What Production Cutbacks! Don’t Be Fooled by the Dwindling Rig Count.

Watch any commodities or energy segment on financial networks like CNBC or Bloomberg and inevitably the diminishing Baker Hughes weekly rig count is harkened upon by prognosticators trying to catch the proverbial “falling knife” during the oil price decline and correction. The implication of a steady rig count decline is that with fewer rigs set up to produce hydrocarbons, that this will cause a decline in production and more quickly lead to a hard bottom in West Texas Intermediate crude pricing. However, there are several reasons why this logic is faulty.

First, such a rationale presupposes that equivalent production can be achieved by all rigs, which is not the case. Production yield varies by formation, and how many hydrocarbons can readily be accessed from where the wellbore to be perforated will lie in said formation. Additionally, the appropriate regulatory bodies typically do not allow maximal production from every well; for example, the Texas Railroad Commission sets the maximum permitted monthly quantity of production (the “allowable”) based on the sizing of the proration unit, what type of resource is being extracted, and from which formation production is occurring.

Secondly, in an environment where oil and gas companies need to be able to pay their bills, they need to maximize production while cutting costs. Therefore, the overwhelming bulk of the rigs that have been laid down and stacked are those that were not as productive. The wells and rigs that are “best in breed,” so to speak, will be those that are allowed to continue producing.

This leads to what is often referred to as the “prisoner’s dilemma,” essentially a collective-action problem. It would be most beneficial for all companies in a collective sense to curb production, thereby curbing supply and spurring a recovery in oil prices. However, in North America, where oil and gas production is a private enterprise rather than a state-controlled enterprise, there is little incentive for a given oil and gas company to reduce production and thereby circumscribe its cash flow. Many companies are highly levered with revolving lines of credit, and they have payments to banks that must be made. Further exacerbating the issue is the fact that it now takes roughly double the amount of production to achieve the cash flow that was typical in 2013-14, when commodity prices were at their peak.

Fortunately it seems that the companies with solid balance sheets who aren’t overly levered have effectively slashed their exploration and production budgets for 2015 – this is not to say that there will be no production, but many will only produce their best resources as necessary to still have cash flow, albeit reduced. Companies like EOG, Concho, and Devon are well-suited to hibernate as necessary and be ready when prices pick back up. Those overly-levered companies, like Whiting Petroleum and Halcon Resources, are likely in trouble. Whiting recently was rumored to be shopping itself for a potential sale that would allow it to stave off a potential bankruptcy, but instead chose to proceed with a secondary stock offering, a desperate attempt to generate some sort of cash flow with which to operate. It should only be a matter of time before well positioned companies suited to acquire distressed assets go from kicking the tires, to making formal offers, and ultimately to closing on acquisitions.

Ultimately, while many well positioned oil and gas producers can survive with less wells operating, they will largely maintain the same production or greater because they will keep their best wells online. However, their cash flow will still decrease due to the pricing environment, and they are prepared to bear the brunt of the situation. Other companies will be forced to produce at full capacity to achieve comparable year-over-year cash flows, and may even be forced to authorize secondaries. Only when many of the recently drilled horizontals are beyond their first few years of greater productivity will production in the North American shale formations begin to decline.

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