Production shut-ins: financial and physical constraints

With WTI prices flirting with $20/barrel or even lower, many U.S. tight oil producers are considering shut-ins. Which types of producers are at the greatest risk of shut-ins, and why? While COVID-19 is injecting uncertainty into the market, we believe that many U.S. and international producers are at very high risk of facing shut-ins. World oil supply appears to exceed demand by 20-30 million barrels a day, and world storage levels are quickly nearing capacity. The recent OPEC+ supply cut will reduce but not relieve pressure on storage. Physical and ultimately financial criteria will lead many producers to involuntarily shut-in their wells, barring an unlikely balancing of supply and demand. The next few weeks and months could be very, very ugly.

Financial shut-ins: onshore and offshore

Shut-in prices vary from region and by project. Some operators manage their wells more effectively, and some producers simply have better rock to work with. The Federal Reserve Bank of Dallas collects operator breakevens and shut-in prices. It then reports the anonymized data and categorizes it by basin. The most recent reported shut-in prices are displayed below:

A few features in this graph are notable. First, the simple average displayed above isn’t weighted by production. The variance within each basin is significant; the Dallas Federal Reserve Bank doesn’t provide the volume-weighted breakeven price. Second, the Permian basin is thought to be most efficient area in the country. Still, several producers claim they cannot cover operating expenses at a WTI price of $50 per barrel. Other producers, scattered in different basins, also claim they cannot produce at prices below $50 per barrel. These producers will be hammered if low prices are sustained. Finally, notice the range on the “Other U.S. (Non-shale)” – at least one producer claims they can operate at prices close to $5 per barrel! What kind of producer can continue to operate single-digit prices?

We think some offshore producers, specifically located in the Gulf of Mexico (GoM), could continue to produce even in an ultra-low price environment. Offshore projects are massive, complex, and expensive projects that often require billions of dollars of investment before a barrel of oil is ever produced. Nevertheless, their post-construction operating expenses are often quite low: we’ve heard that GoM shut-in breakevens generally range from about $15-20. Project breakevens on the newest offshore brownfield projects can fall below $30/barrel. Obviously, shut-in breakevens on the newest offshore projects will be very, very low – potentially close to $5/barrel.

An unprecedented storage build-out

All producers, regardless of their breakeven costs, are contending with an unprecedented storage build-out. The most recent EIA data show declining refinery runs and sharply steeper inventory builds in the U.S. According to the EIA, U.S. refinery runs have not been this low since late September 2008, at the beginning of the Great Financial Crisis. While refinery inputs are (for now) only at cyclical lows, U.S. crude storage inventory additions are unprecedented and eye-popping. We’ve never seen a storage build-out at this pace and magnitude.

U.S. weekly stocks of crude oil, excluding the SPR, stand at 504 million barrels for the week ending April 10th, up 11% from 4 weeks ago. This rapid injection in inventories over just 4 weeks is unprecedented in EIA data extending to 1982. A 50 million-barrel build-up over 4 weeks is astonishing: the next highest buildup occurred in April 2015, when inventories rose by 34 million barrels. Similarly, this is the largest percentage increase in storage levels in U.S. crude history: the next highest build-up occurred in March 2001, when storage levels rose by 9.9% from four weeks prior. Later this month, U.S. storage levels will likely blow past the all-time high of 536 million barrels in storage set in March 2017.

Physical shut-ins

In the next few weeks and months, physical shut-ins will likely become more and more commonplace domestically and internationally, with local, regional, and finally world storage insufficiency constraining production. Platts estimates that world storage capacity, totaling around 1.4 billion barrels, will be filled by June. If storage fills, watch out. Prices could crater, with some analysts speculating that WTI and Brent could face negative prices as producers desperately try to avoid plugging up their wells.

There are only four ways storage overflow and negative prices could be avoided. First, more storage could come online. Building storage is expensive and time-consuming however, so this option is only feasible at the margins. Second, oil producers could sharply slash their output. We think production cuts are almost inevitable, although we doubt OPEC+ can coordinate the gargantuan (over 10 million barrels per day) cuts needed for this task. Moreover, if oil demand remains down by 20-30 million barrels a day, even a production cut of 10 million barrels a day still implies that 300 – 600 million barrels will need to find a home every month. Can OPEC+ maintain institutional coherence amid a 20-30 million barrel per day production cut, when every single OPEC and non-OPEC producer will have individual incentives to cheat? We think not. The third way – bringing demand more in line with pre-crisis levels – seems like the most fruitful way to avoid a catastrophic storage overflow. Social distancing in North America and Europe could begin to unwind sometime in May, although authorities will doubtlessly seek to prevent a second outbreak. As social distancing measures recede, consumers could get in their cars again and consume more oil. Still, a return to pre-crisis habits (and consumption) seems very unlikely for several months, probably longer than a year. People are not going to fly on jets, take cross-country trips, or eat elbow-to-elbow at restaurants – until therapeutics or vaccines are widespread. Since a V-shaped rebound in oil demand is highly unlikely, the market will need option 4: all of the above. If the market can bring online some more storage, sharply slash output, and stabilize demand, we might avoid a storage max-out.

Dark times

Preventing storage overflow – and negative prices – will require an “all-of-the-above” solution. More storage needs to be found, producers will have to endure massive cuts, and consumption needs to rebound. It could happen. Even in this best-case scenario for producers, however, many local or regional pricing benchmarks will turn negative as local, landlocked storage proves inadequate. Things could get very ugly before they get better.