150,000 to 250,000 barrels. The operator gets almost as much oil as drilling another well but at a significantly cheaper price. It’s no wonder that production continues to increase when rig counts have been decreasing. The shift to EOR allows operators to stay afloat in even the most hostile oil environments.

There are different EOR techniques for different oil deposits, and as mentioned earlier, companies are focusing more on EOR as oil prices continue to decline, especially in the US shale plays. Operators are becoming more innovative—anything to shave additional operation costs and to get the “most for their buck.” One company that we cover in the Casey Energy Report has led the pack in EOR innovation and has the most prolific acreage in North America to apply it to. It’s poised to grow even at $50 oil and leveraged to skyrocket at any sign of recovery. Click here to find out which company that is.

The type curve is widely used, but it does come with some limitations. First, the people who utilize it are at the mercy of the company’s assumptions. For its type curve, the company used an oil price of $95.00. Oil is now at $55.00/bbl, so the economics of the well are now unrealistic, making charts like this that accompany a type curve irrelevant:

Also, the range that makes up a type curve isn’t represented; and since not all wells are the same, the type curve should not be used as the absolute benchmark. So while the junior E&P company’s first well had an IP30 of 50 boe/d, the next two may come in at 120 boe/d and push the company’s average production closer to 100 boe/d. Expecting every single well to come online at what the type curve depicts is unrealistic, and a company can be unfairly punished or awarded by that attitude.

The Casey energy team has been able to identify which E&P companies have the potential to either beat or underperform their type curves. With detailed analysis of companies around certain formations, we’ve been able to identify which companies have serious potential and which ones are simply hype. Stay ahead of the curve and check out the Casey Energy Report for a free three–month trial.

K-Man’s Fave Tweets:

A lot of my readers are like Doug Casey and don’t follow me on Twitter. If you want to follow me, by all means do so: my Twitter handle is marinkatusa.

I post my take on the resource markets daily, as well as interesting developments and other tweets are just to make my followers smile. Here are three of my tweets that many people enjoyed. I’ll also post some of my favorite tweets from others I follow.

https://twitter.com/MarinKatusa/status/577536359872667648

https://twitter.com/MarinKatusa/status/572842055925411842

https://twitter.com/MarinKatusa/status/575367058436677633

 

Cool Charts of Interest

Send Me Feedback Regarding The Raw Deal

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This comment from my buddy Dennis Miller in reference to last week’s The Raw Deal is worth sharing with all, in my opinioin:

Marin, I loved this article and analysis.

In the article, you mentioned the oil industry has tried to stay away from government. I have some insights as to why that you can verify with some old-timers.

At one time, the oil industry and government were hand in glove. They had all kind of breaks like depletion allowances, etc. During the Carter years, we had a shortage, and the industry could not meet the supply needs they had contractually committed to. Here are some of the things they did.

1. They unilaterally voided all client supply agreements and went on “allocation.” “If you don’t like it, sue us, and you won’t get any product at all!”

2. Allocation was not fair. XXXXXX was a client of mine, and they cut off all slow-paying customers and customers who had pissed off some executive years ago, and the allocation formula was constantly changed based on who bitched the loudest to his member of Congress. Rules came down from the top to favor this company versus that one kind of thing. At the same time, the local sales team could pull shit too and reward their friends and hurt their friends’ competitors.

3. XXXXXX fired the bulk of their sales force. The few who remained were jerked around like I have never seen before. Longtime industry expert on marine lubrication in Louisiana was told, “If you want a job, you must be in Kansas City in two weeks, and you are now selling asphalt.” JR Ewing was alive and well.

4. Their product line and mix was changed unilaterally. I had a small plane that ran on 80 octane aviation fuel. Our local airport was told they could not get it anymore, but they could get plenty of 100 octane at double the price. They cut the barrel differently into everything thing they could make high margins on and raise prices even further.

5. I sat in a meeting where the VP of sales at XXXXXX told his sales force their goal was to get every penny of possible profit out of every ounce of hydrocarbon regardless of what it takes.

6. I called on some franchised XXXXXX dealers (with the local sales rep) where XXXXXX owned the building and the operator leased it along with the franchise. This was before the days of convenience stores (which by the way I suggested to XXXXXX and they told me I was full of shit. A marketing guy was in the meeting, and six months later, the first one was born in Houston). The code was TBA: tires, batteries, and accessories. They had a big tire promotion, and the salesman told the dealer (whose shelves were already full of tires he could not sell) that he needed to buy 100 more because his lease was coming up for renewal and there was no guarantee they would renew it. They did not much give a shit if their dealers made a profit.

7. Their agricultural business had always placed tanks on the farmers’ facilities and supplied them with truck delivery regularly. They demanded that all their customers buy the tanks at current retail value, even though some were 20 years old and had been written off long ago. If you didn’t do that, you got no product. Their asset sales were huge because they forced their customers into buying them.

Soooo, the bottom line was the arrogant greed of the entire industry pissed off the public, and then Congress, and there was a huge backlash. I think they passed something like an “excess profits tax” and things like that to slap down the industry. It was basically a falling out between the government and the oil industry, which seems to have remained today. It was complicated later with all the environmental stuff which made it politically popular to go after big oil.

I have never seen an industry that treated their people and customers so ruthlessly. I found your article really interesting because now big oil needs help and politically it might make sense to help them.

Have a great weekend,

Dennis

Until next time,

Marin Katusa
Chief Energy Investment Strategist
CASEY RESEARCH Energy Division