By Dan Dicker. Originally published at Oil & Energy Insider
“Fracklog” is the latest term running around the oil world, a new game that oil producers are playing to try and outlast temporarily depressed oil prices. The Catch-22 is that the more doggedly shale players hold on to production, the longer prices stay depressed and the more difficult it will be to carry on.
Recently, one of the techniques that US oil producers have been using to keep production in reserve without relinquishing acreage is to delay well completions. The economics of shale drilling can be difficult for the oil producer; most leases require oil companies to develop at least some of the acreage in order to maintain control of the mineral rights, and several standard clauses allow landowners to renegotiate leases should production fall under a certain level. So, many smaller oil companies choose to partially develop lease acreage but stop short of ‘completion’ – the point in drilling when oil finally comes out of the ground. The completion stage is by far the most expensive.
It’s a trick of necessity, allowing tremendous Capex reductions while still controlling the prime acreage at the same lease rates that were initially negotiated. But it has created what is being called a ‘fracklog’ – a backlog of ready production that companies plan to turn on as soon as market conditions allow. In other words, there’s a lot of oil out there waiting for oil prices to rally.
And there’s the problem – oil waiting for a rally puts continuing pressure on oil prices, and the more oil you’ve accumulated under a ‘fracklog’, the more pressure you’ll get.
Already, the EIA has estimated 9.35m barrels a day of US production for 2015, up 50,000 barrels a day from its last estimate and 200,000 barrels a day from last year. Add our ever increasing ‘fracklog’ of wells awaiting completion, and it’s going to make a significant oil rally practically impossible for many months ahead.
I’ve watched so many investors (even private equity firms) recently chase an oil sector they know to be too cheap to last. They are right: economics do not ultimately support oil prices below $75 a barrel. But the instinct to jump on here is wrong – there is still far too much pressure on oil prices for them to even think about turning around substantially. For example, I’ve watched Whiting Petroleum (WLL) stock go up as it searches for a buyer to save it from bankruptcy. Secondaries in seriously distressed oil companies are regularly oversubscribed and trade almost immediately below ‘insider’ prices. Every tiny blip upwards in oil prices are met by big runs in the cheapest beta names.
I tell you, these are trading plays that a serious investor should beware of. Oil is headed lower first before the real blood of this shale bust can be spilled. More companies need to be restructured or sold. We’ll need to see many more thousands of jobs lost, more bond defaults, and more than a few refinancing attempts that utterly fail to attract interest.
Things have to get much, much worse before real production here in the US comes offline and at least some of that huge ‘fracklog’ of potential production is retired. Until then, I believe it’s too early yet to invest in the sector.