A Year Into The Bust, American Oilfield Ingenuity Is Still Thriving

We're now one year into the oil bust. For a time there was hope that this downturn would be kind of like 2009, where prices fell sharply in the wake of global economic collapse, but shot back up just as quickly – leaving little collateral damage behind. It’s clear now that’s not going to happen. The 2009 collapse was driven by a sudden drying up of demand. This time around there’s just too much supply -- especially in the United States. And it’s simply not going away. According to the Energy Information Administration, domestic crude oil output peaked in April at 9.6 million barrels per day. Since then it has slipped to 9.2 million bpd, about where it was a year ago, when the bust began.

This isn’t how it’s supposed to happen. In every commodity, everywhere, when prices plunge the high-cost producers (U.S. tight oil and Canadian oil sands) get washed out and the low-cost producers (Saudi, Iran, Iraq) consolidate market share. That's what the Saudis were hoping for when last November they decided to hold oil output steady. And yet, America’s high-cost oil producers are not going off quietly to meet their maker. Rather they are kicking and screaming, moving quickly to slash costs, cut rigs, cut heads (200,000 in layoffs so far), and demanding discounts from suppliers. They are getting leaner, smarter, better.

“Every company is in the process of restructuring,” says Ken Hersh, CEO of private equity giant NGP Energy Capital Management. Some might end up in bankruptcy court, but for the vast majority it’ll be a multi-year slog through the trenches before emerging on the other side, battered but stronger. “It’s a tug of war between American ingenuity and the quality of the rocks. Ingenuity is winning. It’s the great thing about our system, and it means that you can make money at $60 oil.”

That’s better than the $75 breakevens of a year ago, but still $10 per barrel higher than where oil is trading today. At this price deck, says Frederic Choumert, principal at Roland Berger, a business consultancy, fewer than 20% of oil and gas companies and just 5% of oilfield service providers are able to earn their cost of capital.

But they sure are trying. Even with 60% fewer rigs, U.S. companies are still drilling thousands of new wells. And the wells they do drill are cheaper and more productive. Pioneer Natural Resources recently disclosed that it has reduced the number of days it takes to drill a well in the Wolfcamp B interval of the Permian Basin from 40 days a year ago to just 25 days in the third quarter. Incredibly, Pioneer (current production 211,000 bpd) says it will grow 11% this year, and 15% next year. “Over time, we continue to think we’ll need less rigs than we’re even saying now,” said CEO Scott Sheffield last week.

In the Bakken field, Oasis Petroleum (NYSE: OAS) has managed to grow production 10% this year while reducing capital spending by 57%. Its costs per well are down 30% and drilling time per well is down to 16 days from 24.

Anadarko Petroleum too has reduced drilling times 20% in the Wattenberg field in Colorado and has cut well costs 40% in the Wolfcamp. And Anadarko, like many operators, is drilling wells but not completing (or fracking) them, instead keeping the potential production in reserve for when prices recover. In past eras only the Saudis maintained such a production cushion.

Helping them out are innovative service providers like Flotek Industries, which has seen rapid growth in demand for its more environmentally friendly chemicals that are added to hydraulic fracturing fluids. Instead of using benzene or xylene as a solvent, Flotek (NYSE:FTK) has invented a new solvent, called d-limonene, which is derived from citrus peels. This and other fracking additives are used by companies to "restimulate" old wells at a much lower cost per barrel than drilling a new well.

Choumert, of Roland Berger, says that one of the keys to survival during the downturn is for operators to embrace standardization. The time for expensive experimentation has passed, and drillers are now zeroing in on what works best. In recent years drilling rig contractor Helmerich & Payne has been a driving force in helping such oil company customers do more with less. Choumert explains that H&P “has followed a disciplined approach to standardize its equipment and processes by building a highly automated, standardized rig fleet. It has harmonized operating procedures, and invested in knowledge management and information systems to leverage know-how across its rig fleet.” (See Roland Berger's full oil industry report here.)

For the E&P companies repetition, not customization, should be the name of the game. The poster boy for this is Royal Dutch Shell , which blew through more than $5 billion on its doomed expedition to drill in the Arctic waters off Alaska. Everything about that mission was one-off, purpose built. And Shell has nothing to show for it. The same goes for a handful of ultra-deep wells drilled in the shallow waters of the Gulf of Mexico by the oil division of mining giant Freeport McMoran. The Davy Jones well, for example, went down more than 30,000 feet, found trillions of cubic feet of natural gas, but was such a complex and risky well that even after spending $1 billion McMoran couldn’t bring it online and had to plug and abandon it. Try getting the green light for an experiment like that today.

Another tactic: be flexible in how you pay or get paid. Oil companies are hanging onto what little cash they have for as long as they can, so instead of just cutting their prices to try to appeal to customers, oilfield service companies need to think of new ways to get compensated. During good times the oil and gas exploration companies would look sideways at oilfield service providers like Halliburton and Schlumberger if they made moves to take equity stakes in oilfields. But now that times are tough small operators might want to leverage their contractors’ balance sheets. Choumert explains that Schlumberger’s Production Management division will agree to manage a field from development through production and on to abandonment, in exchange for a share of revenues from the field. In this way Schlumberger essentially becomes a working interest partner, reducing the E&P company’s equity stake in the field, but also dramatically reducing their upfront development costs.

The companies that will survive the downturn and thrive in the recovery are those run by executives who are continuously thinking about how to evolve their business to make it better. It’s not a time to hunker down and hide from the bust. It’s a time to double down on the spirit of ingenuity that kicked off the boom. F