Alright folks, enough ranting. It’s too tiring to be angry all the time, even though the government makes it so easy. This week, it’s mostly positive stuff. Why? Because oil is solidly above $50 and there are many reasons for optimism. In fact, I’m so pumped that I just bought tickets to an “Up With People” revival.

 

But first, a couple of housekeeping items.

 

As expected, the hardest working man in politics ™ won the Alberta United Conservative Party leadership race with a margin close enough to my prediction that I patted myself on the back. Finally in office, Premier Jason Kenney will… wait… What? He’s not premier yet? Oops. OK then, as the new leader of the Opposition he will be able to hold the NDP to account in the legistature… wait… What? He’s not even an MLA? Well what was the damn point then? What? Oh, a long term MLA resigned his seat to make way for Kenney but now we need a byelection? Which has to be held in the next 6 months? Oh. My. God!!! I can’t take it anymore. The politics, the insults and the rhetoric are killing me. It’s worse than Groundhog Day and it’s been less than a week!

 

Other housekeeping item – last week I said oil (and gas) were under-priced relative to what the inventory levels were telling us and goldarnit if those dang prices didn’t start moving in the right direction this week! It’s almost like the market is starting to look at the energy industry a bit differently…

 

Which conveniently brings me back to my current happy space, which is one where WTI prices have finally entered into backwardation and – dare I say it – a distinct odour of bull seems to be in the air.

 

Speaking of bull, is anybody else spending any time reading this horse-hockey BS about how all these shale/tight oil firms are all of a sudden starting to operate differently and concentrating on “profits” and “positive cash flow” instead of “growth”. It’s an interesting concept this whole making money thing. As business owners I can tell you unequivocally that Dave and I are all about the profits over growth – the only time you would do that is if you had access to unlimited amounts of capital that you weren’t really accountable to and had no qualms about walking away from if things went sideways. Wait a second, now I get it.

 

Anyway, most of this talk of fiscal discipline mantra comes from my favourite place in North America, the Permian, otherwise known as the epicentre of US tight oil, rampaging growth and unbridled market hope. I have seen more than one press release from an E&P company swearing homage to “live within your means” gods. Of course, we should note these are the same guys who over-produced the industry into the worst bear market in a century and then compounded the problem by their leaps in “efficiency” achieved mostly by cherry-picking sweet spots and grinding their service providers down to the same rates that were paid a century ago…

 

But I digress.

 

What is the reason behind this flim-flammery? I suspect it to be driven by an imperative of some sort, but maybe not the ones the oil companies are telling you. I mean vraiment, how likely is it that a bunch of these firms would suddenly start acting like Canadian producers and be super cheap, cost conscious and exercise balance sheet discipline. I know, right?

 

As usual the answer is staring us right in the face and it has less to do with disciplined drilling programs as it does with the drying up of the money machine that was feeding those drilling programs. It would appear, at least for now, that the investment community at large has finally gotten tired of the tight oil shtick and has, for the most part, taken its bags of money and parked it elsewhere. Oil and gas capital raising has gone as cold as ice and the prospect for a major turnaround is unlikely unless one of these horizontal fracs yields iphones instead of hydrocarbons. So many companies are now touting themselves as stable, mature plays in the hopes of attracting at least enough capital to plug the leaks in their free cash flow.

 

And with energy prices still below that shiny level that will bring back the speculative capital that allows for unbridled drilling, the capital discipline is par for the course.

 

Don’t get me wrong, the drilling is still needed to hold up production and it still is happening, but it’s at a much more rational pace now, almost at a “maintenance” level.

 

So, levelled off activity for the time being, what does it mean?

 

Well in its simplest form, it likely means that the growth forecasts for the Permian and other tight oil plays are probably vastly over-estimated. Thus, when the market finally figures out that Permian growth isn’t going to meet global demand growth, the price response should be pretty quick.

 

Which brings me back to my happy spot, because a Goldilocks Permian allows the market to focus on what is actually going on in the big bad world around, figure out that the energy sector is poised for a sharp turnaround and maybe lift some of my portfolio dogs out of the gutter.

 

But wait, if prices go up, doesn’t this mean that all of these tight oil companies are going to toss their new found fiscal discipline out the window, unpack the drilling rigs and make swiss cheese out of Texas? Won’t the growth just resume? Well, maybe yes and maybe no. There are a number of factors at play here. Some of which will hold back growth, some of which mean that it may not matter what happens in the US.

 

First, demand growth globally has been very strong and with OPEC staying true to their mission of production restrictions, the draw-downs in inventory are accelerating. So there is suddenly more than enough room to accommodate American tight oil. Demand has managed to grow its way through the over-supply situation – tight oil is still important, but it’s no longer the existential threat to the market it was once deemed to be, if it ever should have been seeing as how tight oil is less than 2.5% of global demand meaning it would probably have to almost double every year to meet global demand growth.

 

So what about US tight oil specifically?

 

Well things are not exactly what they seem in the tight oil world. There are many headwinds that work in favour of prices.

 

Let’s start with one of the more glaring ones – production. While overall US production has grown significantly (about 500,000 bpd) in the first 7 months of the year, most of that growth was in the first part of the year. And this growth has, overall, lagged well behind the consensus forecast of 1.0 to 1.2 million barrels per day by year end – 800,000 now seems more likely. Still impressive though, right? Well dig through the numbers a bit and you will see that production growth in Texas and New Mexico (the centre of the Permian) has been about 300,000 bpd year to date. Hardly the metrics one would expect of a rapid response swing producer.

 

So what is holding back production growth anyway? Aside from the access to capital issue that was discussed above, production is being held back by the classic combination of business influences namely equipment, labour and opportunity.

 

On the equipment side, it’s a pretty simple story in the oil patch. You can have all the drilling rigs in the world, but that’s just poking the hole – you also need to get the oil out and on the completions side of the ledger, the guys who show up when the drilling rig leaves (pressure pumping, downhole tools, cementing) there is a real shortage of equipment that won’t be fixed for months.

 

In the US, demand for pressure pumping equipment exceeds functional supply by about 25%. All the equipment that was parked for the past three years needs to be overhauled and repaired if not replaced. Today’s fracs are longer, more intense and more complex, requiring more horsepower, more sand and higher pressures and are thus harder on the equipment, reducing its useful life and increasing maintenance costs, which in turn raises prices requiring a higher commodity price to break even. It’s a vicious circle.

 

And given what happened from 2014 through to the present day, no service company in their right mind is going to rapidly expand their fleet until they have real certainty that the price recovery is firmly in place.

 

You can see it in the number of DUCs – drilled but uncompleted wells – which have been rising rapidly all year. The companies can’t keep up.

 

Hand in hand with equipment issues are the basic manpower issues. There are simply not enough frac crews available to manage all the equipment even if it was there. Running completions equipment requires a high level of skill and experience and since many workers have permanently left the service industry as the downturn stretched on, service companies are stuck using less experienced workers if they can even find them. This leads to less efficiency, longer lead times and increased costs.

 

The last leg of this is the opportunity leg. The Permian is a vast and prolific play. But human nature is what it is. When times were easy and there was a quick buck to be made, companies drilled the best spots to maximize output and cash in as prolifically and quickly as possible. When times got tough and companies needed cash flow and results to survive (and raise money), they flocked to the best plays and avoided those that were harder, marginal or less of a sure thing. The concern now, after such an explosion in activity is that squeezing the next marginal barrel out of the next to best areas will be harder and so on. And all the while existing production appears to be declining faster than originally anticipated.

 

Where is this all going?

 

These are all the underpinnings of my level of relative happiness. It has taken a long time, but there is reason for optimism, even when people are forecasting a slight decline in 2018 capex and drilling activity (I’m looking at you, PSAC!).

 

Basically, there are four reasons I am bullish on prices going forward

 

• Demand growth from a growing global economy has surprised everyone. We are going to hit 100 million barrels a day of demand well before anyone anticipated it.
• Inventories are shrinking at an accelerating pace. This is happening everywhere except, ironically, Cushing. The side effect of this is a pretty wide spread between WTI (Cushing) and Brent (Europe) prices for oil which has super charged US exports
• OPEC/NOPEC will most likely extend their restrictions on production until the end of 2018 or the Aramco IPO – probably whichever comes first.
• US production, primarily tight oil, will grossly underperform the aggressive forecasts that the market baked into a $45 to $50 price range – with the market already pricing in these targets, there is even a buffer when tight oil can surprise to the upside.

 

In this context, I think $60 by year end is a distinct possibility. $60, the new $50. Who’d a thunk that a month ago?

 

Prices as at November 3, 2017 (October 27, 2017)

• The price of oil stayed string during the week on inventory and OPEC cut commitments
  • Storage posted a decrease
  • Production was flat
  • The rig count in the US was flat
• Natural gas rose modestly during the week

 

• WTI Crude: $55.65 ($53.98)
• Nymex Gas: $2.982 ($2.752)
• US/Canadian Dollar: $0.7839 ($ 0.7798)

Highlights

• As at October 27, 2017, US crude oil supplies were at 454.9 million barrels, a decrease of 2.4 million barrels from the previous week and 27.7 million barrels below last year.
  • The number of days oil supply in storage was 28.5 behind last year’s 31.2.
  • Production was up for the week by 46,000 barrels a day at 9.553 million barrels per day. Production last year at the same time was 8.522 million barrels per day. The change in production this week came from an increase in Alaska deliveries and a slight rise in Lower 48 production.
  • Imports fell from 8.123 million barrels a day to 7.571 compared to 8.995 million barrels per day last year.
  • Exports from the US rose to 2.133 million barrels a day from 1.924 and 0.404 a year ago
  • Canadian exports to the US were 2.933 million barrels a day, down from 3.017
  • Refinery inputs were down during the week at 16.015 million barrels a day
• As at October 27, 2017, US natural gas in storage was 3.775 billion cubic feet (Bcf), which is 1% lower than the 5-year average and about 5% less than last year’s level, following an implied net injection of 65 Bcf during the report week.
  • Overall U.S. natural gas consumption was up 14% during the week, influenced by a whopping 73% increase in residential demand as a cold front moved in
  • Production for the week was up 1%. Imports from Canada were flat compared to the week before. Exports to Mexico were down 2%.
  • LNG exports totalled 22.4 Bcf.
• As of October 31 the Canadian rig count was 186, 131 Alberta, 23 BC, 30 Saskatchewan, 2 Manitoba. Rig count for the same period last year was 160.
• US Onshore Oil rig count at November 3 was at 729, 8 less than the week prior.
  • Peak rig count was October 10, 2014 at 1,609
• Natural gas rigs drilling in the United States was down 3 at 169.
  • Peak rig count before the downturn was November 11, 2014 at 356 (note the actual peak gas rig count was 1,606 on August 29, 2008)
• Offshore rig count was down 2 at 18
  • Offshore rig count at January 1, 2015 was 55

• US split of Oil vs Gas rigs is 80%/20%, in Canada the split is 56%/44%

Drillbits

• The Trump administration said it will exit a global anti-corruption effort that compels oil, gas and mining companies to disclose the payments they give governments worldwide.
• Kinder Morgan has appealed to the National Energy Board to get the City of Burnaby to stop stonewalling on various permits needed to start construction on the federally approved TransMountain Pipeline. Things are eating up.
• Earnings season is on and it has been overall a very profitable quarter for the oil patch. Some notables:
  • Cenovus reported cash flow from operations of $592 million in Q3-17 versus $310 million in the same quarter last year
  • CNRL reported Funds From Operations of $1,675 million for Q3-17 versus $1,021 million in Q3-16
  • Royal Dutch Shell reported cash flow from operations of $7.582 million in Q3-17 versus $8.492 million in the same quarter last year
  • Exxon reported cash flow from operations and asset sales of $8.4 billion in Q3-17 versus $6.3 billion in Q3-16
  • EOG reported net income of $111.3 million in Q3-17 compared with a loss of $220.8 million in the same quarter last year
  • Seven Generations reported Funds Form Operations of $223.3 million for Q3-17 versus $211.8 million in Q3-16
• Trump Watch: Robert Mueller indicted two former Trump campaign officials in the first arrests of the Russia investigation, the “Cut, cut, cut and Jobs” tax plan was introduced and a departing Twitter employee deleted his Twitter account. All in all a weird week. Clearly Hillary’s fault.