Has Drilling in the Permian Peaked?

The current production level in the Permian Basin, as of September 2017, is 2.6 mmb/d. That is enough to make the Permian, which straddles Texas and New Mexico, the single largest production area in the US, having exceeded offshore output from the Gulf of Mexico since early 2016.

Projections indicate that production from the Permian could exceed 5 mmb/d by 2025. That vast increase in output will come not only from the small, nimble players that have characterised the shale play since 2010, but also the supermajors - Chevron has upped its Permian spending budget to US$4 billion for 2018 alone, while ExxonMobil has just bought an oil terminal in the Delaware Basin from Genesis Energy, connecting Gulf Coast infrastructure to its planned push into the Permian. These rosy projections sound familiar, having been applied to other major American basins in the past. But the Marcellus hit midstream bottlenecks, Bakken and Haynesville are dealing with massive production swings and Eagle Ford sweet spots ended up being far smaller than originally anticipated. Given that the active rig count in the Permian has plateaued in recent weeks, could the Permian peak sooner than anyone anticipates?

The Permian has always been important. This is, after all, where the Santa Rita No.1 oil well was drilled in 1923, kicking off a production dynasty that has lasted almost a century. In its heyday between the 1940s and 70s, the Permian represented half of total American production, a percentage that declined only when offshore Gulf production kicked in. It is estimated that some 30 billion barrels of oil have been extracted from within the Permian borders. That sounds like a lot, but estimates also suggest that there are some 60-70 billion recoverable barrels left in the ground – a reserve that rivals Saudi Arabia's great Ghawar field. After three decades of decline, activity in the Permian mounted a huge comeback in 2010, coinciding with the shale revolution.

The number of active drilling rigs in the Permian has plateaued in recent months. According to Baker Hughes data, there were 370 active rigs (all oil) operating in the Permian at end-July 2017. As of mid-October, that number is 378. It's easy to look at this and tie it in with price signals. WTI crude oil prices have been stuck in a stubborn US$48-52/b range since July; stagnant prices like that don't inspire much new drilling. Extend the rig data back further, and we find that it has increased from 267 in January 2017 and a paltry 199 sites exactly a year ago. Against a backdrop of OPEC (twice) enforcing a supply freeze, crude prices rose and Permian activity with it.

Consultant Wood Mackenzie recently released a report questioning the sustainability of Permian growth, highlighting potential geological and technological hurdles. It is concerned that tighter well space and well-on-well interference, stemming from an unparalleled increase in drilling activity, could interfere with growth. The sheer amount of activity means that Permian output would see a steep jump in the immediate years, but Wood Mackenzie points out that unprecedented close-proximity drilling and fracking could reduce future estimated ultimate recovery (EUR) by 30% or 1.5 mmb/d of future production in the long-run. If that happens, then peak production will be brought forward to 2021 from 2025.

A few ultra-efficient shale drillers have breakeven prices well below the current market price but on average; the shale sector requires a more sustainable $50 - $55 per barrel to be profitable. In such circumstances, most players have not been hitting their profit targets to meet their debt obligations from investors.

Previous generous financing and cheap capital from Wall Street, are running dry now. Confidence that the oil market will rally up to $70 or more seems to be getting weaker, and this is making investors lose their patience, and ultimately their interest to re-invest into shale for now.

Doug Suttles, CEO of Encana Corp in a presentation at the New Your Stock Exchange puts across a new reality for North American oil and gas producers. “The industry had gone from “resource capture” to “value maximization”. And as reported by Ed Crooks of the Financial Times, “This is a profound change. Since the shale oil revolution began, management teams have mostly focused on growth at any cost and investors have mostly been prepared to back them. In 2017, however, investor sentiment has shifted. Shareholders are less dazzled by the excitement of the shale boom and more interested in orthodox measures of success including returns on capital and cash generation.”

Technically speaking, there is still room to grow in the Permian. The lowest number of active rigs in the Permian was 132 sites in May 2015, but the highest was 562 sites in October 2014. Of course, WTI crude prices in October 2014 were at some US$85/b. There's a strong correlation here – a 40% difference in WTI prices between October 2014 and October 2017 has led to a 35% difference in active rigs in the same period. Should WTI be able to make a rally towards US$60/b, could more rigs could be added?  Ultimately if the shale drillers cannot demonstrate a sustainable profitable business (either from a cost or oil price perspective), the prospect of  investment returning back to support drilling activity may eventually disappear.

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