FRACTIONAL FLOW

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Bakken, Something About EURs, PDP Reserves and R over P Ratio

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Proven reliable methods on the Estimated Ultimate Recovery (EUR) for any well (or other agreed parameter like EUR for the average well of specified vintage populations for plays, fields, companies or other) is crucial to make estimates on remaining Proven Developed Producing (PDP) and Proven UnDeveloped (PUD) reserves which are the linchpins for assets backed lending (reserves-based lending).

Attainable EURs with realistic decline curves are also the foundations for reasonable estimates on future cash flows, which forms the basis for the companies’ financial planning inclusive CAPital EXpenditures (CAPEX) for future well manufacturing.

Reserves-based lending is what the companies depend on to leverage their equities inclusive owners’ capital for loans that together sets the pace for developments of their acreage. These loans often come with clauses about the speed for the drilling of the companies’ area as the lenders want to see their capital returned with a profit within an agreed time frame. These loans come with covenants of various scopes commonly described by financial metrics which the borrowers have accepted to honor.

In this article, I will focus on PDP reserves as there is more uncertainty associated with developments of PUDs in time, price, and cost.

This article is based on a more comprehensive and granular analysis of the average EUR estimates by vintage and developments for PDP reserves and R/P for Bakken than what was presented in the article “The Bakken, a little about EUR and R/P” in August 2016.

A low R/P ratio (index) gives expectations of a steep decline in extraction from the growing population of wells, which results from Light Tight Oil (LTO) wells had steep and now steeper initial declines. The steeper declines also explain why the companies must stay on the treadmill to bring in a high number of new wells to sustain/grow the production and, more importantly, sustain/build their PDP reserves, which are the significant component for reserves-based lending.

  • This study estimated remaining Proven Developed Producing (PDP) reserves in the Bakken(ND) as of end Oct-19 for the reference case to 1,6 – 1,7 Gbo (Giga, billion barrels).
    The PDP reserves are from all the more than 14 000 horizontal wells started from Jan-08 and per Oct-19.
    The EURs for the average well of the 2008 – 2019 vintages used in this study are shown in figure SD 6 at the end of this article.
  • As of the end of Oct-19, the R/P (for Bakken, ND) was estimated at 3,3 (reference case).
    A sensitivity analysis adding 5% to EURs for the 2015 – 2019 average vintage wells increase the R/P to 3,5.
  • This study Juxtaposed the PDP estimates with the PDP numbers from the SEC 10-K filings for 2018 for some public companies that are heavily exposed to the Bakken (more than 90% of their equity/entitlement production from the Bakken).
    At the end of 2018, this study found that these companies’ SEC reported PDP reserves were overstated with 30% – 50%.
  • An independent verification confirming overstated reserves would, for those affected, likely result in a downgrade of their credit rating. A downgrade to below investment grade would have far-reaching consequences as any institutional investors would be forced to sell their bonds into a liquid starved junk bond market, and the companies would be faced with much higher interest rates for debt that is rolled over which eats into their cash flows.
  • Should several independent and seasoned third parties verify the magnitude of overstated reserves, several LTO companies would be cornered, and the only way to paper over this would be to sweat it out while praying for a significant lasting higher oil price (like $90/bo or higher) soon.
    Cornered because any sale of a significant portion of their well portfolio to buyers that have done their due diligence based on actual well data could come up with a much different assessment from the seller’s reserves and asked price based on the seller’s booked value of the portfolio for sale. A realized sale of a significant portion of the well portfolio reflecting the buyer’s offer could highlight that the seller’s booked to model PDP reserves is much lower. A realized sale could force the seller to take considerable impairments, which subsequently would raise questions about the remaining PDP reserves on their books. And as the PDP reserves of one or several companies become questioned, more would follow.
  • Based on the PDP reserves from this study, it was estimated that each barrel of oil in the ground was burdened with about $30/bo (includes revenues from natural gas) to recover employed capital.
    Another way to put this is that each barrel of oil has to netback $30/bo at the wellhead, or gross about $55 – $60/bo at the wellhead to recover employed capital (owners’ capital and debt) and also pay for Plugging & Abandonment. The estimated $55 – $60/bo is to recover employed capital and thus leaves no profit.
    Applying simple project economics to earn a return of 7% (for the Bakken as one big project) would require an oil price of $80/bo at the wellhead for the PDP reserves as of end Oct-19.
  • Management in many shale companies has a performance incentive structure in which production developments has been/is dominant.
  • For the next 1-2 years, managements of LTO companies will generate and implement strategies that search to balance allocation of available capital to sustain and/or grow their production and reserve base (used for reserved based lending), deleverage and/or pay dividends to a growing number of impatient owners.
    To exacerbate this challenge, the banks now have tightened requirements on revolving credit, decreased their loans, and voiced concern that the assets of some shale companies will not cover the loans. This is commonly referred to as balance sheet/accounting insolvency, and if the situation continues, creditors and lenders could force the company to sell assets or declare bankruptcy.
    At present oil/gas prices this becomes exquisitely balancing acts as any financial deleveraging and dividend payouts eat into funds that otherwise could be made available for more well manufacturing.
  • Reducing CAPEX for well manufacturing below some threshold to generate some Free Cash Flow (FCF) comes with some catches, and this is not only from the prospects from a decline in production/extraction and thus operational cash flow.
    Changes to the Reserves Replacement Ratio (RRR) is an important parameter to follow and how it affects PDP reserves. Many companies have relied heavily on reserves-based lending, and a significant decline in PDP reserves will, by default, increase financial leverage and may (stress) test some of the loan covenants.
  • Covenant light loans give less protection for investors. Credit rating agencies flagged problems with these for years, and issues with leveraged loans can happen overnight as it is challenging to see stress building on balance sheets from inflated (oil and gas) reserves estimates.
    Realistic EURs and R/P estimates (produced by competent and independent third parties) could become a real game-changer for the future pace of US LTO developments.
  • In recent years I have come to use the global credit impulse as one of the major leading indicators to predict the band of the oil price one year forward. Back in August 2018, I used the global credit impulse (amongst several other indicators like supply and demand, storage, etc.) to predict the oil price one year forward.
    As of now and for 2020, few things suggest the global credit impulse will give support for a material higher oil price. Then throw in the US presidential election in 2020, which now makes me extend my price band of $55 – $70/bo from late 2018 for Brent Spot for this year.
    OPEC+ may cut more to supplies to shore up the oil price, but OPEC+ has no control over changes to the global credit impulse, the future strengths/weaknesses to the US$, and developments in affordability amongst the global consumers.
    In 2019 an average oil price in the mid-’60s (Brent Spot) triggered protests amongst consumers in several economies. There is a limit to how much higher the oil price for struggling US consumers can rise before it starts to affect consumption. The affordability threshold in recent years has declined with the higher and continued growth in total global debt.

    My expectations for the oil price for 2020 are in line with most other analysts, and if that comes true, LTO operators should not expect much financial relief from the oil price this year.

Figure 1 Bakken split produced and PDP Oct 19

Figure 1: The chart above with stacked areas shows the development in total produced (red area) and total Proven Developed Producing (PDP) reserves (blue area) from Jan-08 and per Oct-19 [rh scale]. The black line is the price of North Dakota Sweet (or Williston Sweet) [lh scale].

Figure 1 shows that since early 2015 and through the slow down till early 2017 and per Oct-19, the remaining Producing Developed Remaining Reserves (PDP) for the Bakken has remained almost flat. In other words, reserves were extracted/produced at about the same rate flowing wells were added.

LTO extraction grew from 0,92 Mbo/d in Jan-17 to 1,43 Mbo/d in Oct-19 or close to 60%.

In the same period, PDP reserves grew with an estimated 90 Mbo or about 6%.

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The Powers of Fossil Fuels, an Update with Data per 2017

This post is an update and small expansion of The Powers of Fossil Fuels spanning more than two centuries of the history of the world’s energy, primarily fossil fuels (FF), consumption.

  • Between 2002 and 2017 world energy consumption grew with about 39%, world Gross Domestic Product (GDP) by 130% and world total debts by more than 160% (market value and expressed in US dollars).
  • The narrative of the growth story of the world economy (GDP) appears as a rule to leave out two participants:
    1. DEBT and the accelerating debt growth since the 1980’s, more notably since the start of this millennium and how this unprecedented growth in total world debt helped pull forward ENERGY demand.
      Post the Global Financial Crisis (GFC in 2008/2009) the continuity of economic growth became facilitated by concerted policies by the world’s major central banks by their low interest policies and Quantitative Easings (QE).
      Lower interest rates allowed room for more DEBT on most balance sheets and growth in total DEBT is important for continued economic growth.
    2. ENERGY (and primarily FFs) consumption and its strong growth facilitated by the rapid growth in DEBT.
  • Simplistic explained is GDP a monetary measure of the annual volume of transactions.
    These transactions involve the exchange of products and services which require some input of ENERGY and in recent years growing amounts of DEBT allowed for this to happen.
    This illustrates that money/currency is a claim on ENERGY.
    The orderly retirement of the growing DEBT is a claim on future ENERGY.
  • This post also takes a brief look at the recent years’ growth in solar and wind (renewables, RE) and how their growth measured up against FFs since 1990 and Year over Year (YoY) changes for FF and RE since 2000.

Figure 1: The chart shows the developments in total world energy consumption split on sources as of 1800 and per 2017.
Energy sources are stacked according to when these were introduced into the world’s energy mixture.
The black line (plotted versus the left hand scale) shows development in the world’s GDP in current US dollars since 1980 based on data from the International Monetary Fund (IMF).

In the early 1800s biomasses (primarily wood) were humans’ primary source for exogenous energy. Coal was gradually introduced into the energy mixture after the successful development and deployment of the steam engine which gave birth to the Industrial Revolution. Coal is a nonrenewable, abundant and a denser energy source than wood.

The growing use of biomasses had led to deforestation in those areas serving energy intensive industries like mining and metals.

The steam engine and its use of abundant coal as an energy source made it possible to rapidly expand the industrial production, create economic growth and thus the Industrial Revolution was made possible by fossil fuels.

With the most recent discoveries and introduction of fossil oil and natural gas there appeared to be several abundant sources of volumetric dense energy that could entertain exponential debt fueled economic growth.

Fossil fuels represent natures’ legacy stock of dense energy (ancient sunlight) that during some decades has been subject to an accelerated depletion.

Several reports in the media may now leave the impression that we are at the threshold for a smooth transition from FFs to RE (solar and wind).

How does this measure up against hard data for RE (solar and wind) versus FFs?

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Oil, Interest Rates and Debt

At first glance it is hard to see how oil, interest rates and debt are connected. Two of them are human constructs while oil (fossil sunlight), a gift from Mother Nature, took tens of millions of years to process. Oil is an endowment extracted from a confined underground stock and is now the most dense and versatile energy source known to man.

Figure 1: Chart that shows the development of [extraction] cost of oil and interest rates (US 10 Year Treasuries) has developed since 2000 and a likely trajectory for oil extraction costs.

Figure 1: Chart that shows the development of [extraction] cost of oil and interest rates (US 10 Year Treasuries) has developed since 2000 and a likely trajectory for oil extraction costs.

Both lines are SIGNALS, and most likely plan their future based on only one of them.

The 10 Year Treasury (or similar) rate is the reference used for amongst other things to set interest rate for mortgages. Most now, aware of it or not, base their future plans on the expectations to developments of the 10 Year Treasury.

What is now playing out in the oil market may be described as below;

Low interest rates [stimulates debt growth] => Pulls demand forward => Oversupply => Deflation

How will the interest rate develop in the future?

This is important as the present huge global debt overhang weighs heavily in the consumers’ balance sheets and their affordability for costlier oil. It is also important for oil companies’ long term planning to bring costlier oil to the market.

A lasting, low rate makes higher debt loads manageable. Interest rates works both sides of the demand/supply equation.

A higher interest rate will have serious implications for highly leveraged consumers and oil companies.

The dynamics may be described as below:

Higher interest rate => lowers demand => downward pressure on price [deflation] => makes it harder for [highly leveraged] consumers/oil companies to service their debt overhang => lowers investments to develop costlier supplies

At some point in time the present oil supply overhang will come to an end. This will become reflected in a higher price.

The timing of these events creates uncertainties and the agile and financial strong oil companies will sweat out a lasting low oil price.

Few are aware of that the costs of accessing our real capital (like oil) that runs our economies are rapidly increasing.

What is different this time is that the oil price may remain lower for longer than the estimated full cycle break even costs for new developments.

The suggested path for costs is believed in the near term to come down as oil service companies have reduced their prices to shoulder the burden from the recent price collapse. Over time, the capacities of the service companies will become aligned with the demand for their services and products. At some point, as the oil price recovers and investments pick up, the market mechanisms will bring the prices from the service companies up as the service companies also need to make a profit to stay in business.

In figures 4 and 5 are shown how the combination of lower interest rates and a lasting, high oil price encouraged the oil companies to rapidly take on more debt to develop costlier oil on the expectations that consumers had remaining ability to take on more debt/credit to pay for this, thus allowing the oil companies to retire their debts.

The oil companies’ behavior in the recent decade is reminiscent of group think. Few expected the oil price to collapse, though the oil industry itself repeatedly point out the cyclical nature of the oil price.

The aggregate of developments (primarily driven by an amazing growth in the extraction of light tight oil [LTO]) gradually resulted in a supply overhang that made the oil price collapse.

The costs of extracting real capital, like oil, has been rapidly increasing, yet we are making decisions for the future as if it were decreasing, based on the price of capital (money). This is a short term phenomenon that will last until supply and demand become balanced.

The present situation with an apparent oil glut and low prices is a temporary false signal.

This may also be the case with the low interest rates.

The near future will reveal how the competition for available funds to service a still growing huge global debt overhang fare towards the need to fund developments of costlier oil.

Can an increasingly leveraged global economy handle both higher oil prices and interest rates and still remain on its growth trajectory?

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