Things I Learned This Week While Unpacking

August 4, 2023

Okay, a quick aside. I took my 20-year-old son on a bike and boat trip hitting the islands between Dubrovnik and Split in Croatia with 16 of our friends. Too much fun and the reason for missing last week. And it was a GREAT reason. Ten days with your 20-year-old son. Not many of those left.

The Markets. OFS earnings are mostly behind us; E&P operators and Majors are deep into reporting season as well. The lower rig count, frac spread count and commodity prices for the quarter most definitely put a damper on results and enthusiasm. While everyone has known about the decline in activity, it isn’t until the conference calls that we start to get a handle on pricing. Pricing declines follow activity declines historically and this time it does not seem any different. Cautious comments abound and we are reminded of the old adage, “no analyst lowers numbers only once in a decline”. As an industry, we are almost required to be optimistic, and the optimism on higher commodity prices in the second half of the year has been a continuous mantra, and recently, we have indeed seen strength. Though one must remember that we have been “head-faked” many times just in the past few years. Now we see headlines noting China’s recovery shows signs of falling and the world is still growing production even with OPEC+ withholding millions of barrels. Everyone is looking for the demand drivers, and inventory levels have not been a reliable indicator of oil prices in some time.

NEXT! So, what is a person to do?? We are already seeing the needed reaction. Combinations. Patterson and NexTier, over $18 billion so far this year on E&P consolidation. It is only a start and needs to continue. The biggest problem we face is that we are too good. In 2008, there were 1,600 rigs drilling for natural gas. In 2020, twelve years later, that number fell to 80 but natural gas production climbed every year. And now we are surprised when something similar happens in oil?? It may not be as dramatic but note the continued widening of the trend lines between production and rig count. And if we focus only on the period from 2016 to present, the divergence is significantly greater.

Remember the Giddiness of 2014? Activity and margins were through the roof with companies coining money. We had taken crude oil production from 5.5mm BOPD in 2010 to over 9mm BOPD by 2014 and the rig count had gone from 430 to 1,600. We set records for growing crude oil production faster than any country in history and we did it for two straight years. Of course, during that period, we started to over-supply the oil markets. Famously, right after Thanksgiving, OPEC decided to leave the markets alone and not cut production, so we watched as oil prices fell from $103 in August 2014 to $25 by early 2016.

Collapse. The drop in activity matched the drop in oil prices, and our world collapsed. It was one of the fastest drops ever recorded and resulted in quarterly sequential revenues down as much as 80% in some cases. We staged a recovery from those 2016 bottoms but got less than halfway back to 2014 levels, as oil production continued to march higher. We collapsed again, due to the drop in oil demand from the COVID-19 pandemic, of almost 10% globally, and oil went famously negative for a day. We then began another recovery in 2021 as everyone was cautious but it was obvious that the world was coming back from depressed COVID levels. That rally stalled in December of 2022. This year, we have seen an almost 12% decline in drilling activity yet crude oil production is up 4.3%.

A Trend is Developing. Even with well productivity falling in some basins and DUCs bouncing around, the bottom line appears to be that we are doing more with less. Just like we did with natural gas. Yes, the molecule size is smaller for natural gas, and it has more energy. Conventional recoveries of natural gas can be in the 90%’s while crude oil is stuck just under 50%. And for shale reservoirs, it is a fraction of that – sub 20% for natural gas and about 10% for crude oil. But it appears that technology continues to improve. We know where vast amounts of oil and gas exist, and the industry continues to develop more ways to increase those recoveries. Two-mile laterals are getting more common so while the recovery per foot may decline as we step out further from the core, more rock is connected.

So What Does It Mean? First, consolidation is key and by that we mean both corporate consolidation and consolidation of services by companies. If you already have a team on the rig doing some work, why not have the same service company do more tasks, have fewer vendors and cross-train the people. That has been talked about for years and implemented in some small ways, but it needs to accelerate and is especially being focused on by the larger oil companies. The NEX-PTEN deal is an example of both. Not only end duplication of administrative effort but be able to provide more services with fewer people as long as the services and equipment are good across the span of work. The future of the industry is one that is more technical, more automated, more efficient and focused on returns but so far, acceptable returns have only happened at cyclical peaks and we have to find a way to generate acceptable returns throughout the cycles.

Haves and Have Nots. From the E&P side, $18 billion in consolidating acquisitions is impressive. Longer laterals can encroach on adjacent leases and acquisition solves that problem. One plus one can often equal 1.5x in terms of field operating costs, and drilling inventory is shrinking for many companies, playing havoc with valuations. Last year, PE backed companies and other privates were leading the charge in drilling while they tried to dress themselves up enough to attract acquisition interest. But their prospect inventories were often short and out spending cash flow can only be justified for a while. This year the larger public companies are taking the lead, and OFS companies that have focused their efforts there have benefited.

Away. And of course, international and now offshore are leading the way. The Middle East is on a spending binge to increase production capacity, not just Saudi. Offshore has been improving steadily now for a couple of quarters at least after six years in the ditch. The significant thing here is that international and offshore activity has much more momentum than U.S. onshore. If it’s been getting good for a while, it is more likely to continue to get better. In the U.S., we can stop and start on a dime and that makes efficient supply chains a true challenge. The momentum was also seen on the downside as the sector dropped 6-7 years in a row. But they’re baaaaaaaaack.

EIA Weekly Crude Report:

Bullish draw but the market remains skeptical (exports + adj factor + mogas cracks).
U.S. crude production was 12.2mm BOPD, unchanged from previous week, and up 0.1mm BOPD from same period last year. Domestic crude supply growth looks to be notably slowing.
Refinery runs 16.5mm BOPD, utilization at 92.7%. Peak of seasonal demand coming up.
Crude Imports (net): 1.4mm BOPD

Investment Grade. Several stories are out this week about the government’s debt downgrade. Fitch Ratings, one of the big ones, downgraded its long-term rating to AA+ from AAA, echoing a move made by S&P Global Ratings, which cut its rating for the U.S. in 2011. Fitch placed America's sovereign status on watch back in May but suspending the debt limit did not convince the rating agencies that anything had changed for the good. "The repeated debt-limit political standoffs and last-minute resolutions have eroded confidence in fiscal management," according to Fitch. "In addition, the government lacks a medium-term fiscal framework, unlike most peers, and has a complex budgeting process [and] the GG (General Government) debt-to-GDP ratio is projected to rise over the forecast period, reaching 118.4% by 2025. These factors, along with several economic shocks as well as tax cuts and new spending initiatives, have contributed to successive debt increases over the last decade."

Ouch. We have written about the loss per Electric Vehicle (“EV”) for major manufacturers. $139,000 for a Rivian truck, a 4-Series BMW with the loss of each EV sold by Ford last year. Now executives for BMW warned investors that the cost of making EVs will be heading up, at first, around 6%. The average cost of an EV is $66,000 versus $45,000 for an internal combustion engine (“ICE”). GM and Ford both announced losing $4.5 billion each on EVs. The number of stories starting to finally come out based on practical action and observation rather than government estimate or mandate are getting more frequent every day.

Heavyweights. The Energy Workforce & Technology Council and API joined 17 other energy trade groups representing all sectors of the U.S. natural gas and oil industry, calling on the Biden administration to support U.S. energy security by finalizing a robust program for federal offshore leasing. In a letter to President Biden, the energy trade groups urged the administration to finalize a program that includes the maximum number of lease sales and begin the pre-leasing work required to start holding sales in 2024. The letter follows a recent Stipulated Stay agreement that imposed baseless restrictions on an estimated 11 million acres in the U.S. Gulf of Mexico, leaving the offshore energy industry in an extended period of uncertainty. One can only hope. He did approve the Willows project in Alaska. Maybe we’ll get lucky!

Headlines.

Texas crude production at 40% of total U.S. set new record at 5.49 million barrels
OPEC production plunges to three-year low as Saudi implements deeper cuts
OPEC production was 27.79 million barrels per day
America Is Awash in Critical Minerals, but Regulations and Environmentalists Are Blocking New Mines
World inventories are projected to drain rapidly in the months ahead
New study confirms that leaked hydrogen has a significant global heating impact, around 37x that of carbon over a 20-year time frame
Former Russian President Dmitry Medvedev said Moscow would have to use a nuclear weapon if Kyiv's ongoing counter-offensive was a success

Snippet. Oil inventories are beginning to fall in some regions as demand outpaces supply that is constrained by deep production cuts from OPEC leader Saudi Arabia, providing support for prices which are expected to rise in coming months.

Schooled. “For all you fanatics who think the climate is getting ‘hotter’, consider this chart of temperature going back 65 million years. We are now in the Pleistocene Ice Age, the coldest it has been in 250 million years. There was no ice in the Arctic until about 3 million years ago.” - Patrick Moore, co- founder of Greenpeace and a PhD in ecology. And again, “Here’s the truth about the claim that July 2023 was the hottest month in 120,000 years. There is no question that there were higher average temperatures in the 1930s. Canada has the coldest annual average temperature of all the world’s countries.”

Well Said. “All summer, western legacy media platforms have inundated their fading audiences with an avalanche of climate alarmist propaganda: The seas are boiling, forest fires are being started by 3 degrees warmer than normal temperatures, glaciers that were supposed to have disappeared by 2020 are really, truly melting away this time - mass hysteria. The propaganda has been relentless, continuing even after the claims have been easily debunked. No, the Gulf of Mexico didn’t reach 101 degrees last week; the wildfires in both Canada and Greece have been shown by authorities to have been the result of arson; both Arctic and Antarctic sea ice levels are at normal historic levels. The BBC has been proven to have been intentionally reporting fake temperatures to its viewers, and central Europe is about to get snow in August.” - David Blackmon

Whipped. Have we beaten the inflation boogeyman? Last week the Federal Reserve raised its key interest rate again, but after a head fake earlier in the year, we might be done for a bit, but it took some effort. The 25-basis point raise put the rate at a 22 year high at 5.25%-5.50% all while the Consumer Price Index dropped to 3%. That is still above the target but within spitting distance. This also caused the market to show the biggest winning streak in almost 40 years. Few saw that coming. GDP growth, the rate of change in the economy, was also a surprise to the upside as were durable goods orders, giving a great deal of cover for those who have been predicting a “soft landing” rather than a full blown recession.

It Must Be Climate Change! If something catches on fire these days, from matches to your BBQ grill, it must be climate change, right? So, when a ship full of EVs caught fire this week, it just couldn’t have been those batteries. They never do that. At least not more than a few every week. I am seeing all those fish who have been driving the Rolls Royces and Porsches that went down last year when a ship sank. Now they get to try an EV instead. I’d take the Porsche.

The REAL Cost? President Joe Biden said extreme heat is costing the U.S. $100 billion a year and linked it directly to climate change. Hilary is out saying that climate change is caused by MAGA republicans, and the head of the UN said we are now boiling the planet. Why? Control. All of this as the World Health Organization proposed a treaty, giving it full authority to declare lockdowns and all sorts of draconian measures worldwide for the next pandemic. Or from climate change. Seriously…

Here Comes John. John Kerry pointed out the real enemy causing a very large part, 33%, of emissions and said something must be done about it. Farming. I knew those radishes had something to do with it! Of course, Sri Lanka and the Netherlands have seen 30% drops in crop yields from avoiding the use of fertilizer made from natural gas. Now climate change is threatening India’s food supply. I’m confused. Which is it? The climate shifts I have seen forecast the continuing desertification of Northern Africa. The Sahara is growing. But Canada is expected to see a huge shift to more agricultural land and North America wins the most water per capita as a result. Some gnash their teeth at “climate deniers” but all of us in the oil and gas industry understand it better than most. How else would Midland, Texas have been at the bottom of an ocean. The real question is the extent of human contribution. Remember those pesky Dinosaurs, when the earth had CO2 levels dramatically higher than today and the planet was hotter and more humid than Houston in August. That might have been caused by the cave men cooking Brontosaurus over a wood fire. Everyone either hunted or gathered all day every day just to survive and there are many who see that as the desirable future for mankind. Let’s put up with rolling blackouts for the sake of climate change. All that food in the fridge? Well, it’s gone. Making EVs in the dark? Doesn’t the government have a training program?

Worthy of a Panic Headline? “NYC is in for a sweltering Friday as a dangerous heat wave persists over the East Coast. Some neighborhoods will swelter more than others with parts of Midtown Manhattan on average 1-2°F hotter than the Financial District.” OMG. In the dead center of a concrete jungle, it could be 93 degrees but at the lower end of Manhattan, you know, the part of the city closer to the water on both sides, it would only be 91! Following the course of recent politics, the financial district should be taxed more, and part of the money given to everyone in midtown with the balance going to more government studies of the obvious. Goldman, grab your checkbook.

Branching Out. Saudi Aramco to Build Pakistan Mega-refinery. Four Pakistani state-owned companies signed an MOU with Saudi Aramco to build a 300,000 b/d refinery in Gwadar, doubling the country’s refining capacity for an estimated cost of $10 billion.

Bubbling Over. Chinese Oil Stockpiles Shoot Through the Roof!! Great headline. Russian imports hit an all-time high and Iran has doubled their delivery. It is estimated they have almost 1 billion barrels in inventory. That’s nothing! We have… uh….uh…. Oh right. We used that trying to manipulate the oil markets!

More Gas. The issue has been that U.S. companies looking for long-term LNG deals in Europe found few utilities with the wherewithal and no governments willing to commit past the current election cycle. We noted that companies such as BP and Shell are being aggregators of LNG, and now we see that energy major BP signed a long-term LNG supply deal with Austria’s OMV to deliver 1 million tons of LNG starting in 2026. Long lead times.

And You Think We Have It Bad? Wanted: A central bank governor to help reset Lebanon’s financial system that collapsed under decades of corruption and mismanagement, in a country whose currency is almost worthless and where the banking sector faces losses nearly three times the size of the economy. And with just four days to go before incumbent Riad Salameh steps down, with no successor in place.

Any and all comments, arguments and rebuttals are welcome!

In addition to my association with PPHB, I serve on three private company boards. Merit Advisors is a property valuation company and I have long been a fan of optimizing how a business is run, not just the tools we make. Merit is in the business of savings companies’ money, actual cash, by doing a much more in-depth and realistic view of equipment and reserve valuations and I am very impressed with their work. I am also on the advisory board of Preng & Associates, a leading executive search boutique that specializes in all things related to Energy & Power. Nova is a gas compression company run by a very dynamic CEO with a very strong board and ownership.

I serve on the Advisory board of the Energy Workforce & Technology Council (formerly PESA), the National Ocean Industries Association (NOIA), and the Maguire Energy Institute at SMU my alma mater.

jim

214-755-3914 | james.wicklund@pphb.com

Leveraging deep industry knowledge and experience, since its formation in 2003, PPHB has advised on more than 180 transactions exceeding $11 Billion in total value. PPHB advises in mergers & acquisitions, both sell-side and buy-side, raises institutional private equity and debt and offers debt and restructuring advisory services. The firm provides clients with proven investment banking partners, committed to the industry, and committed to success.