Energy in 2016: The Year of the Hedge (Expiration)

This post is also available on my LinkedIn page.

A Houston Chronicle article from a few days ago is a reminder of what some of us already know but have put in the back of our minds – the hedges and three-way collars put on by savvy oil and gas companies as protection against the current precipitous drop in WTI and Brent pricing globally will soon begin to expire, with virtually none being active as we head into the year 2016. Put simply, this means that anyone selling hydrocarbons will be on the same equally terrible footing. However, those highly levered and whose assets are heavily mortgaged based on boom pricing will really start to feel the pain, as their hedges and collars expire.

What does this mean? First and foremost, industry consolidation will ramp up even more. If the oil services sector is any indication, there will be large-scale M&A; recent activity in that space includes Schlumberger acquiring Cameron, and the merger of Halliburton and Baker Hughes, the latter still being subject to regulatory approval. Times of austerity mean that redundancies will be eliminated. Companies in crowded segments of the industry will have to show their mettle, reducing costs yet improving or at least maintaining efficiencies. Those that cannot play ball will fail, or be folded into those companies who can.

Bankruptcies will increase later this year and into 2016, and assets will still change hands. Those in the land and title portion of the oil and gas industry, such as myself here in the Permian Basin, have not seen as precipitous a decline in work as other portions have (i.e., drilling crews). No matter how assets are acquired (M&A, new lands being drilled via new leases, etc.), the title ultimately still needs to be vetted by highly skilled landmen and attorneys. Unfortunately, other industry sectors face a more difficult battle as the hedges begin to expire.

My Humble Attempt at Predicting Longer-Term Oil Pricing Going Forward

This article can also be found at my LinkedIn profile, available here.

While I absolutely appreciate the white noise machine that activates in my head and quite likely the majority of heads of my oil and gas industry cohorts when the phrase “I predict that oil prices will be <insert price here> in the year ____,” it seems that there are at least general comments and postulations that can be discussed. So, let’s all suspend our collective skepticism and disbelief for a few minutes and look at the situation.

Most of us would agree that the scales are tipping in the favor of the United States in terms of being the decisive producer in the global oil and gas marketplace; much of this has come directly through the advent of shale fracking. Many of those commenting on financial networks about rig counts dropping missed the crucial fact that companies were high-grading their asset bases (which mitigated the impact of such rig declines); their presupposition that all rigs produce equal amounts of hydrocarbons was flawed. Looking forward, there seems to be a similarly erroneous presupposition being baked in to predictions regarding pricing, that being the fracked wells producing and soon-to-be-producing will have flatline and consistent production for the life of the well – the spigot will flow consistently for years and year. However, let’s take a look at an example of the typical production forecast for a fracked shale well, a Wolfcamp/Spraberry Formation (A/K/A Wolfberry) production declination curve from a 2012 Laredo Petroleum quarterly earnings report (full report available here).

Now first, I will point out that drilling efficiencies and technologies are always improving – the exact numbers are less important than taking notice of the very general declination curve. If we assume that this curve is even remotely reflective of the current state of fracked shale well efficiency, then it becomes clear that the majority of any given shale well production occurs in the first few years of its life. (NOTE: Yes, I realize this specific graph pertains to vertical wells, but the same phenomenon applies to horizontal production, too).

Given the commodity collapse (oil, as well as copper, natural gas, etc.) that we are currently working through, there is less drilling of new wells occurring at this time. Many wells have been drilled but not completed, as well. I would argue that a majority of the wells that will be producing for the next year or two have been drilled. If this is the case, then we are currently enjoying the production fruits from wells that are easily producing at peak flows. As these wells begin to produce less than their peak flows several years from now, American oil supply will be at lease somewhat lessened. If pricing is still somewhat depressed in a year or two, I believe that these factors could result in the market slack being tightened quite quickly, bringing prices up with all deliberate speed. Although economic figures from China are indicating much less demand than that which spurred the pricing increase several years ago, demand in many parts of the world is steadily rising. An eventually dwindling supply (the author assumes that OPEC/Saudi Arabia will not be flooding the market a few years from now, lest their social programs and kingdom crumble) and increasing demand could meet together in a sudden manner in 2016 or 2017. Ultimately, the longer the oil pricing depression, the harder the snapback will be, whenever it occurs.

A Critical Juncture for Saudi Arabia – Double Down or Act Rationally?

This piece is also available via my LinkedIn profile.

In a piece written this morning in Financial Times by Kings College Professor Nick Butler, the ensuing dichotomy of options for Saudi Arabia in terms of its role in the global oil markets is coming into focus. Their first option is to keep open the proverbial floodgates of production, hoping to metaphorically drown a number of weakly positioned and/or poorly hedged American shale producers; the second option involves Saudi Arabia coming to their senses, curtailing some production, and rising the tide for oil producers. Their are interesting points on each side.

As to Option 1 (doubling down), Butler notes that the shale producers in the United States are proving to be more resilient than perhaps the Kingdom expected them to be. Certainly, some companies have already filed bankruptcy, and others likely will in the coming months and even into 2016; however, there has not been anything resembling a crippling industry-wide impact. With depressed crude oil pricing, Saudi Arabia is finding it difficult to pay for costs to run the country, including social programs –  this could explain a round of lending that Saudi Arabia has undertaken very recently. As Butler observes, they may believe that more of the brunt of the pain would be borne by other players such as Venezuela, Russia, or Iran. The author opines that “[t]his hardline assertive approach…is not immutable,” stating that “the alternative is a more pragmatic view of Saudi’s true interests and a more realistic assessment of whether those interests are being well served by the current policies.”

Option 2 (acting rationally) involves the Saudis accepting that economic stability would better serve their long term interests, and would better aid in their efforts to maintain their current level of influence. The Saudis believed they could crush shale producers and frackers, and to a large degree they have thus far proven to have largely erred in this calculation. Butler intelligently observes that the current king is 79 years old, and current oil minister Ali al-Naimi is 80 years old – arguably they have become so used to the global economies and oil markets of yesteryear that they believe their influence is currently as strong as it was decades ago. If this is true, it is a miscalculation on their parts. The pragmatic approach, Butler argues, for Saudi Arabia would be to cut oil production by 1-2 million barrels/day, which would commensurately bring crude oil into largely rangebound $70-80 levels.

Ultimately, sustained depression of oil prices will cause political unrest, instability, and even potentially attempts of upheaval. The Saudis tried to execute their plan, and to a large degree it has not worked. Accepting the oil markets as they operate today would mean that their country, as well as other producer nations, stave off economic hardship and suffering, thereby mitigating any potential deleterious political or social consequences. If Saudi Arabia doubles down on their current practice, they may succeed in driving out of business a marginal number of American producers, but they will do so at great cost not only their own nation but to other OPEC nations.

Leveraging Social Media to Gain Professional Exposure in the O&G Industry

This entry is going to deviate from the normal topic matter (oil and gas, energy and legal developments), but I think it will provide a good discussion on how social media in a professional context can be wielded in a way that significantly supplements traditional face-to-face interaction and conversation. I probably come into this area at an advantage in the sense that I have been around technology and social media all of my life – MySpace, Facebook, Twitter, LinkedIn, instagram, the list goes on and on. Some of those platforms are unquestionably for pure social sharing and contact – others like LinkedIn, Twitter, and any number of blog websites, however, are increasingly being used by professionals as a way to share tips and tricks in their trade, provide industry updates, and discuss legal developments.

LinkedIn

When it comes to keeping up with contacts that you meet in your professional life, the Rolodex of decades ago has now been supplanted by LinkedIn. This is obviously an oversimplification, but the way that I currently describe it to people who are unfamiliar with it is with the three word phrase “Facebook for professionals.” While it can be used to “cold-connect” with virtually anyone who has a profile, I feel it is best used not as a singular vehicle for creating one’s professional network, but as a supplement to traditional networking. This strategy is effective because most professionals are tech-literate enough to have at least one social media profile (oftentimes on Facebook), and many do end up creating a LinkedIn once they see its value and relative ease of use. A few years ago I was not as enthusiastic about LinkedIn because it seemed that there was a disproportionate amount of younger professionals in comparison to more accomplished and experienced professionals, oftentimes the power brokers typically making hiring decisions. Today, I am a devout LinkedIn user – I do not meet often meet colleagues or industry professionals who do not now have at least a rudimentary LinkedIn profile. A few relatives of mine who work in recruiting have also sworn by the efficacy of using LinkedIn for sourcing candidates – anything an aspirational and career-minded person can do to increase their visibility to hiring professionals is probably worth doing.

Twitter

I recall creating a personal Twitter profile years ago soon after it launched; I was actually in the first group of 100,000 to get a Twitter profile (total nerd fact) – sadly that Twitter handle was deleted years ago. Twitter is a medium that probably requires a bit more coaching to see its professional value, as its not as organically geared and driven solely towards working professionals or career-minded people. Twitter is essentially a mass collection of timely 140-character blurbs, and these blurbs can be employed in any way one’s mind can conceive to a Twitter user’s followers. A news organization can provide breaking news alerts, a mother in Idaho can share baby photos, and a young, enterprising attorney can harness it to share his own industry news or obtain fresh industry news. I realize that it is not necessarily as obvious what the value is for a professional to be connected on Twitter, so I’ll provide a sampling of people or entities that I follow:

  • Boutique Energy Law Firms (Burleson LLP, Steptoe & Johnson, Beckmen Law, etc.)
  • News Outlets (Wall Street Journal, CNBC)
  • O&G Companies (ExxonMobil, Shell, etc.)
  • Career-related entities (State Bar of Texas, AAPL, NAPE Expo, DrillingInfo)
  • A few personal Twitter pages to both show an interest in them, and for their updates (SUNY Buffalo Law School, San Diego Padres, and the best investor and CNBC contributor on Twitter Josh Brown @ReformedBroker)

It is entirely left to the discretion of the Twitter user to choose what people or entities to follow, allowing for total customization of what you’re seeing and who you’re connected to. I personally usually have two Twitter accounts – a personal one and a professional one – that I keep wholly independent of one another, but some have managed to coexist across both planes of Twitter existence with one account (I’m not so daring).

Blogs

I think that an interesting and well-written professional blog can do wonders in lifting one’s visibility, but more importantly in demonstrating that one is both knowledgeable in a subject area but is also passionate enough to devote the time, energy and thought required in order to regularly prepare and send out blog entries for nothing more than the satisfaction of sharing information or opinions with those in the industry who might take the time to read it. By committing to regularly doing blog posts, you are more likely to be keeping up with industry developments (assuming you want your posts to be at least somewhat novel and helpful to your readership). I find that for myself, it forces me into not only keeping up with news and issues that are important to those who work in my industry, but to go deeper and think critically about how all of these things interplay with one another. Whereas Twitter is designed more for blasting out short little blurbs, an effective blog is more expositional in nature and allows for more space to communicate an idea.

Implementing the Social Media Hodge-Podge

Effective and regular usage of these three social mediums can do wonders for the career-minded professional in the oil & gas industry, or pretty much any other industry. They allow you to make and sustain important connections (LinkedIn), curate and share interesting news or developments (Twitter), and expound in more detail and at greater length on interesting news and novel developments in your industry (blogs).

Harvard Study Yet Another Call for Repeal of 1970s Oil Export Ban

This is a good read from EnergyInDepth.org – a recent Harvard Business School study calls for a repeal of the oil export ban levied in the 1970s as one step in a multi-pronged strategy to bolster American energy independence.

Link to EID Story: http://energyindepth.org/ohio/new-harvard-report-five-ways-shale-development-is-a-win-win/

Link to the HBS Study: http://www.hbs.edu/competitiveness/Documents/america-unconventional-energy-opportunity.pdf

I would not bet any money based on this, but I bet that one of the first dominoes to fall should a Republican take the White House in 2016 (which based on my knowledge of political science is more likely than not, even with the clown car of Republican candidates already in the field) will be the oil export ban. CEOs of major oil companies – including Scott Sheffield of Pioneer Natural Resources (#PXD), Lee Tillman of Marathon Oil Corporation (#MRO), and the soon-to-be-departing Steven Chazen of Occidental Petroleum (#OXY) – have been advocating its repeal in closed-door meetings in Washington, D.C. for several months. Sheffield earlier this year called 50/50 odds of this repeal occurring in 2015, almost no chance of it happening in 2016 due to the focus on the presidential election, but said that 2017 should be the end of the line.

TX Supreme Court: ORRIs Don’t Automatically Bear Post-Production Costs

In an opinion delivered June 12, 2015, a narrow 5-4 majority of the Texas Supreme Court held that overriding royalty interests (ORRIs) in leases do not always automatically bear a proportionate share of post-production costs, based on the language of a particular oil and gas lease. The Hyder family had been victorious against oil and gas producer Chesapeake Energy at the trial court and appellate court level, and this time was no different. Analysis in the case turned on whether the generally accepted industry-wide model of ORRIs bearing post-production costs was so entrenched as to disincline the court from upsetting the apple cart by concluding that different lease terms can dictate different outcomes; ultimately, the court chose to go with the latter model.

The lease at issue was one signed in 2004 for 948 net mineral acres in the Barnett Shale, and was originally entered into by the Hyders with Four Sevens Oil Company. Four Sevens Oil shortly thereafter assigned the acreage to Chesapeake Energy in 2006. Years later, the Hyders and Chesapeake began to disagree about how post-production costs were being deducted from the Hyder family’s ORRI. Chesapeake contended that the ORRI clause in question – “a perpetual, cost free (except only its portion of production taxes) overriding royalty of five percent (5.0%) of gross production” – allowed them to deduct post-production costs because a cost-free overriding royalty is synonymous industry parlance for an overriding royalty. The Hyders asserted that the “cost-free” language can only be referring to the post-production costs given that ORRIs by their very nature do not bear any other costs.

The court ultimately sided with the Hyders, concluding that the “cost-free” language in the ORRI term at issue did in fact include post-production costs. After the court’s decision in Heritage Resources, Inc. v. NationsBank, 939 S.W.2d 118 (Tex. 1996), there was a changing in the oil and gas law tides – leases would be governed by a fair reading of their text and terms on an individual basis, and would not be subsumed by general industry meanings or understandings. The court notes that the lease at issue did disclaim that holding, stating that “Lessors and Lessee agree that the holding in the case of [Heritage] shall have no application to the terms and provisions of this lease.” However, the majority herein clarifies Heritage’s applicability, stating:

Heritage Resources does not suggest, much less hold, that a royalty cannot be made free of postproduction costs…[it] holds only that the effect of a lease is governed by a fair reading of its text. A disclaimer of that holding, like the one in this case, cannot free a royalty of postproduction costs when the lease itself does not do so. Here, the lease text clearly frees the [lease royalty as to gas] of postproduction costs, and reasonably interpreted…does the same for the overriding royalty.” (emphasis supplied).

It is important to appreciate that the Texas Supreme Court has been issuing rulings on a fair number of nuanced oil and gas law cases in the last few decades, many as to lease terminologies. However, it seems that more often than not the court has limited the overall holdings on a case-by-case analysis, and resisted the urge to pontificate broad and sweeping change from the judicial bench. The ORRI provision in the Hyder lease was, as it turns out, written by savvy mineral interest holders who were in an advantageous bargaining position when their lease was signed; it does not represent what most would think of as a “typical” ORRI. This is yet another case demonstrating that the norms of the oil and gas industry are oftentimes not sufficient to overcome specific language in lease terms that can be read to have a different meaning. The moral of the story certainly would be to carefully scrutinize the terms of the lease and don’t assume that ambiguous terms or unusual phrases in the lease will later be defeated in court by the argument of “we believe the term has a generally accepted meaning of  _____ in the industry,” because the lease terms will probably govern.

This write-up is also available on my LinkedIn page under “Posts.”

TX Cities About to Lose Right to Ban Hydrofracturing

Per the Dallas Morning News (amongst other myriad news outlets), it appears that a measure to ban hydrofracturing bans is only a matter of time and ceremony, as Texas Governor Greg Abbott is expected to sign off on the bill that has been paraded through the State Capitol and easily passed both legislative houses. The subject has been one of much contention and has come to a head in recent months, as Denton, Texas residents had voted to authorize a hydrofracturing/”fracking” ban within municipal limits. The article points out that this legislation would also put a kibosh on ordinances addressing underground activity, such as wastewater disposal wells.

Without getting too political, it is certainly interesting to watch a state whose citizenry and politicians largely oppose the federal style of government and would profess states’ rights (or a small-c confederacy) bend over backward to bend their true political beliefs to accommodate the oil industry, but that is for political scientists and pundits to dissect and debate. The move has been made to protect the oil and gas industry in the state, clearly; but, it also preserves the exploration and mineral rights of those interest owners who believe that they have the right to harvest those resources.

It is no surprise, then, that the standard upon which potential and enacted municipal ordinances will be measured under this forthcoming law is not only one of reasonability, but “commercial reasonab[ility’.” This gives courts immense discretion in determining whether or not a town’s ordinance impinges on oil and gas industry activities. One would imagine that barring a devastatingly damning congruence of facts, that Texas courts will be hesitant to impose great burdens onto the industry.

Tangentially, it is interesting that a more liberal and federal-leaning state such as New York has used the process of cramming a ban on high-volume hydrofracturing down the throats of all state citizens, yet Texas, which is arguably diametric on many political issues, is about to use the same process to cram its own version of a ban, which itself bans any fracking bans. The juxtaposition is certainly interesting.

Expect much litigation in this space, with courts being highly reluctant to bring the hammer against the industry at large. I dare say that any decisions against the oil and gas companies and/or operators will be disclaimed as to that particular entity too, unless either 1) the transgression is severe enough to warrant industry-wide change, or 2) altering the action or behavior that caused the transgression would not be financially or logistically onerous.

TX Supreme Court: A Punt on Trespass vis-à-vis Wastewater Injection

Last week, the Texas Supreme court again declined a jurisprudential invitation to rehear a decision that could have potentially broadened the application of a trespass cause of action to industrial wastewater injection underground that pollutes a landowner’s groundwater.

The facts of the case provide that a company drilled an injection well in 1997 on farmland in Liberty County; throughout its lifespan that well injected over 100 million gallons of wastewater several thousand feet subsurface. Wastewater typically contains chemicals and other industrial liquids, and this situation was no different – expert testimony highlighted that the wastewater in this case was laced with acetone, and that the wastewater in question probably reached an underground brackish water acquire beneath the farmland. The farm argued that a desalinator, were it installed, could have made that water drinkable and potable, and subsequently sued for an underground trespass.

At the county level, a jury decision was rendered in favor of the well operator. On appeal, that jury decision was overturned. Upon review by the Texas high court, they chose to dispose of the case on narrower technical grounds and rendered a verdict in favor of the well operator. Brian Sledge, a prominent Austin water lawyer, observed in a Texas Tribune article that the Texas Supreme Court “found a way to avoid issuing that opinion that could have had huge economic and political implications. The impacts to the oil and gas industry would be huge.”

This observation is an apt one. The Texas Supreme Court tends to be cognizant and wary of imposing huge and sudden hurdles on the oil and gas industry absent compelling justification. Should they have determined that a trespass occurred, such a decision would have had significant financial and logistical ramifications for well operators and energy companies; wastewater would need to be removed and disposed of in some other fashion, and trespass causes of action would be broadened from a landowner perspective.

Both cited articles come from The Texas Tribune website.

Incentivizing Waterless Fracking via Tax Credits: A Win-Win Proposal

Per an April 3, 2015 article on the Houston Business Journal website (available here), several bills have been put forward in the Texas House of Representatives that would reward those oil and gas producers that use alternative fracking fluids, otherwise referred to as waterless fracking. The author of the first bill, Representative Tracy King of Batesville, suggested that the tax credit would be beneficial to Texans, especially where drought conditions are most severe. As she put it, “[citizens are] grateful for the production that is there, but 40 percent of the water that is used in Dimmitt County, Texas [in the Eagle Ford Shale] is used for hydraulic fracturing…it’s believed that increased production is available through the use of alternative-based fluids.” Representatives Drew Darby of San Angelo and Abel Herrero of Corpus Christi have also proffered similar bills, that differ slightly in scope and the amount of a potential tax credit.

Oil and gas companies are apt to point out that conventional fracking does not use more water than traditional drilling, but that argument is a bit of a red herring – one need only look to recent statewide impositions on water usage in California in the wake of a generational drought to appreciate that any actions that can be taken to reduce water usage should be taken. It does not appear that the industry is being targeted in retributive fashion for their water usage by these bills; rather, it would merely be provided an incentive to consider an alternative means of oil and gas production that also has the added benefit of water conservation. Though there would obviously be a cost associated assuming the bill were to become law – and that companies chose to pursue waterless fracking – the costs could be offset through the state’s gargantuan “rainy day” fund, the coffers in which lie the billions of dollars Texas has collected from oil and gas production.

Ultimately, this could be an example of potential innovation through legislation of incentivization. Oil and gas companies would have an option to pursue measures that will benefit them through lower taxes by innovating and improving the waterless fracking process, which would benefit citizens through the conservation of water. Rather than cramming heavy-handed legislation down its citizens’ throats, Texas would be putting forth a trial balloon of sorts in an effort to assuage both oil and gas companies as well as citizens on the same issue. This preemptive effort to recognize and address the fact that water conservation will likely be a point of contention in later years should be applauded.

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.