October 28, 2021

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What It Means In The Oil Fields

8 min read

Bill Gilmer, Director of Institute for Regional Forecasting, C.T. Bauer College of Business


Today COVID-19 is the center of attention for American oil as prices hover in the mid-$40s and a vaccine for the virus remains on the horizon. But the U.S. fracking industry has been under continuous financial pressure since the oil bust of 2014 when OPEC and the Saudis withdrew as swing producers in world markets and allowed oil prices to collapse. A moderate oil price recovery in 2017-18 brought a partial return of activity in the oil fields, but it was quickly followed by an industrywide credit crunch in 2019, and the rig count and oil-related employment were in decline again well before the problems brought by COVID-19

The most compelling issue for fracking is always the price of oil. It is a high-cost source of oil requiring prices over $60-$65 for real profitability, with $55 oil hurting many companies and $2 natural gas lethal for others.  And it is today’s price that matters most. Unlike conventional drilling, the typical fracked well delivers 40 percent of its production (and half its present value) in the first year.    

Changes in oil prices come and go, but as current events unfold in the oil fields it is the ongoing credit crunch in fracking that will change industry behavior and leave a lasting scar on the industry. Fracking was born in an era of cheap money from the central bank, and too many producers used low interest rates and a rising stock market to try for a quick killing instead of building a viable business. 

This past behavior is forcing changes in the industry’s credit model that will divert large amounts of capital away from reserve replacement and new production, leaving a smaller and chastened fracking industry in its wake. The question addressed here is how financial change translates into oilfield activity and how much smaller the industry will be.      

Growth vs. Value

By 2019, producers were struggling to deliver steady income and growth, and their failure to impress saw stock markets turn their back on the industry. (Figure 1) Energy stock prices never recovered from the 2015-16 downturn, began to decline again in 2018-19, and have continued the trend downward apart from a quick return from COVID collapse last summer and a small bounce from recent vaccine news.

A wave of bankruptcies, delistings, and forbearance hit the industry hard in 2019, initially focused on the weakest companies. Figure 2 shows that as oil prices settled into a steady $55 per barrel in 2019 and early 2020, it resulted in mounting bankruptcies for both oil producers and service companies. By early 2020, it looked as if the core of the fracking industry – companies with solid operations and better balance sheets – had worked its way through the bankruptcy problem. Then came the COVID-19 pandemic and the Saudi-Russian oil war, resulting in a complete rout of oil markets in May. The number and scope of recent bankruptcies now rivals the serious setback of 2015-16.

Pressure from Wall Street increasingly has forced producers to sell themselves as a low P/E, dividend-producing value stock.  In the past, they marketed themselves as rapidly-growing growth stocks that reinvested all profits.  Apart from the big integrated companies, there was little thought of paying dividends in the upstream oil industry, and investors were expected to make their money on rapidly mounting equity gains. 

Fracking producers now approach Wall Street with hat in hand, promising a new value model. What does the value-stock model mean?  Borrowing some conservative numbers from a recent analysis by Richard and John Spears at Spears Associates (“Thinking About Free Cash Flow”), a $60 oil price immediately will see about 10{3e23aca6dff8443bad358258a275ae16086855242df8e16c87fa1d6cea0e066b} to 15{3e23aca6dff8443bad358258a275ae16086855242df8e16c87fa1d6cea0e066b} taken off the top as a simple adjustment for oil-price and project risk, 20{3e23aca6dff8443bad358258a275ae16086855242df8e16c87fa1d6cea0e066b} goes to royalties and taxes, and another $15 is needed to cover production costs. What is left of the initial $60 would be free cash flow of $26 under the growth model, which is the amount available for capital spending or to replace reserves and expand production.

However, the new value model requires another haircut of 30{3e23aca6dff8443bad358258a275ae16086855242df8e16c87fa1d6cea0e066b} of these cash flows to pay down debt or pay dividends to stockholders.  At $60 the capital allocated to drilling falls from $26 to about $18.  The first three columns of Figure 3 show oil prices from $30 to $100 per barrel and the cash flows under both models. The percentage haircuts for risk and royalties bite hardest at high oil prices and the fixed $15 in production costs hurts more at low oil prices. Cash flows turn negative near $20 per barrel.  

Less Oil-Field Activity

The growth model has dominated fracking for years, and the new value model will provide fewer funds to invest in the oil fields. What are the ground-level implications? The Baker Hughes rig count is still a useful and widely-watched measure of oilfield activity, and we ask here how the loss of cashflow translates into fewer rigs at work?

I have a simple statistical model that can do a respectable job of estimating the rig count from oil and natural gas prices. This model can answer our rig count question but only after a couple of small tricks as we go from oil price (P) to cash flow (C1,C2) to rig count (R1,R2).   

Growth: P -> C1 -> R1

Value: P -> C2 -> R2

The first problem is that the statistical model just skips over cash flows and goes directly from price to rigs, an issue since the change in cash flows sits at the heart of the problem. But if we know the financial model, Spears Associates offer a simple linear transformation from oil price to cash flow, and to know one is to know the other.

Second, the regression model is based on a growth-model history, so using a $60 price to forecast gives us a $60 growth-model outcome. What we now need for future rig counts is a value-model outcome somehow taken from the growth history.  This requires value-model cash flows and the hypothetical oil price that would have generated them under the growth model. In the first row of Figure 3, for example, $100 oil corresponds to cash flows of $52.50 or $36.75 depending on the financial model. The value-model cash flow – if it had materialized in the growth model – would have been generated by an oil price of $76.70.  Just interpolate between $70 and $80 in the first column.  Putting this cash-flow equivalent price in the regression equation now yields the number of rigs at work at $100 oil and under the value model. Column four of Figure 3 shows the value cashflow-equivalent prices that correspond to each headline oil price.         

The forecast of the rig count uses an error-correction model based on data from 1990Q1 to 2018Q4, with real oil and natural gas prices as independent variables. Oil prices dominate the results relative to gas.  Also included are shift variables for the fracking boom of 2004-2018, the fracking bust of 2014-15, and the post-bust recovery 2015-18. After accounting for oil prices, the bust and recovery periods still show 10{3e23aca6dff8443bad358258a275ae16086855242df8e16c87fa1d6cea0e066b} to15{3e23aca6dff8443bad358258a275ae16086855242df8e16c87fa1d6cea0e066b} fewer rigs at work after 2014, marking the end of the fracking bubble in oil markets. The number of rigs at work adjusts to changes in oil and gas prices over the following four quarters.   

Our analysis is a hypothetical example. It simply ignores the on-going credit crunch and current COVID recession and assumes a switch from growth to value that begins in early 2019. Beginning from an oil price of $57 per barrel in 2018Q4, we forecast the effects on the rig count of oil prices that could rise as high as $100 per barrel or fall as low as $30. Natural gas prices are held flat at $3 per thousand cubic feet.   

Figure 4 shows the rig count’s response under growth and value models.  The solid red lines are the number of rigs that would be at work in the growth model for oil prices from $40 to $90, while the broken blue lines are the equivalent post-2018 outcomes under the value model. Drilling activity under the value model shifts down sharply at every oil price.    

The right side of Figure 4 spells out details of the number of rigs lost to the value model by oil price, e.g., 102 rigs at $60 in 2022Q4. Differences between growth and value narrow sharply as cash flows shrink quickly below $50 per barrel. Above $50 the losses to the value model range from 80 to 160 rigs and reduce oilfield activity by 9{3e23aca6dff8443bad358258a275ae16086855242df8e16c87fa1d6cea0e066b} to 13{3e23aca6dff8443bad358258a275ae16086855242df8e16c87fa1d6cea0e066b}. Once the rig count completes its adjustment to higher prices, the differences between financial models remain but are stable over time.  

What It Means

These estimates are an illustrative example of a quick swing by an entire industry from value to growth. Based on the financial straits of today’s fracking industry there is no question that such a swing is underway. It will not be a complete swing, as the large integrated companies have long paid dividends, and some independent companies may have a strong enough reputation and balance sheet to resist the change to value. But even if everyone doesn’t join in, it brings bad news for the industry: as oil prices slowly climb back from $40 to $50 to $60, it implies that the coming recovery in the oil fields will be slower than the past at every step, with drilling expectations perhaps reduced by as much as 10{3e23aca6dff8443bad358258a275ae16086855242df8e16c87fa1d6cea0e066b} to 15{3e23aca6dff8443bad358258a275ae16086855242df8e16c87fa1d6cea0e066b}. 

There is some good news as well. The often-predicted death of the fracking industry has been greatly exaggerated. Oil prices will recover and gravitate back to a long-run marginal cost near $60 per barrel. If we previously expected to see 1,028 working rigs at $60 oil, we still will see 926 in this recovery. And while the value model looks like it will be with us for some time to come, nothing is forever. Just take oil prices that are typically balanced on a knife edge, mix with faddish and fickle financial markets, and you have an enduring recipe for unexpectedly unraveling the most carefully laid financial plans.      


Bill Gilmer is director of the Institute for Regional Forecasting at the University of Houston’s Bauer College of Business. The Institute monitors the Houston and Gulf Coast business cycle, analyzing how oil markets, the national economy and global expansion influence the regional economy. Gilmer previously served the Federal Reserve Bank of Dallas for 23 years, retiring from the bank as a Senior Economist and Vice President.

UH Energy is the University of Houston’s hub for energy education, research and technology incubation, working to shape the energy future and forge new business approaches in the energy industry.

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