Wednesday, March 11, 2020

The Perfect Storm

It's been quite a week across the world.  Many are asking "what is going on?".  I believe that we're experiencing a "perfect storm" from many parallel fronts.

The oil industry is suffering greatly and it’s starting to feel like 1986 and 1991.  My dad was a geologist so I've grown up in this business.  I graduated from geology undergrad in December 1985 when oil crashed from $33 to $9.  I've spent 34 years enjoying this "rollercoaster".

"How did I get here?"
Once In A Lifetime, The Talking Heads

The unconventional resource boom started with the Barnett Shale in the Fort Worth, Texas area.  George Mitchell and Mitchell Energy spent 20 years researching and developing the Barnett Shale.  They were the pioneer shale "code crackers" which led to a frenzy across the industry for the past 17 years.  The initial focus was natural gas in shales.  Natural gas, due to the smaller molecules, can produce easier in low permeable reservoir rock.  
During this time, the "two worlds" of horizontal drilling and hydraulic fracturing (fracing/fracking) came together.  The industry has been performing vertical frac jobs for 80 years.  Performing this procedure in a horizontal wellbore was the "new new thing".  

Following the initial shale boom, several other rock types became targets so the industry "lumped" them under the title "unconventional reservoirs".  For instance, the Eagle Ford Shale is technically a limestone.  This "unconventional" nomenclature is mostly attributed to the low permeability in the rock.  Oil and gas are trapped, and fracturing the rock enables the gas and fluids to be released.  Following the shale gas boom, tight oil reservoirs were then experimented with and the oil shale boom took off in 2009 starting with the Eagle Ford Shale in South Texas.

The great success in the gas shales (Barnett, Fayetteville, Haynesville, Marcellus, and Utica) resulted in a significant increase in U.S. gas production.  This increase in supply unfortunately coincided with the timing of the "mortgage crisis" in 2008/09 and subsequently natural gas prices crashed from their all-time high.  They've never fully recovered and are currently at a significant low ($1.93/mcf).

This same phenomena, of a rapidly increasing supply, has now occurred in the U.S. oil market.  The industry, once again, is a victim of its own success.  Supply and demand are simple economic concepts.  A rapid increase in supply will drive commodity prices downward.

Many don't understand that the "low hanging fruit" fossil fuels are "long gone" in the United States.  Hydraulic fracturing is a very expensive process.  Wells can cost $6-14 million. Significant volumes of water, sand, and chemicals are required to successfully cause the reservoir to produce at high rates.  The industry has done an amazing job at improving the technology, increasing efficiencies, and lowering the costs.  In contrast though, Saudi Arabia, Russia, Iraq, Iran, China, and many other nations are still producing the "easy" hydrocarbons.  The United States is in a much later stage of development that is more technologically challenging and expensive.

During all "manias", money "falls from the sky".  The unconventional resource boom has been no different.  Wall Street, private equity firms, private investors, and banks opened their checkbooks in a big way.  

I consider the Mitchell Energy "research and development effort" to be Phase 1 of the Unconventional Reservoir Mania.  Phase 2 was the great "land rush".  It might have been the greatest and largest "land grab" of all time.  My two strongest memories from the early part of this phase both occurred in the Haynesville Shale.  In 2006, Chesapeake Energy, leased the Dallas-Ft. Worth Airport for $10,000 per acre.  Many considered that both impossible and insane.  Later in North Louisiana, some mineral owners received lease offers of $23,000 per acre.  Some actually declined and greatly regretted it.  Pigs get fat.  Hogs get slaughtered.  Chesapeake hasn't been profitable in over 12 years and they're heading towards bankruptcy for a reason.  

Over the past thirteen years, a massive amount of capital has been invested in leases and drilling.  Not very different from the DotCom and Tulip manias, "2nd and 3rd movers" paid way too much to "enter the game".  Two years ago, I represented a mineral owner and we sold their minerals for $52,000/acre in the Midland Basin....absolute insanity!  Other deals we closed were $23,000/acre in the Eagle Ford.  In the North Louisiana Terryville play....$10,000/acre.  All seemed historically crazy to me.  

I call Phase 3 of the era, "HBP the Units".  HBP stands for "held by production".  After leasing, the oil companies have to drill one well in each unit to hold the acreage.  For example, if an operator has 100,000 acres in a play with unit sizes averaging 1000 acres, they have to drill 100 wells to HBP all of their acreage.  If they paid $8,000 per acre, then they invested and risked $800 million.  If the wells average $9 million each, then they risked an additional $900 million.  That totals $1.7 billion of investment and risk!

Phase 4 is the development stage where multiple wells are drilled per unit.  The early Wall Street mantra was "production growth".  This caused a drilling frenzy across all of the economically proven plays.  Despite the per-well economics, companies signed multi-rig contracts and responded to Wall Street's call.  About 15 months ago, Wall Street pivoted overnight to "free cash flow" (FCF).  They wanted profitable wells and production growth.  Even at $50-60 per barrel, free cash flow was not possible in many plays.  Also, each play has a spread of Tier 1, 2, and 3 acreage. All reservoir rock is not created equal....and its thickness changes across a play.  The rapid shift to FCF had an immediate negative impact to many companies.  The recent drop in oil prices greatly exacerbates this negative cashflow.

An additional challenge has been that the offset wells are not achieving the results that the oil companies have not only published, but have also "booked" as reserves.  Oil companies are valued based on their hydrocarbon reserves.  

The industry denotes the first well in a unit as the "parent" well.  The offsets are the "child" wells.  For example, a company might have "booked" reserves for eight wells per unit.  The early stage development indicates that only four are needed.  The company now has to adjust its booked reserves.  For most of the industry, this downward adjustment hasn't even occurred yet.  That's a future "tidal wave" to come.  Chevron just wrote down $5 billion of acreage (750,000 acres) in the Marcellus play.  This dates back to 2010 when they acquired Atlas Energy.  Yes, $5 billion of capital destruction.  Chevron is a very good, large operator.

Now in Phase 4, we have an industry "drowning" in a massive amount of debt.  Imagine if you had $20,000 on your credit card and you can't pay the minimum payment due.  That's where many companies are today.  They can't "drill" their way out of debt.  They can't fund new wells at this current price.  Once the drilling stops, the production and income declines rapidly.  Game over.  Chapter 11 or be bought or merged for "pennies on the dollar".  Shareholders and investors lose.  Some companies like Halcon have already filed Chapter 11 twice!  They call that Chapter 22.

I compare the "overheated" Anadarko purchase by Oxy to the Time Warner-AOL purchase in the DotCom era.  At the time, it was the "deal of the century".  It marked the peak of the DotCom era.  Oxy's deal structure will likely doom the company.  Anadarko was a really good company with a nice, diverse asset portfolio both domestic and international.  Think of the great movie assets that Time Warner had.

Congrats once again to the Oracle of Omaha....preferred stock with a 8% dividend! He'll be the only one that makes a profit.  Mr. HotTakeOfTheDay is very wrong on this one....way before the oil crash.  Also, congrats to Chevron for exhibiting great discipline.

Even if oil were $60 per barrel, there are many companies that have "no way out".  The pure gas players are really in trouble at $1.93 per thousand cubic feet.  The massive supply of U.S. natural gas will be an issue for many years to come.  Once again, we're a victim of our own success.  

Hopefully, one day, Americans will realize what creates electricity!!!!

One interesting fact to note is the number of multi-generation "oil families" that cashed out over the past few years:
That's almost $10 billion....thanks Grandad!

Due to the very contentious political environment the past few years, I've concluded that some have greatly overstated the impact of the U.S. unconventional production.  The statements that the U.S. is "oil independent" is nonsense.  This week we were reminded of the facts.  Saudi and Russia are still easily flowing conventional oil and can "turn the faucet on" as needed.  The U.S. public also doesn't realize that the flow rates of hydraulically fractured reservoirs decline very rapidly.  A well that starts at 1000 barrels of oil per day will likely produce 200-300 barrels a day a year later.  Conventional (high permeability) reservoirs produce at a much slower decline.

Nassim Taleb coined the term "black swan" when he released his book of the same name in 2007.  The simple explanation is that it represents an unpredictable and unforeseen event.  Some examples are 9/11, Mortgage Crisis, WWI, and the Soviet Union collapse.  The recent Covid-19 virus expansion represents the latest example.  Who would have thought that a flu-like virus could contribute to the collapse of oil prices?

The rapid spread of the virus has caused an abrupt and significant halt of transportation in many countries including China, Italy, and Iran.  Decreasing transportation means decreasing oil demand which results in price decline for petroleum.  We're very likely just at the beginning of this phenomenon.  Many "lock downs" are occurring across the globe including the U.S.  Google recommended that all of their U.S. staff work from home.

Saudi Arabia has been going through a transition of power to their younger generation of princes.  Thirty-five year old, Saudi Crown Prince Mohammed bin Salman, is now in charge. He took over power in 2017 and has made some aggressive moves.  On several occasions he has detained and arrested family members through a power struggle.

Vladimir Putin requires no introduction.  He has been the official and unofficial leader of Russia for over 20 years.  Just recently, he has backed changes to the Russian constitution which would allow him to remain as head of state until 2036.  The theory that he and President Trump are best friends might now be debated.  

Since 1960, OPEC has been a cartel controlling worldwide oil prices.  Russia is not a member and this past week they declared war on OPEC by not agreeing to decreasing oil production for the purpose of increasing the price of oil.  Who knows where this will lead?  It's financial suicide for both countries.

Do you really want to know?
Yesterday morning Marathon called it quits on the Crowell 3H-1 well.  After ten days of challenges including fishing a metal object and a failed casing test, the company decided to abandon the drilling until a later date.  They were still in the vertical hole after 35 days of drilling.  Even if oil were $100/barrel, this area has drilling challenges.  Mr. CEO Tillman, please don't shoot the messenger!

You can't blame them for "taking a breather" after the past week's developments in oil prices.  Let's hope that the Crowell #2 exhibits some good production over the months ahead and, with higher prices, activity will return.  

It will be interesting to see what they decide to do with their 500 square mile 3D acquisition project that is currently underway.  I would stop acquisition today and process/interpret what you have.  Shoot 100 square miles over your Tier 1 area, drill some wells, and then add more through time.  In an area with no additional large targets, the size of this 3D shoot has baffled me from the beginning.  Maybe another example of too much capital being available.

Who knows where all of this will lead?  There are so many factors involved and no one has the magical "crystal ball".  One of my favorite "calm geniuses" is Ray Dalio.  His track record is astonishing and he understands economics and market cycles better than most.  

If you want to follow someone who really understands the oil markets, check out my old Amoco colleague Art Berman.  He called all of this from the beginning.  Many "yahoos" have showed up in the last six months claiming expertise.  Art also had the courage to fight the mainstream headwinds.  Being a geologist, I stick to the rocks, logs, and maps.  Predicting future prices is not my thing.

The good news, from my perspective, is that on the "backend" of manias, some very good companies result.  Think of Ford Motor during the initial automobile boom.  Amazon resulted from the DotCom boom.  When the smoke clears in Phase 4 of the Unconventional Era, we'll have some very strong oil companies producing hydrocarbons for decades.  That will be very important for the United States.  We represent 4.25% of the earth's population yet consume over 20% of the energy.  Houston we have a big problem....Our "supersize me" mentality has to end.

As Coach Bernich used to say "it's time to buckle your chinstraps boys!".

I hope that this "high level" rant was informative.  Follow up with your own research.  Stay positive, informed, creative, and wise my friends!


  1. Your assessment of the cyclical and boom and bust nature of the Oil & Gas was very interesting. It documents for the most part, what I have experienced over the last 40 years while working in this industry.

  2. When the Chief of the Chalk talks, I LISTEN. THanks Kirik...hope you are hunkering down.

  3. Great read, Kirk...really love the Coach Bernich reference!

  4. Kirk:

    Good blog article as always. I differ somewhat on Art Berman. While prognosticating requires a certain amount of "pragmatic contrarians" such as Mr. Berman, the fact is that the amount of investment and innovation may arguably not have occurred at all if POVs like his were to have ruled the day. The Barnett was bound to be known as "Mitchell's folly" (as well as other more derisive terms) unless he and his company continued to pursue it to long-term viability - the industry still has its purposes for wildcatters and dreamers, IMO...

    1. Warrland,
      No doubt about it. Every mania has massive capital destruction but usually something good comes out the back end. My reference to Berman was on his supply/demand/price projections. Being an explorationist, we have to continue to take risk to find new reserves. Horizontal fracking was a big risk in the beginning.