Crude Observations

Whither LTO?

Well folks, another week gone by, another political crisis or two under our belts. I don’t know about the rest of you, but it’s getting to the point where instead of being constantly exhausted by all the hyper-partisan rhetoric and aggrievement that I am becoming numb to it.


Speech from the throne that doesn’t specifically address the issues facing the oil and gas industry? I’m over it, expected nothing more. Prime Ministerial address in prime time that was nothing more than an infomercial for government policies? You thought it might be different with this crew? Donald Trump trying to sow the seeds of chaos and confusion by implying he won’t peacefully hand over power if he loses? What, is it Tuesday already?


It’s at times like these that I feel the need to find something to relax my nerves, to go back to more simple times when a blog topic didn’t need to be political or divisive or subject to ridicule or scorn by any number of (vaguely) interested parties.


It is in dark times like these that I cast about for a topic that gives me great joy and comfort. And, as regular readers know, that topic typically revolves around Light Tight Oil and the prospects for American shale.


Fortunately, shale is the gift that keeps giving, whether it is while it is in ascendance or, as is readily seen to be case right now, on the decline.


As luck would have it, I recently had the opportunity to be a fly on the wall (or a small Zoom window on a screen) at a webinar wherein the main topic of conversation was “what the heck is going to happen to shale” or something like that.


Hosted by a think tank and featuring some highly regarded analysts, academics and industry participants, the session provided some pretty valuable information and insight, which I will do my darnedest to summarize for you here in this abbreviated blog.


Out of respect for those of you who don’t have a lot of time to get into too much detail, I’ll give you the short version first.


It was good for a bit, no one made any money and the party is most definitely over, time to return the empties and clean the carpet. Fortunately the house is still usable.




But how did we get here? Part of the discussion was that in order to understand how the next few years in shale are going to play out, it is important to do a quick review and understand how we got to where we are and how this particular moment in time and industry crisis differs from the last crisis, four short years ago.


Since 2006, the growth of shale gas and light tight oil in the United States has been a well-documented success story, moving the United States from being an importer of natural gas to being self-sufficient and ultimately an exporter and turning the oil market on its head to such an extent that the United States has become a net exporter of oil and, technically, self-sufficient (I say technically since it is well-documented that many of the refineries in the United States aren’t configured for the light tight oil produced in such abundance, thus they import heavy and export light – netting to zero).


At any rate, production in the continental United States more than tripled over that time, peaking at more than 13 million barrels per day in February of 2020 before being derailed by a combination of price war and the demand destruction wrought by the pandemic.


The growth of the LTO market has been a heady ride fuelled by entrepreneurial dreams, technical innovations and access to a virtually infinite supply of cheap capital delivered via an endless procession of dump trucks filled with dollars.


Until it wasn’t.


For the last year or so, investors and banks have been sounding the alarm about new-fangled terms like profit, free cash flow, living within your means and debt reduction instead of growth at all costs and maximizing CEO compensation.


While the crash due to the pandemic has been dramatic, the consensus on this webinar I was on is that the wheels were already well off the LTO growth machine and that change was afoot already, as evidenced by declining rig counts all through 2019 and the drying up of capital.


It is interesting to compare 2020 to 2016, which was the last major downturn. At that time, shale was still in a position to be a major growth area and while production and activity declined drastically in response to low prices, it soon recovered thanks to productivity growth and access to cheap capital once prices recovered.


Some of the most significant gains happened in the key shale plays that we all know and love such as the Eagle Ford and the Permian where production growth reached triple digits as operators moved from basin to basin chasing tier one locations and drilled them deeper and longer and frac’d them with exponentially more horsepower and volumes of sand and liquid.


As 2019 came around, the wheels were starting to come off. Capital was less available as were the tier 1 acreages. Productivity stalled out and with growth coming to a standstill, the realization emerged that the LTO business model was not self-sustaining and had failed to deliver free cash flow back to its investors since, well, since it all started. To many industry participants, the realization started to come that the model needed to shift and become focused on profitability, self financing of operations and to stop leveraging to grow for growth’s sake.


If LTO were a person, you could say that it had finally settled down, got a mortgage and started saving.


Then came 2020 and the pandemic (never mind a brief but ridiculous price war) which knocked the stuffing out of global oil markets to the tune of an estimated 8 million bpd demand collapse for the year.


The supply response around the world was of course massive, but was particularly disruptive in the LTO world, where production fell by 2.5 mm bpd and the rig count collapsed to such an extent that at current levels it isn’t enough to maintain current production given the realities of high decline rates, lack of access to capital, low prices and a stagnation of productivity gains.


So what’s a Shale Guy to do?


Reinvent yourself apparently!


First off, this is not the death knell for LTO, far from it. It is a natural progression from heady go-go times to a business model focused on maintenance and modest growth. That’s right, the major thesis from the webinar is that shale is mature and that basins are reaching capacity.


This leads to the second major theme which is that when presented with this environment, companies will realize that less growth is needed and that the only way to emerge from this crisis isn’t to grow out of it but to consolidate out of it. Squeezing and looking to get the most out of each acre and well and barrel, managing debt and being prudent with reinvestment.


In a mature marker, scale through consolidation is critical. You are able to manage down G&A costs by spreading it across multiple properties and projects, reducing your costs and generate internal cash flows to make the business more sustainable.


It was theorized that we could see a 60% to 80% reduction in the number of large and midcap companies operating in the Lower 48 through this consolidation leaving between 25 and 40 operators where once there was more than 100.


These consolidated entities will be in a much better position to prudently manage their business and will be able to, through a maintenance versus growth approach, start to generate free cash flow to reinvest in their businesses (remember the lack of capital) and, hopefully, reduce the overall industry decline rate by optimizing existing production and extend the time at which each basin reaches “capacity” (all the prime acreages have been drilled) from the current estimate of 5-6 years to 8-10.


Of course this whole maintenance shthick could go out the window if prices recover and this is a major investor fear, but there is a growing realization that core depletion is the major risk in high depletion basins such as LTO ones and that ultimately industry will be better off and more stable with a maintenance model.


So with this cap on growth, it was estimated that the United States LTO would be able to grow at 3% to 4% per year for the foreseeable future and no longer post the massive growth rates it had in previous years. The irony now being that the US is the largest producer in the world (still) and may maintain that title for a while, but in the current market is no longer the most influential (if it ever was).


This of course has major implications for a number of related energy sector participants so it would be worthwhile to touch on those briefly.


Let’s start of course with Canada, whose energy market is so intertwined with the United States. Canada has of course been seeing similar trends as it regards consolidation and fixing balance sheets, although we got an earlier start and are much more “on the other side” of the transformation.


The prevailing view was that Canada’s upstream sector as a whole isn’t rewarded for growth, our maintenance costs are lower and that market access, whether perception or reality, is always going to be a factor.


The flip side of course is that as core depletion becomes more evident in the United States and decline rates become an issue, then Canada, with its much more stabilized production levels will attract much more attention.


As it regards natural gas, the analysts were of the view that many of the dynamics at play in the LTO world are also at play in the gas industry which, as we all know, is the original shale play.


On a production basis, with LTO associated gas declining with oil production, lower investment, increased exports and consumption holding steady, it is estimated that production in the US will exit 2020 at about 89 BCF/d, down from 99 BCF/d and that 2021 gas production will be flat exit to exit.


This has major implications for pricing and for Canadian producers (hint, it’s positive). The thesis is that the gas market is already quite consolidated and that balance sheet management, higher margins and mitigating decline is the primary driver of operators.


This slowdown in activity is expected to push the inventory of Tier 1 locations out for a decade.


In the midstream sector, there are many uncertainties and the driving force is what happens when the production demand shock finally flows into what was a supply driven expansion of transportation capacity.


With all the new projects coming on stream, the Permian will be under capacity sometime in 2021, which will allow for more gas offtake and a reduction in flaring, but if the oil market doesn’t stabilize, there is a very real risk that the midstream sector has overshot in its buildout which will have major implications for well economics and the upstream sector.


Finally, the discussion pivoted from a discussion of the benefits of reduced flaring and how controlling emissions in an ESG world was critical to what was the impact of the unfolding Energy Transition for the LTO world.


The general consensus was that two or three years ago, producers large and small and midstream operators didn’t have a lot of buy-in to ESG or energy transition but that has changed and they are changing and adapting. This is a large focus for US based Oil and Gas bankers (sorry, Energy bankers!) and ESG benchmarks are a regular fixture in bond issuances.


With the general thought that within 3-5 years EV’s will be on parity with ICE vehicles on a non-subsidized basis the group felt we should all be making ourselves ready for a fleet turnover that could last decades but will begin to accelerate over the next decade.


From a producer standpoint, the real impact on gas demand will happen towards the end of the decade with diesel taking longer.


As well it was felt that the market was overestimating demand impact for the next five years of the energy transition but that industry cheerleaders and government were underestimating demand impacts for the five years subsequent to that.


It was a lot of meat in one session, but the main points I picked up?


  1. US LTO business is reinventing and adapting to a new reality, so I should really stop picking on them
  2. The days of unbridled growth in the energy sector are over
  3. A maintenance/modest growth model that incorporates scale matters
  4. Oil and gas companies need to participate actively in the energy transition world or be left out of both the opportunity and capital markets
  5. Governments need to get on board and out of the way because they are hopelessly behind both market forces and the private sector adaptation to them
  6. Canada is, go figure, well-positioned for this new market paradigm
  7. Pipeline infrastructure currently planned is probably good for a while
  8. Capital eventually figures it out
  9. Natural gas still matters as a transition
  10. Justin Bieber is more aware of the woes of the energy sector than Trudeau (don’t believe me? Watch this weirdness – New Justine Bieber Oil Job Loss Music Video)


That is all, I must go. It is my wedding anniversary today.



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