From The Fuse

Pipeline bottlenecks are taking some of the shine off the Permian basin.

Prices for oil in West Texas have fallen to double-digit discounts relative to the WTI benchmark in Cushing, Oklahoma. The Permian basin has been hyped as the most prolific oil basin in the world and the key to the United States becoming an energy superpower. Output there has indeed soared and continues to grow. But the region is running up against a series of constraints, including for labor, drilling services and equipment, water management and most importantly, pipeline capacity. That combination is pushing up costs, increasing breakeven prices for producers. Relief in the form of more midstream capacity is at least a year away.

Oil production in the Permian basin is expected to rise by another 78,000 barrels per day (b/d) in June compared to a month earlier, putting total output at 3.28 million barrels per day (Mbd). Pipeline bottlenecks have not yet curtailed production growth, but they are causing wide discounts for Midland crude. It is trading at a discount in excess of $10 per barrel relative to WTI in Cushing. Meanwhile, Midland-WTI is trading at a $10 per barrel discount to international marker Brent.

The Permian has roughly 3.175 Mbd of takeaway capacity, according to Genscape, including rail and local refining. This means that existing pipelines carrying oil from West Texas to the Gulf Coast are essentially full. The Permian glut, which is increasing by the day, has exacerbated regional discounts. The myriad problems could ultimately eventually lead to lower-than-expected production figures.

Permian falling out of favor

Pipeline bottlenecks are just one of many constraints facing Permian producers. The high concentration of drilling has strained the market for labor, evidenced by the region’s extremely low unemployment rate and salary inflation. The shortage of fracking crews and other drilling services has led to a sharp uptick in the number of drilled but uncompleted wells (DUCs), as companies are forced to defer completions. The DUC backlog has more than doubled since the start of 2017, rising from 1,374 to 3,086 as of April 2018.

The Permian does not have enough pipeline capacity to handle all of the additional gas.

Pipeline bottlenecks for natural gas are also problematic. With oil production increasing sharply, associated gas has climbed in corresponding fashion. The Permian does not have enough pipeline capacity to handle all of the additional gas, and there are limits on the volume of gas that companies can burn. Ultimately, regulations could force drillers to curtail oil production if the rate of flaring nears the limit. With flaring rates approaching maximum levels, and no midstream solution on the horizon, there is pressure on state lawmakers in Texas to loosen flaring restrictions.

A lesser known problem is water. Drilling a shale well involves injecting large volumes of water underground, volumes that have increased over time as companies have tried to pull more oil and gas out of a given well. The wastewater that flows back, plus naturally-occurring water that is “produced” along with oil and gas, needs to be either disposed, recycled, or somehow reused. With the volume of water coming out of the ground increasing over time, water management costs are on the rise. “The combination of rising volumes and higher disposal costs threaten to shift cost curves and pose a growing risk to oil production growth in the Permian,” Ryan Duman of Wood Mackenzie wrote in a recent report. “Water risks to date have largely been described as a cost issue, but as projects continue to build scale, the risks become more serious,” Duman said. “They could impact the ability to actually carry out operations. Investors and project partners should challenge operators on how water is being managed.”

WoodMac estimates that higher water management costs could rise by $3 to $6 per barrel, which could curtail oil production by some 400,000 b/d by 2025.

WoodMac estimates that higher water management costs could rise by $3 to $6 per barrel, which could curtail oil production by some 400,000 b/d by 2025.

Rising costs and falling prices are weighing on Permian producers. Once darlings of Wall Street analysts and investors, “pure play” Permian drillers are now seeing their share prices suffer relative to their peers. As Bloomberg notes, a sampling of 15 shale companies that are mainly pure Permian plays lost billions in value over the last few weeks, while more integrated companies with Permian exposure but assets elsewhere fared much better. “You just don’t want to touch these Permian names,” Gabriele Sorbara, a Williams Capital Group analyst, told Bloomberg. “They are falling off a cliff.”

Eagle Ford making a comeback

The list of problems facing Permian drillers is breathing new life into other shale regions.

The list of problems facing Permian drillers is breathing new life into other shale regions. For the last few years, shale executives tried to highlight their Permian assets when speaking to analysts or shareholders, and a long list of companies started to divest themselves of holdings in the Eagle Ford and the Bakken to concentrate on assets in West Texas. Now momentum is swinging back in the other direction, with executives beginning to trumpet their non-Permian assets.

“[W]e get great margins out of the Eagle Ford,” Alan J. Hirshberg, Executive Vice President at ConocoPhillips, said on an earnings call in April. “There’s just been less competition for goods and services in the Eagle Ford and better netbacks because there’ve been less people trying to jam their barrels down the same takeaway capacity. So, everything about the Eagle Ford is really hitting on all cylinders for us.” In May, Conoco’s CEO said it would “go slow” in the Permian because it is “completely constrained today.”

Others are also shifting focus. On June 4, Matador Resources said that it could move resources from the Permian to the Eagle Ford, citing the steep discounts for Midland crude. “Should these widening oil differentials persist in the Delaware Basin, Matador would also have the option of shifting a portion of its drilling activities from the Delaware Basin to its largely held-by-production properties in the Eagle Ford shale where oil pricing is currently more favorable,” Matador said.

Eagle Ford production peaked at 1.72 Mbd in March 2015 and declined sharply, before bottoming out last August at just over 1 Mbd. Since then, output has rebounded and is expected to rise to an average of 1.39 Mbd this month.

Permian growing pains and world oil prices

The problems could be chalked up to growing pains, but higher costs and lower sale prices may translate into production figures falling short of expectations. This scenario would have large implications for global oil prices. The United States is the main non-OPEC producer expecting to see large output gains this year and next. But with the Permian possibly falling short of expectations, the U.S shale boom may not be the panacea to keep prices relatively low at a time OPEC is restraining supply and geopolitical risks threaten more supply disruptions.

 


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