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OPEC Has To Extend Cuts – Shell Will Benefit Strongly From The Action

Gary Bourgeault: 28 March 2017

One of the best things to happen to the U.S. shale industry was the plunge in the price of oil. It caused creative companies with good management to aggressively pursue ways of slashing costs, while at the same time improving productivity.

A number of the pure plays like EOG Resources (NYSE:EOG) have been able to significantly improve efficiencies, to the point EOG can generate a 30 percent return when oil is at $40 per barrel. Lately, major producer Royal Dutch Shell plc (NYSE:RDS.A) (NYSE:RDS.B) has taken a larger position in shale, and says new wells in its Permian holdings can generate a profit at $20 per barrel. Overall, it can make money when oil is at $40 in the Permian.

The new game in town isn’t what OPEC is doing or not doing, but whether or not U.S. shale producers can continue to pump oil at a profit at most oil price points. Along with Shell, Chevron and Exxon are going to spend a lot in the Permian over the next year, and will lead the U.S. to produce an estimated 1 million more barrels per day by the end of 2018.

Not to be outdone, EOG is boosting capital expenditures by 44 percent this year to just under $4 billion, and Continental Resources, Inc. (NYSE:CLR) is raising its CapEx by 68 percent, to $1.95 billion.

This, along with other major producers like Canada and Brazil increasing production by over 400,000 barrels per day in 2017, reinforces my thesis that OPEC and the others are playing a dangerous game by entering into the agreement in the first place, and now contemplating extending it for another six months.

Myth of the price range OPEC considers safe

There is a general idea being thrown around in the media that OPEC is looking to bring oil to a specific price range in order to support it, while at the same time not allowing it to go too high, which would encourage even more output from shale producers.

That sounds like a great strategy, but the reality of the market shows that new wells being completed are making money at a far lower oil price than in the past, and producers can make money where oil is at now. Many shale producers have clearly stated the goal is bring costs down to a level they can make money at almost any price.

As mentioned earlier, Shell has said its new wells can generate a profit at about $20 per barrel. In regard to that part of its upstream business, what OPEC does is irrelevant. And when taking into account the many pure play shale producers that are not that far off from those numbers as well, it makes no sense to throw out those numbers.

One caveat I will add is some of the older wells in production are offsetting the more profitable premium wells being completed, so it will take a little time to get the full benefit of the profitability of the newer wells.

The majors, because they have higher cost offshore wells, are able to reduce the overall upstream costs across all their portfolios, but they won’t bring it down to levels the better shale producers can. That said, they’ve taken costs out of their offshore operations as well, and are able to compete much better at lower oil prices.

OPEC’s major problem

Now that OPEC made the deal, it’s stuck with it. Contrary to the silly comments that the market is rebalancing, it is getting worse as inventory levels continue to rise. If it takes a lot longer to give even the semblance of a rebalancing, OPEC and others will have to extend the deal. There is no doubt that is how it’s playing out.

With shale producers able to produce at much lower costs, it’s doubtful OPEC will be able to support oil at desired levels, which means it eventually has to face the time when it brings full supply back to the market. As I’ve been talking about recently, that will devastate the price of oil.

Now the problem OPEC faces is whether it wants to continue to support weak oil prices, or it wants to battle for market share at a lower price, while waiting for demand to organically catch up with supply.

Prolonging the ordeal, in my opinion, will make it much worse over the longer term. It would be better for OPEC to just end the deal in June and allow market forces to dictate the price of oil. Yet that’s exactly what the cartel is considering doing.

Shell’s improvements

Shell has been able to slash its cost per well 60 percent since 2013, down to $5.5 million. It also now drills five wells on a single pad, rather than the one it used to. Add in the improved productivity per well and the amount of oil, at a low cost, continues to rise. Costs are also lower because of the additional wells per pad.

A strong balance sheet and increasingly low costs provide Shell with the strong probability of not only maintaining its high dividend, but also to grow it going forward.

Again, Shell is a bellwether of the overall shale sector, especially among the majors, and not only can it compete in the shale patch with those that are pure plays, but it can increasingly compete against other competitors on the global stage, no matter what OPEC decides to do.

Low costs and increased productivity are the key to this, and Shell and others still have a lot of improvements left in them.

Conclusion

OPEC and the production cut deal are a distraction in my view. The story of oil is how much costs are being taken out of production in shale wells and rigs, and how much more oil is being extracted from each well and rig.

In reality, OPEC and the others made a huge mistake by entering into this deal, as the pressure for shale producers to have to continue to slow down would eventually have paid off. But OPEC was being pressured by its own high-cost producers to support oil, and is now stuck with the consequences of its actions and the impact of when the deal is exited.

Once again the market has misinterpreted how strong shale producers have become, and how much they’ve improved efficiencies while boosting productivity. When Shell says it can break even at $20 per barrel with its shale assets, you know the oil market has forever changed.

The bottom line is lower prices no longer have the same impact in the past because of where the breakeven point now is. While OPEC and some analysts keep on talking about what happens next with the output cuts, shale continues to improve costs and generate a profit at lower oil prices.

Why OPEC thinks doing the same thing over and over again will change the outcome is a puzzle I have yet to solve.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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