Side Effects Leading World Oil Production: Pipeline Bottlenecks And Cheap Undeveloped Acreage
Oil and gas production in the United States continues to grow. Last year a momentous occasion came and went when the U.S. unseated Russia and Saudi Arabia as the world’s leading oil producer on a daily production basis. The last time that happened was 1973, and a lot has changed since then. There were genuine concerns at the time that conventional oil recovery was at or near a peak. Back then, resources and drilling inventories were widely perceived as limited and thus investors paid a premium for companies that possessed more robust reserve reports while perceived demand for midstream assets waned. This has changed. Some side effects of this current market have included choke points in pipeline capacity and a precipitous drop in prices for undeveloped oil and gas acreage.
While fracking techniques have existed in prior forms since the 1940s, the innovations in fracking technology have allowed companies to stimulate previously uneconomic wells. This revolutionized production and reframed mindset as to whether oil recovery was at a peak or not. In fact, production patterns improved so quickly over the past five years that infrastructure such as pipelines, processing and logistics has had trouble keeping up.
The Bakken and Three Forks formations located in the Dakotas and Montana are a good example of this. For years, there has been a dearth of pipeline access to the formation and most of the oil produced has been transported out of the region by rail, a less efficient solution compared to pipelines. This issue has been even more acute for natural gas transportation. According to the EIA, in 2017 Bakken operators flared 88.5 billion cubic feet of gas, worth about $220 million and enough to heat 1 million homes.
The Dakota Access Pipeline, which was much discussed in the news due to protests, opened in 2017 and is proposed to expand. It helped correct steep pricing differentials as compared to West Texas Intermediate crude pricing. There is still more to come (gas flaring is still prevalent), but constraints should lessen as time goes on.
Another trend has been flagging prices for undeveloped acreage. We researched transaction data in the Bakken over the past two years and according to our research from the fourth quarter 2017 going into the fourth quarter 2019, average prices for acreage in the Bakken dropped from $14,250 per acre to $11,919 per acre. While limited in sample size, what’s particularly interesting about these statistics is that on a flowing barrel basis the average price for production increased ($53,338 per flowing barrel in the period entering the fourth quarter 2018 vs. $55,246 going into the fourth quarter 2019).
This indicates that current production valuations remain steady while acreage values for future production weaken. The explanation for this dynamic is layered yet connected, and it is not isolated to the Bakken area.
At Hart Energy’s A&D Strategies and Opportunities Conference, industry participants emphasized a theme of seeking to buy current oil and gas production as opposed to longer term developmental acreage. This is a result of the capital discipline and returns that investors are demanding. Thus, with public markets struggling to show returns to many investors, acquisition and divestiture activity has slowed. The most prominent transaction oriented activity in the Bakken this year was ironically QEP’s decision to terminate a deal to sell its assets for $1.73 billion. Part of this is driven by public funding drying up. Some companies are turning to creative asset backed bonds to facilitate fundraising.
This dearth of funding incentivizes investors to be particularly selective in their asset purchases and be more weighted to current returns. Thus, there is less capital available to invest in longer term drilling inventory. The valuation theory is straightforward: there is more sensitivity of the price paid today for drilling inventory that may not be monetized for 10 or 15 years or more from a net present value perspective. It’s not worth much in today’s dollars, and thus becomes challenging to justify the significant capital outlay considering alternative investments.
Another factor driving declines in acreage values is large swaths of private equity backed properties that are considering monetizing their assets due to expiring fund holding periods. While perhaps up to $5 billion of non-operated oil and gas packages are potentially available in the Bakken, many aren’t currently transacting because of the low prices and wide bid-ask spreads. This may not last and funds will eventually have to sell their assets. When that happens, acreage prices could drop even further if commodity prices or other fundamentals do not improve. It may not appear reasonable to some sellers, but it is fair in many buyers’ minds. It’s a somewhat unexpected side effect alongside a global shift in energy markets.