Is This the Most Bullish News for Oil Since 2014?

By Leonard Brecken for

Whiting Petroleum announced earnings on February 24, with probably the most bullish and shocking news to come to the oil patch since the crash started in June 2014.

It announced that it will not maintain any active rigs in the Bakken shale region in 2016 and also announced production cuts of 15-20 percent and a capital spending reduction of 80 percent.

The significance of this is that, contrary to popular belief, the so called breakeven points are not anywhere close to $30 when you take into account cap ex. That should be obvious enough, but the media and many analysts have consistently misrepresented this either due to ignorance or bias.

Essentially Whiting admitted as much by choosing to finally cut production instead of continuing to burn through cash flow. The takeaway is this: the E&P space will finally have to come to grips with the fact that it can no longer fund its capital expenditures externally through Wall Street. Instead, companies will need to de-lever and fund their needs through free cash flow. This is exactly the intent of Whiting in their announcement.

Furthermore, the expectation of U.S. production declines of 5 percent or so in 2016 may be too optimistic, a fact underscored by Whiting's announcement. If prices stay where they are I expect cuts will be closer to 10 percent, or about 900,000 barrels per day in 2016, and more in 2017 as hedges roll off almost completely.

However, I do admit that if prices rise to over $50 per barrel many of the uncompleted well inventory will probably be completed and brought on line, albeit much more slowly than in prior years. Wall Street won't be as generous, forcing more companies to fund completions through free cash flow (FCF). The effects of sustained lower capital expenditure are more profound and will be a longer-term problem on the supply side as companies like ExxonMobil see their reserves decline.

Another important takeaway from the Whiting announcement: after 18 months of media spin, the myth that says that U.S. production is so resilient is finally being dispelled. I think this fact, much more than OPEC noise, is the most bullish singular event I can remember since the down turn.

I very much doubt that OPEC will cut production at any point soon, especially considering that U.S. production is only beginning its descent, evidence that their strategy is working. I suspect that if prices don't respond as U.S. production falls then, and only then, will they really consider a production cut, perhaps in December. Keep in mind the slow-down in global economies is now offsetting any production declines.

Continental Resources also reported 4Q15 earnings on a conference call on February 25. There weren't any major changes to prior guidance -- production in 2016 is still expected to fall some 10 percent. Interestingly, they were essentially FCF neutral at prices in the mid-$30s despite capital expenditures running nearly $400M.

However, given depletion and capital expenditure cuts, production is beginning to decline and that trend will continue if prices don't recover. Continental offers an especially interesting case to watch because it is much less hedged than the rest of the industry, offering a clue into how companies can fare in today's pricing climate.

Although they are achieving FCF neutrality on much lower prices than many probably thought, if production declines further in 2017 that threshold will need to rise. That could mean more cap ex cuts, which would only push production further downwards. Continental, like most shale companies, is living off of uncompleted well inventory, not from drilling costly new wells. As it finishes the uncompleted well inventory capital spending will continue to decline as it defers new expenses.

Furthermore, the industry continues to focus on lowest cost opportunities, which in my view, can be sustained only so long.

Overall oil prices have finally bottomed out as shifts in monetary policy begin to occur, OPEC considers a policy change, and U.S. production declines. Offsetting this is the very real possibility that demand slows, which has already characteristically slowed during the winter months ahead of busier spring.

I don't believe any of the expectations of a 2H16 economic rebound. If anything, things will decelerate further compared to the first quarter of 2016. Thus, some price recovery can be expected, but until governments around the world realize that loose monetary policy only temporarily boosts growth while making things worse by contributing to higher debt, prices can only rise so much. The real spark to prices will come when pro-growth polices get adopted.

You can find additional commentary and in-depth analysis from Leonard Brecken on his Youtube channel