FRACTIONAL FLOW

Fractional flow, the flow that shapes our future.

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Oil, Interest Rates and Debt

At first glance it is hard to see how oil, interest rates and debt are connected. Two of them are human constructs while oil (fossil sunlight), a gift from Mother Nature, took tens of millions of years to process. Oil is an endowment extracted from a confined underground stock and is now the most dense and versatile energy source known to man.

Figure 1: Chart that shows the development of [extraction] cost of oil and interest rates (US 10 Year Treasuries) has developed since 2000 and a likely trajectory for oil extraction costs.

Figure 1: Chart that shows the development of [extraction] cost of oil and interest rates (US 10 Year Treasuries) has developed since 2000 and a likely trajectory for oil extraction costs.

Both lines are SIGNALS, and most likely plan their future based on only one of them.

The 10 Year Treasury (or similar) rate is the reference used for amongst other things to set interest rate for mortgages. Most now, aware of it or not, base their future plans on the expectations to developments of the 10 Year Treasury.

What is now playing out in the oil market may be described as below;

Low interest rates [stimulates debt growth] => Pulls demand forward => Oversupply => Deflation

How will the interest rate develop in the future?

This is important as the present huge global debt overhang weighs heavily in the consumers’ balance sheets and their affordability for costlier oil. It is also important for oil companies’ long term planning to bring costlier oil to the market.

A lasting, low rate makes higher debt loads manageable. Interest rates works both sides of the demand/supply equation.

A higher interest rate will have serious implications for highly leveraged consumers and oil companies.

The dynamics may be described as below:

Higher interest rate => lowers demand => downward pressure on price [deflation] => makes it harder for [highly leveraged] consumers/oil companies to service their debt overhang => lowers investments to develop costlier supplies

At some point in time the present oil supply overhang will come to an end. This will become reflected in a higher price.

The timing of these events creates uncertainties and the agile and financial strong oil companies will sweat out a lasting low oil price.

Few are aware of that the costs of accessing our real capital (like oil) that runs our economies are rapidly increasing.

What is different this time is that the oil price may remain lower for longer than the estimated full cycle break even costs for new developments.

The suggested path for costs is believed in the near term to come down as oil service companies have reduced their prices to shoulder the burden from the recent price collapse. Over time, the capacities of the service companies will become aligned with the demand for their services and products. At some point, as the oil price recovers and investments pick up, the market mechanisms will bring the prices from the service companies up as the service companies also need to make a profit to stay in business.

In figures 4 and 5 are shown how the combination of lower interest rates and a lasting, high oil price encouraged the oil companies to rapidly take on more debt to develop costlier oil on the expectations that consumers had remaining ability to take on more debt/credit to pay for this, thus allowing the oil companies to retire their debts.

The oil companies’ behavior in the recent decade is reminiscent of group think. Few expected the oil price to collapse, though the oil industry itself repeatedly point out the cyclical nature of the oil price.

The aggregate of developments (primarily driven by an amazing growth in the extraction of light tight oil [LTO]) gradually resulted in a supply overhang that made the oil price collapse.

The costs of extracting real capital, like oil, has been rapidly increasing, yet we are making decisions for the future as if it were decreasing, based on the price of capital (money). This is a short term phenomenon that will last until supply and demand become balanced.

The present situation with an apparent oil glut and low prices is a temporary false signal.

This may also be the case with the low interest rates.

The near future will reveal how the competition for available funds to service a still growing huge global debt overhang fare towards the need to fund developments of costlier oil.

Can an increasingly leveraged global economy handle both higher oil prices and interest rates and still remain on its growth trajectory?

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Are the Light Tight Oil (LTO) Companies trying to outsmart Mother Nature with their Financial Balance Sheets?

In this post I present what I found from applying R/P (Reserves divided by [annual] Production) ratios for Light Tight Oil (LTO) for 3 big companies in Bakken/Three Forks/Sanish.

The companies are; Continental Resources, Oasis Petroleum and Whiting Petroleum, which operated 28% of total LTO extraction in the Bakken(ND) in December 2014.

  • Undertaking oil and gas reserves assessments are just as much an art as a science.

From previous work with LTO from Bakken I kept track of the R/P ratio for wells/portfolios and generally found it was in the range of 3 – 4 after their first year of flow. This suggested that 25 – 35% of the wells’ Estimated Ultimate Recovery (EUR) was extracted in their first year of flow.

This made sense as extraction (production) from LTO wells are heavily front end loaded and have steep initial declines.

Examining some big Bakken companies SEC 10-K (SEC; Securities and Exchange Commission) filings for 2014 I noticed that these had R/P ratios for Proven Developed Reserves (PDP) that ranged from 7 – 9.

(Refer to the end of this post for more detailed explanations/definitions of PDP and PUD)

That did not make sense and R/P ratios give away powerful and very valuable information about likely future extraction trajectories.

About 50% of the companies’ total LTO extraction (flow) in Dec 2014 in Bakken (ND) were from wells started in 2014. In other words, the flow was dominated by “young” wells which decline rapidly. Therefore, whatever flow data (monthly, quarterly) that was annualized it should be expected a R/P ratio for total extraction around 4 for 2014.

What I present is how PDP, extraction data and R/P data derived from the 3 companies SEC 10-K statements compares to what was derived from actual data. Further, what actual data now is projecting for EUR for the average well for these companies.

Figure 1: The chart above shows developments in average well first year LTO totals (productivity) for some companies and by vintage. The colored columns for 2013 and 2015 show projected financial performance based on average well first year LTO totals. For 2013 the chart is based on: WTI at $98/b and a type well at $10M was found to have a 0% return with a total first year LTO flow at about  50 kb.  For 2015 the chart is based on: WTI at $60/b and a type well at $8M was found to have a 0% return with a total first year LTO flow at about 90 kb.  The chart illustrates that the well productivity has been on an upward trend. So far the productivity improvements and cost reductions have not fully compensated for the effects from a much lower oil price.  The profitability equation of the type well was solved for the equivalent total first year flow for various oil prices and costs on a point forward basis. A lower oil price makes the red columns “push” the other ones upwards (moves the profitability bands upwards). Wells of 2015 vintage (pre May) are on a trajectory close to those of the 2014 vintage. kb,  kilo barrels = 1,000 barrels

Figure 1: The chart above shows developments in average well first year LTO totals (productivity) for some companies and by vintage. The colored columns for 2013 and 2015 show projected financial performance based on average well first year LTO totals.
For 2013 the chart is based on: WTI at $98/b and a type well at $10M was found to have a 0% return with a total first year LTO flow at about 50 kb.
For 2015 the chart is based on: WTI at $60/b and a type well at $8M was found to have a 0% return with a total first year LTO flow at about 90 kb.
The chart illustrates that the well productivity has been on an upward trend. So far the productivity improvements and cost reductions have not fully compensated for the effects from a much lower oil price.
The profitability equation of the type well was solved for the equivalent total first year flow for various oil prices and costs on a point forward basis.
A lower oil price makes the red columns “push” the other ones upwards (moves the profitability bands upwards).
Wells of 2015 vintage (per May) are on a trajectory close to those of the 2014 vintage.
kb, kilo barrels = 1,000 barrels

LTO in Bakken will now generally work profitably with an oil price (WTI) above $80/b.

The willingness of several companies to sell more debt (obtain more credit), assets and equity to continue to manufacture LTO wells which estimates showed were not commercially viable have had many analysts puzzled.

Something was likely overlooked, and chances are that this is related to EUR driven incentives to expand assets/equity on the companies’ balance sheets (or “book to model”).

As companies drill wells and puts these in operation (production), it allows them to book reserves on the balance sheets. And reserves are the biggest portion of the LTO companies’ balance sheets.

The rush to use credit/debt to drill what likely would become unprofitable wells (applying project economics) with a lasting, low oil price appears driven by some perverse incentive to grow booked reserves to grow assets and thus equity on the companies’ balance sheets, overriding outlooks for poor profitability. High equity on the balance sheets allows for more debt.

Looking at actual, hard well data (from NDIC; North Dakota Industrial Commission) this strategy will at some point have to face up to the realities of physics and Nature. And physics and Nature do NOT negotiate.

  • Using actual data for LTO wells strongly suggests that the PDP (and thus PUD) estimates in companies’ SEC 10-K filings for 2014 are grossly inflated. If so, this has inflated the assets/equity numbers on the companies’ balance sheets.
  • The findings from this study suggest that the massive drilling activity funded by growing debt, was likely motivated by balance sheets expansions of assets, and thus the equity from inflated EUR numbers (“book to model”) which made room to take on more debt.
  • An inflated balance sheet that allows for a debt load above the carrying capacities of the real underlying collateral, will at some point in time turn against their creators and call for revisions of future plans and expectations.
  • It will be interesting to see how the LTO companies’ balance sheets and their profitability respond as it become Mother Nature’s turn with the bat.

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Written by Rune Likvern

Monday, 3 August, 2015 at 10:33

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