After enduring 2015-16 it is about time for some good news, right? And that’s just what 2017 is shaping up to be—a relatively good news year for energy markets. But don’t go crazy with this. The key word in that sentence is “relatively’” —which means better than 2015-16, but if you are looking for that other “R” word (“recovery”) you won’t see it here. Crude prices will be up some, but nothing like the first few years of this decade. Natural gas and NGL prices will be stronger too. But both may have to wait still another year before seeing a real upswing in 2018. Nevertheless, 2017 is looking good for most of the energy market. Not for everyone, mind you. Many will struggle because their assets are in the wrong places, they are at the wrong end of the food chain, or they were simply unprepared for this new market reality. How will you know the difference between the winners and losers? Well of course, by looking deeply into the RBN crystal ball to see what 2017—Year of the Rooster—has in store for us. Cock-a-doodle-do!
We have a long-standing RBN tradition with this annual Prognostications blog, and unlike many forecasters, we also look back to see how we did with our forecasts the previous year. Usually we do the look-back and the Prognostications in the same blog, but there is a lot that will be coming at us in 2017. So this time around we split the blog into two pieces. Yesterday’s blog, titled The Top 10 RBN Energy Prognostications—2016 Scorecard, was the look back. We feel our predictions were pretty accurate, with the first half of the year a bit tougher than we expected, and the end of the year a bit better. Overall, though, we saw modest improvement in prices, somewhat higher rig counts that we would have expected at these prices, and easier access to capital than we would have thought these prices would justify. That is a good setup for the 2017 Prognostications that we will explore below.
And Now 2017
According to the Chinese calendar, 2015 was “Year of The Goat” and that year certainly lived up to its name. The Goat was followed in 2016 by “Year of the Monkey”, another pretty good description of energy markets during the year. So how should we think about 2017, “Year of the Rooster?” Well, according to some of the Chinese astrology websites, the Year of the Rooster can be lucrative, if you try real hard. And that sounds like a pretty good assessment for the market environment we see in the year ahead. Definitely on the upswing compared to 2015 and 2016, but the opportunities will only present themselves to the hard-working and well-prepared.
Each year in this Prognostications posting we try to discern a common theme for the year. Way back in 2013, our theme was surplus, which was a real shocker to a market accustomed to shortage. The next year, oversupply hit home, and the focus turned to demand—trying to figure out where all those hydrocarbons were going to go. Twelve months later, we concluded that the theme for 2015 should be price, and that certainly turned out to be true. In 2016 we broke with tradition and selected two opposing themes for the year: commitment and cash. The conflict between these two themes is what we saw last year (a) commitments already made to use things, build things and pay for things, and (b) the cash (or lack thereof) to pay for those commitments.
For 2017, our theme is hope, or more specifically A New Hope (sorry, could not resist a Star Wars reference). That’s right. RBN is going positive on you. We are predicting a market where producers can make money at market prices, production volumes increase, and midstream assets start to see some of those volumes they were built to handle. But like we said in the introductory paragraph, don’t go crazy with this. The year 2017 will be better than 2015-16. Oil and gas prices will be higher. However, don’t be gearing up for a return to the pre-crash market of 2012-14. In 2017, participants will have to slog it out to achieve profitability. If they do work hard at the right things in the right places, though, the profits will be there.
Like all good New Year’s top ten lists, we’ll start at #10 and work our way down to #1.
10. We’ll see no crude price breakout in 2017, one way or the other. OPEC and NOPEC will muddle along, announcing cuts, finding creative ways to avoid those cuts, and generally keeping the crude market in limbo. Which is a lot better than 2015 and most of 2016. U.S. exploration and production companies (E&Ps) will contribute to the muddle, increasing crude production over time to offset a portion of any real OPEC/NOPEC cuts, and will send personalized notes to the Saudi’s saying “Thanks for the market share.”
9. U.S. crude production in 2017 will increase, but not at the 1 MMb/d a year growth rate seen from 2012-14. Production growth will be characterized by three factors (Prognostications #9, #8 and #7), the first of which is flattening of the decline curve. Recall that most shale wells have a very steep decline curve, but only for the first two or three years. It was that dynamic that we saw playing out during 2016, when production from wells drilled over the preceding two years declined precipitously, which contributed to some of the big drops in production seen in basins like the Eagle Ford (See Good, Bad and The Ugly). But the decline curves on those wells are starting to flatten out. In other words, since there have been far fewer wells drilled in the marginal basins since the crash in crude prices, a lot of those existing wells are hitting the flatter part of their decline curve. Bottom line, production declines from older wells are slowing, which will make it easier for new wells in prolific basins like the Permian to contribute to overall production growth.
8. Rig productivity will continue to improve. A second factor supporting production growth is rig productivity. The oil and gas that an individual drilling rig can bring to the market each year has been rising dramatically since the start of the Shale Revolution. For example, from 2011 to 2016 rig productivity was up 260% in the Bakken, 465% in the Permian and 840% in the Niobrara. These improvements have come not only from producers narrowing their focus to their “sweetest” drilling spots, but more importantly from improvements in drilling and completion technologies, not the least of which have been the use of longer laterals, more sand and more frack stages. Producers and drilling services companies alike are highly motivated to maximize the volume produced from every dollar spent, and that trend is going to be with us for the foreseeable future.
7. Capital will drive economics. The third factor supporting production growth is financial—capital will drive economics. Traditionally it has been the other way around. Historically, plays with the best economics attracted capital and that is where the drilling took place. But now that equation is being turned on its head. Producers with access to capital are building out significant contiguous acreage positions in their core operating areas, which gives them the ability to lower drilling, completion and operating costs. That is extremely important in the low-price environment producers must deal with today. It is the low-cost producer that survives and thrives. What we are seeing is capital being used as a weapon to make strong producers stronger by consolidating strategic geographic positions. That’s another trend that will be with us for a long time to come.
6. The natural gas forward curve is mispriced. How about that one for a prediction! As of the last day of the year, the 2017 strip was $3.62/MMbtu, 2018 was $0.48 lower at $3.14/MMbtu and 2019 was $0.27 lower still at $2.87/MMbtu. That’s backwardation for you futures buffs. And the strip in 2022 is only $2.93/MMbtu. It just can’t be. Not with at least 10 Bcf/d of committed LNG exports and another 3-4 Bcf/d of exports to Mexico in the cards. Ignoring whatever the Trump administration has in store for gas and coal, gas production must increase by 13-14 Bcf/d to meet demand based on “normal’ weather”, which of course never happens. But even assuming normal weather, we will need to see gas prices in the mid-to-upper $3.00 range to meet the increased demand that is already in the cards. By the way, if you make this trade and it goes bad, remember we always say that RBN is not an investment advisor and your mistakes are your own.
5. The new administration may Trump down oil and gas prices. Speaking of soon-to-be President Trump, there have been many billions of pixels lit up over the past few months extoling the virtues of a carbon-friendly federal government—Tillerson, Pruitt, Perry, Viola… Wow. But think about it. Even under the decidedly carbon-unfriendly Obama administration, U.S. producers succeeded in overproducing oil and gas enough to crush global prices for both. What might they do if the shackles come off? We don’t want to think about it.
4. Big natural gas price differentials are coming to West and South Texas. If you like market ironies, and widening price differentials, you might want to pay attention to two somewhat obscure natural gas market hubs: Waha and Agua Dulce. Waha is the hub closest to the Permian, which is by far the fastest growing crude oil basin (basins) in the U.S., if not the world. All that crude comes along with a lot of associated gas, and if you do the math it won’t be long before Waha could start to experience takeaway capacity constraints, and consequently see downward pressure on prices. The situation at Agua Dulce, a short 500-mile jaunt (in Texas miles) to the southeast could not be more different. Over the next couple of years, Cheniere Energy will have a new LNG export facility next door at Corpus Christi and in addition a lot more gas will be moving to Mexico out of Agua Dulce, tightening the market at that hub, potentially increasing prices. And at least for now, there is no good way to get much more gas from Waha to Agua Dulce. So the irony here is that Texas may end up with some of the highest and lowest prices in the country, at the same time.
Our top three prognostications are about NGLs. Actually, we are a bit early with these, because most of the big NGL developments won’t really hit until 2018. But like all markets, energy anticipates. And by the time we get to 2018, most of the changes will already be working their way through the supply/demand balances. Here’s the basic thesis. NGL production growth has subsided due to lower prices for crude, gas and NGLs. But over the next two years, five to eight new mostly ethane-only petrochemical plants (steam crackers) will come online at the same time new ethane export capacity is cranking up. Some of that ethane demand can be met by reducing volumes of ethane that today are being “rejected” (that is, sold as natural gas). A decline in rejection volumes only happens if ethane prices increase relative to gas, which they will. But it won’t be enough. Flexible crackers that are now running ethane will need to switch off ethane and run more of other feedstocks, mostly other NGLs—propane, some butane, even natural gasoline (pentane plus). The net result will be an increase in NGL prices back to the levels relative to oil and gas that were “normal” before 2012, the year when oversupply hit the NGL market. The implications for the NGL market, and energy markets in general are profound as described below in Prognostications #3, #2 and #1.
3. The frac spread is coming back along with margins for gas processing. After languishing at $2.30/MMbtu from January 2015 through the end of 2016 (versus $6.30/MMbtu in 2012-14 and $11.30 in 2010-11), the spread between natural gas and a basket of NGLs will be heading back to the $5-6/MMbtu level as NGL prices increase relative to the price of natural gas. That will be good news for gas processors and even better news for producers that over the past few years made multi-year commitments for gas processing, NGL transportation and fractionation services to get new plants built.
2. Ethane production will be ramping up as rejection flips to recovery. At some point between late 2017 and the end of 2018, almost all ethane rejection in Petroleum Administration for Defense Districts (PADDs) 3 and 4 (Gulf Coast and Rockies) will be a thing of the past. In fact, the only ethane rejection remaining will be due to pipeline transportation constraints out of the Marcellus/Utica and Bakken. Producers that are stuck with rejection because they don’t have pipeline capacity to move their ethane to the petrochemical markets will not be happy campers.
And the #1 Prognostication for 2016? First, a word from your sponsor.
And the #1 Prognostication for 2017 is…….
1. Natural gas, particularly wet natural gas, will be a more attractive market than crude oil. If you buy our Prognostications about crude, gas and NGLs, this is where you land. The crude market will muddle along at prices that average somewhat higher than 2016, but no big recovery. The forward curve for natural gas is mispriced—too low given the coming surge in demand from LNG and Mexico exports. And NGL prices will be increasing more than both oil and gas, due to the ramp-up in ethane petrochemical demand and ethane exports. Put all that together and you get a rosier outlook for gas than crude, and an even rosier forward view for wet gas that will be the source for all those NGLs. E&Ps might want to consider this possibility as they make their acreage acquisition plans for 2017.
But as we mentioned earlier, the one caveat that we need to throw into our last few Prognostications is that we might be a year early. Most of those petchems won’t startup until 2018, and much of the additional growth in LNG exports won’t kick in until that year. But like we said above, markets tend to anticipate. So if you think our scenario is plausible, it might not be a bad idea to start thinking about what it might mean for your investment and operating strategies.
That wraps up our 2017 Top 10 energy prognostications. If you strongly disagree, or even strongly agree with any of this, please send us an email to firstname.lastname@example.org.
As we enter The Year of the Rooster, we offer the following as our 2017 New Year’s resolutions: (1) pay close attention to market fundamentals, (2) don’t believe simplistic explanations of complex market phenomena, and most of all, don’t get cocky about this market. There is a good chance that any big run-up in prices will be a head fake. This is a market of cycles, not straight lines. Cock-a-doodle-do!
Happy New Year!