Oil & Gas Slowdown
A mineral owner's perspective on the troubles brewing even before
the COVID-19 pandemic and collapse in oil prices
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Why has shale drilling slowed in 2020?
After ten years of successful shale drilling, why is the oil and gas industry in a downturn? Why has shale drilling slowed? Why are E&P stocks in the toilet? Why has capital dried up?
We will look at these questions from the perspective of a mineral owner. The answers will give you an invaluable insight into the upstream oil and gas industry and help you make informed choices about keeping or selling your mineral rights.
We will look at these questions from the perspective of a mineral owner. The answers will give you an invaluable insight into the upstream oil and gas industry and help you make informed choices about keeping or selling your mineral rights.
Causes of the O&G Slowdown
The shale revolution took us from worrying about peak oil to complete energy independence! American ingenuity once again created a whole new industry and lead to the discovery of the largest oil reserves in the world. So, why, after ten years of shale drilling are oil and gas stocks underperforming and why has capital dried up (causing a drilling slow-down)?
Hundreds of thousands of long fracked horizontal wells have resulted in an overproduction of oil and gas, causing prices to decline.
Drilling wells too close to each other reduces the amount of oil and gas produced by the parent and all child wells. Production forecasts were based on tight well spacing.
Oil and gas company valuations used to be based on proven and producing reserves. Now they are based on potential drilling locations, which include "probable" and "possible" reserves.
Companies focused on growth rather than profits, which lead to drilling uneconomic wells and taking on large amounts of debt.
Rather than playing long game, companies have a defined exit strategy, leading to a pump-and-dump mentality.
Petroleum and reservoir engineers used to make drilling decisions, and lenders only financed what their experts deemed as economic projects.
Lenders, particularly those in the North East, have been burned by investing in oil and gas without conducting proper due diligence and because of forecast errors.
Oil and gas is a cyclic industry. Over 100 companies have filed bankruptcy in the past year, and many more will follow before this downturn is over.
1. Overproduction = Low Prices
A decade ago, the news was filled with stories about peak oil. We were deeply concerned that declining oil reserves would make us even more dependent on foreign oil.
However, the shale revolution, the combination of hydraulic fracturing and horizontal drilling, resulted in the economic recovery of oil and gas from shale. With a whole new way to recover oil and gas, vast oil reserves were discovered, rivaling Saudi Arabia.
The development of the Barnett, Haynesville, Permian, Eagle Ford, Marcellus, Niobrara, Bakken, and other shale plays flooded the market with oil and gas, causing prices to drop. Oil, which was once $100 per barrel, dropped to $18.65 per barrel before rebounding and hovering near $50 per barrel.
The shale revolution caused gas prices to drop from a high of 18 per MCF to less than two dollars. Low gas prices are great for consumers and provide us with an inexpensive source of reasonably clean energy.
Several of the shale plays have been developed so quickly that there hasn't been enough time to build sufficient pipeline infrastructure to take the gas to market. Many companies, especially in the Permian Basin, are flaring the natural gas or having to pay someone to take it to market.
Even though the price of natural gas is around $2, mineral owners are being paid nothing or sometimes small amounts (.40 cents / MCF) for gas.
It feels almost criminal to be wasting such a valuable natural resource. And sadly, gas prices are not expected to rise - even when we get LNG (liquid natural gas) export infrastructure built.
However, the shale revolution, the combination of hydraulic fracturing and horizontal drilling, resulted in the economic recovery of oil and gas from shale. With a whole new way to recover oil and gas, vast oil reserves were discovered, rivaling Saudi Arabia.
The development of the Barnett, Haynesville, Permian, Eagle Ford, Marcellus, Niobrara, Bakken, and other shale plays flooded the market with oil and gas, causing prices to drop. Oil, which was once $100 per barrel, dropped to $18.65 per barrel before rebounding and hovering near $50 per barrel.
The shale revolution caused gas prices to drop from a high of 18 per MCF to less than two dollars. Low gas prices are great for consumers and provide us with an inexpensive source of reasonably clean energy.
Several of the shale plays have been developed so quickly that there hasn't been enough time to build sufficient pipeline infrastructure to take the gas to market. Many companies, especially in the Permian Basin, are flaring the natural gas or having to pay someone to take it to market.
Even though the price of natural gas is around $2, mineral owners are being paid nothing or sometimes small amounts (.40 cents / MCF) for gas.
It feels almost criminal to be wasting such a valuable natural resource. And sadly, gas prices are not expected to rise - even when we get LNG (liquid natural gas) export infrastructure built.
2. Parent Child Well Spacing Problems
As unconventional drilling picked up steam, the shale play became a modern-day gold rush. Everyone, including small independent operators, was trying to lease up mineral owners - especially those who owned minerals core or tier one tracts.
The plan was to lease now and drill later - but not too much later because drilling must begin before the lease expires.
These independents couldn't afford to drill multiple wells at once, so they would drill a single well to hold the lease. The first wells are referred to as parent wells. Additional wells targeting the same formation are child wells.
The industry was really excited by some of the monster wells that produced enormous quantities of oil and gas. Everyone assumed a child well would produce as much as the parent well and companies predicted future revenue based on tight well spacing.
But it turns out child wells produce significantly less oil and gas than the parent wells AND reduces the production of the parent well. The industry found that they could not space wells as close together.
Not only were wells less productive but operators couldn't drill as many wells as they planned. Most of them received funding based on tight wells spacing and assuming all wells would be as successful as the parent well. Less oil and gas produced translates into less revenue.
Higher well spacing ratios and co-development of wells seems to be the better way to develop a field. But not every company can afford to drill and complete multiple wells at once.
The plan was to lease now and drill later - but not too much later because drilling must begin before the lease expires.
These independents couldn't afford to drill multiple wells at once, so they would drill a single well to hold the lease. The first wells are referred to as parent wells. Additional wells targeting the same formation are child wells.
The industry was really excited by some of the monster wells that produced enormous quantities of oil and gas. Everyone assumed a child well would produce as much as the parent well and companies predicted future revenue based on tight well spacing.
But it turns out child wells produce significantly less oil and gas than the parent wells AND reduces the production of the parent well. The industry found that they could not space wells as close together.
Not only were wells less productive but operators couldn't drill as many wells as they planned. Most of them received funding based on tight wells spacing and assuming all wells would be as successful as the parent well. Less oil and gas produced translates into less revenue.
Higher well spacing ratios and co-development of wells seems to be the better way to develop a field. But not every company can afford to drill and complete multiple wells at once.
3. Reserves vs Drilling Locations
It used to be that oil and gas companies emphasized proven reserves (90% chance of recovery), but now companies are including two other categories - probable (50%) and possible (10%) reserves.
All three reserve categories are lumped together and referred to as "drilling locations" without distinguishing how many have a 90% chance vs 10%!
Furthermore, some companies are estimating the value based on future revenue, assuming tight well spacing in all tracts with cherry-picked production data. These inflated numbers look great to investors and stock-holders, but eventually, there is a reckoning.
All three reserve categories are lumped together and referred to as "drilling locations" without distinguishing how many have a 90% chance vs 10%!
Furthermore, some companies are estimating the value based on future revenue, assuming tight well spacing in all tracts with cherry-picked production data. These inflated numbers look great to investors and stock-holders, but eventually, there is a reckoning.
4. Growth vs Profitability
Operating profitably should be the goal of every company. But during the black gold rush (i.e. shale revolution), a lot of companies became more short-sighted.
In order to stay competitive and secure additional funding, companies needed to drill more wells. Wall Street's focus was on growth not profits.
Over time, new innovations and technology drastically reduced the cost of drilling unconventional wells while also pulling hydrocarbons from the ground faster.
All wells have decline curves, but the latest unconventional (fracked horizontal) wells have incredibly steep decline curves, often losing more than 70% of their production after just one year!
With steep decline curves, operators are forced to drill more wells in order to grow revenue. But unconventional wells are expensive and drilling new wells is dependant on access to capital. It'a rat race and sooner or later it catches up to you.
In order to stay competitive and secure additional funding, companies needed to drill more wells. Wall Street's focus was on growth not profits.
Over time, new innovations and technology drastically reduced the cost of drilling unconventional wells while also pulling hydrocarbons from the ground faster.
All wells have decline curves, but the latest unconventional (fracked horizontal) wells have incredibly steep decline curves, often losing more than 70% of their production after just one year!
With steep decline curves, operators are forced to drill more wells in order to grow revenue. But unconventional wells are expensive and drilling new wells is dependant on access to capital. It'a rat race and sooner or later it catches up to you.
5. Pump-and-Dump (or Find-and-Flip)
The oil and gas industry is cyclic in nature. There will always be ups and downs and the companies that weather downturns are the ones that play the long game.
As the Black Gold Rush (i.e. shale revolution) heated up, everyone wanted in on the success. People with very little experience started E&P (exploration and production) companies with an exit strategy in mind.
The pump-and-dump mentality thrives in this environment - especially when you can create temporary value (initial oil and gas production) and shale assets (leases in popular shale basins) are overvalued and overpriced.
If a company can secure funding and drill a number of wells, they can flip the company (or divest the assets) while the wells are still new and production is high.
These companies are playing the short game - not the long game. Some companies couldn't flip the assets soon enough and were left holding the bag. Others took on too much debt and had to file bankruptcy. That's why so many oil and gas companies have filed for bankruptcy in the last year.
Pump-and-dump will never be a long-term business model for a cyclic industry with natural ups and downs. The only companies that weather downturns are those who play the long game and are focused on developing a field responsibly, putting money back into the ground and letting profits drive decisions.
As the Black Gold Rush (i.e. shale revolution) heated up, everyone wanted in on the success. People with very little experience started E&P (exploration and production) companies with an exit strategy in mind.
The pump-and-dump mentality thrives in this environment - especially when you can create temporary value (initial oil and gas production) and shale assets (leases in popular shale basins) are overvalued and overpriced.
If a company can secure funding and drill a number of wells, they can flip the company (or divest the assets) while the wells are still new and production is high.
These companies are playing the short game - not the long game. Some companies couldn't flip the assets soon enough and were left holding the bag. Others took on too much debt and had to file bankruptcy. That's why so many oil and gas companies have filed for bankruptcy in the last year.
Pump-and-dump will never be a long-term business model for a cyclic industry with natural ups and downs. The only companies that weather downturns are those who play the long game and are focused on developing a field responsibly, putting money back into the ground and letting profits drive decisions.
Lack of Due Diligence
Petroleum and reservoir engineers used to make drilling decisions, and lenders only financed what their experts deemed as economic projects. Now, executives make drilling decisions based on growth rather than profits.
Engineers used to plan out the best way to develop a field in order to optimize the extraction of hydrocarbons. But in today's growth-driven find-and-flip market, companies are sometimes drilling, regardless of the long-term economics.
For the while, lenders with zero experience in oil and gas wanted to get in on the "Shale Revolution", making it easy to secure capital (because lenders weren't having their own energy teams conduct due diligence).
Engineers used to plan out the best way to develop a field in order to optimize the extraction of hydrocarbons. But in today's growth-driven find-and-flip market, companies are sometimes drilling, regardless of the long-term economics.
For the while, lenders with zero experience in oil and gas wanted to get in on the "Shale Revolution", making it easy to secure capital (because lenders weren't having their own energy teams conduct due diligence).
Lenders Have Been Burned
Traditionally oil and gas prospects were funded in one of two ways:
- Finding experienced working and non-operated working interest partners who all have a financial interest in the success of a prospect.
- Local banks with experienced energy departments reviewed prospects and funded only those that made economic sense.
As the shale revolution picked up speed and the United States began producing enormous amounts of oil and gas, lenders in the North East wanted in on the action. Most lacked an energy department or even an oil and gas attorney. They often signed deals without understanding anything about oil and gas.
While the deal makers received a cut of the deal at closing, the investors often lost most or all of their money. The exploration and production of oil and gas have always been a high-risk, high reward industry, but the risks are much, much higher for investors without oil and gas expertise.
The bottom line is that lenders have been burned. But so have E&P companies. Lenders were willing to fund almost any shale project, but deals were not specifically structured for oil and gas. Instead, lenders structured deals like they were used to doing and oil and gas companies took on enormous amounts of debt with an obligation to return money to the investors. Traditionally, revenue needs to go back into the ground (be reinvested in drilling, maintenance, and secondary recovery).
This created an impossible situation for both the investors and the exploration and production company. E&P companies need cash. Desperately. But lenders have been burned and capital is drying up.
While the deal makers received a cut of the deal at closing, the investors often lost most or all of their money. The exploration and production of oil and gas have always been a high-risk, high reward industry, but the risks are much, much higher for investors without oil and gas expertise.
The bottom line is that lenders have been burned. But so have E&P companies. Lenders were willing to fund almost any shale project, but deals were not specifically structured for oil and gas. Instead, lenders structured deals like they were used to doing and oil and gas companies took on enormous amounts of debt with an obligation to return money to the investors. Traditionally, revenue needs to go back into the ground (be reinvested in drilling, maintenance, and secondary recovery).
This created an impossible situation for both the investors and the exploration and production company. E&P companies need cash. Desperately. But lenders have been burned and capital is drying up.
What Now?
The upstream oil and gas industry, particularly exploration and production, is having a "come to Jesus" moment.
Here's what needs to change:
Here's what needs to change:
- Play the long game.
- Plan to develop oil and gas fields for long-term profit - not growth.
- Seek traditional sources of funding.
- But money back into the ground (maintenance, reworking, and drilling).
- Return control to the engineers.
- Drill only economically viable wells.
- Co-develop multiple wells (with adequate spacing) to prevent parent/child problems.
- Report proven, probably, and possible separately - not lumped together as "drilling locations".
- Plan for economic downturns.
- Use all well data when forecasting production and consider parent-child production declines.
Why Sell?
The oil and gas industry is cyclic in nature. There will always be ups and down and right now, we are entering a downturn. Commodity prices are falling, stock performance is poor, capital is drying up, and anti-fossil fuel sentiment is rampant. So, what do mineral owners do? You really have two choices: hold on and continue to receive declining royalty checks or sell for a lump sum before royalties decline further.
Why People Sell Their Minerals Rights:
With the price of oil declining and operators practically giving gas away, I decided to sell before the bottom falls out.
I am on a fixed income, and the sale of these minerals will help me secure stable housing. My children will be okay if even if they don't inherit these minerals.
My oil wells have been producing for decades and the reserves are almost depleted. Once the wells are plugged, the value will be significantly lower. I'd rather cash out now.
I inherited mineral rights, but don't want to be involved with fracking and fossil fuels. I would prefer to support renewable energy and do my part to reverse climate change.
Although everyone says, "Never sell your minerals", my daughter needs a series of costly life-saving medical treatments. There are exceptions to every rule.