Into the COVID Fog

While recent data suggests the modest beginnings of a recovery in the oil markets, the sheer number of unknowns in public markets, government policy, and demand, in general, have halted any declarations of victory from the industry. Despite access to an unprecedented volume of data, the industry continues to struggle with the problem of uncertainty; that is, the inability to meaningfully determine what may be lurking just over the horizon. This is not a new obstacle, and perhaps one of the most insightful discourses on managing this uncertainty comes from the time of the Napoleonic Wars, where the great Prussian strategist Carl von Clausewitz, believed by many to be the originator of the phrase “fog of war,” stated:

War is the realm of uncertainty; three quarters of the factors on which action in war is based are wrapped in a fog of greater or lesser uncertainty. A sensitive and discriminating judgment is called for; a skilled intelligence to scent out the truth. — Carl von Clausewitz

While today’s oil markets are certainly painful for many, they fall short of war. For those involved, however, whether they be energy producers, traders, investors, mineral owners, or even state or national governments, Covid-19 can definitely be said to have wrapped ‘three quarters of the factors on which action … is based … in a fog of greater or lesser certainty.” In fact, as Joe Wallace points out in his recent Wall Street Journal article, “Oil Market Flies Blind as Covid-19 Clouds Demand Outlook”, virtually all of the key performance indicators relied upon in calculating demand, and thus price, are in a state of flux.

The uncertainty as to how Covid-19 will continue to impact transportation, consumption, and ultimately the macro-economic health of the global economy through the remainder of 2020 and beyond has driven oil markets on a wild ride throughout the year. As Mr. Wallace notes, “The lack of visibility has contributed to renewed turbulence in the market after prices rose over the summer….” The swings have been dramatic, and only twice in the past three decades has the total oil price range been wider than that experienced this year.

Markets crave predictability, and with major unknowns in terms of public health, public behavior (work from home v. commute/business travel) as well as public policy (it’s an election year), we’re left to read the tea leaves with the data available to discern what is coming next. Without a clear line of sight to the demand equation, we must look to the data that we have – what we do know – to best gauge where we may end up.

It’s clear that the overall drilling activity has fallen off a cliff. Since March 2020, the US horizontal rig count is down approximately 75%, with some basins such as the Bakken down between 85-90% of activity levels in early 2020. According to a recent report by Rystad Energy, the present activity levels are far below those of recent downturns: the total US horizontal rig count in mid-September reached 214, far below the previous low of 314 recorded during the 2016 slump.

Given the steep decline rates in production associated with unconventional (i.e. horizontal) wells, we know that drilling activity is a leading indicator of production declines; i.e. a precipitous decline in drilling activity will generally be followed six to eighteen months later by a corresponding drop in production levels. This linkage is exacerbated by the recent uptick in fracking and completions activities, as US operators have begun to increase completion operations on the abnormally high DUC inventory accumulated during the past 6 months. Based on data from ShaleWellCube, the pace of completions activities has been steadily increasing from the previous low in 2020 week 25. Thus, we know that operators are drilling less wells while increasingly drawing down on their DUC inventory. This means that without a meaningful increase in activity driven by demand, production levels appear set to decline significantly in the coming years.

The EIA and Credit Suisse both forecast this exact scenario, estimating that US Oil production is set for a year over year decline until 2022 from 12,245MBbld in 2019 to 10,915MBbld in 2021. The key question then, is what will this decrease in supply will do for the price? Conventional wisdom is that the US Shale Industry, for lack of a better term, needs approximately a $60/bbl price to function effectively, with a $70/bbl price generally considered the desirable floor. With so many unknowns on the demand side of the equation, we are left to see whether the forecasted decrease in supply will have a meaningful impact on this price level.

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