Drilling down into $40 oil and investment assumptions

POSTED ON October 13, 2015 BY Benjamin Cox
CATEGORY Stories,

A drill rig in the Marcellus Shale.

I used to track the number of natural gas rigs, but then things changed…

The common assumption was that more rigs would equal higher production. Makes sense, right? Except it did not work out that way.

Although the rig count has fallen, production has not disappeared and natural gas prices have remained low. $2-3 per unit of natural gas in North America is the new normal. Rig counts should drive gas supply, but they don’t appear to anymore. Rigs have either become more efficient or new wells have started to matter less; supply has kept up even as the rig count has dropped through the floor.

The bet on oil - by the Saudis and others who are driving down price - is that rig counts will drive oil supply. However, oil could follow gas, with rig counts dropping while production stays at this level or goes up. Decision-making gets very rational very quickly at US$30-50 per barrel for oil.

My theory here is that in a rising market, those managing rigs take more risks on where to put wells. In a down or weak market, they drill the hearts of where they know they will find oil, focusing on solid targets that will deliver. Why would Royal Dutch Shell (NYSE:RDS) stay in the Arctic when they have other locations for those drills with infrastructure in place, where they can tie into production as soon as the well is complete?

I don’t bet on oil and gas, but I figure this change is worth noting from an overall extractive industry perspective. Sometimes things completely change, and if you don’t understand what is going on, you get caught flat-footed.

So what is my prediction going forward? Marginal, risky wells are not going to be discovered and new fields will not show up. Luckily, we don’t need them, as we found enough oil in the last boom to last for a good long while. The drills that are still drilling for oil will find oil, increasing global supply at a reasonable cost.

Other drills that are idled will go through bankruptcy and come back drilling at a lower cost, driving the whole exploration cost curve down.

Unless demand changes, $30-60 oil could be the new normal, and rig counts just might not matter much.

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Benjamin Cox

Prior to founding Oreninc, Mr. Cox served as a senior analyst at the D.E. Shaw Group and as a consultant with the GLG Group, where he worked directly with 15 Wall Street teams in the mining deal space. Mr. Cox is the Chief Executive Officer and a Director of Aston Bay Holdings Ltd. (TSX-V:BAY), a copper and zinc company with properties in Nunavut, Canada. Mr. Cox has researched and developed business, financial, and shipping models for every major global iron ore project. He is also an expert on mining industry market dynamics and metals, with a focus on raw materials including base metals, iron ore, platinum group metals, and industrial materials such as potash and lithium. Mr. Cox holds a B.S. from Brandeis University and an M.B.A. in Finance from Portland State University. More →

bjc@oreninc.com

Benjamin Cox

bjc@oreninc.com

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