Signs of a Return to the Drilling Fields The impact of OPEC s agreement on U.S. shale production.

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1 ? Signs of a Return to the Drilling Fields The impact of OPEC s agreement on U.S. shale production. Morningstar Commodities Research 24 October 2016 Sandy Fielden Director, Oil and Products Research sandy.fielden@morningstar.com Data Sources for this Publication gcme Group gcftc gbaker Hughes To discover more about the data sources used Click Here Higher Prices and Indications of Increasing Production The Sept. 28 OPEC meeting in Algiers surprised the oil market and has been followed by a 12% boost in prices for West Texas Intermediate. U.S. crude has now recovered to above $50 per barrel after bottoming out at $26 in February. However, after an initial boost during the two weeks after the Algiers meeting, producer hedging in the futures market fell back to prior levels last week. Nevertheless, there are other positive signs that U.S. shale production is increasing, including increased drilling and votes of confidence from financial markets. OPEC Talks and the Market Moves At the Algiers meeting, OPEC agreed in principal to cut the group s crude-oil production from its present level believed to be about 33 million barrels/day to between 32.5 million and 33 million barrels a day. The details of the agreement, including quotas for a cutback, will be finalized at the group s Vienna summit at the end of November. The Algiers agreement was followed by a promise of support from non- OPEC Russia to freeze its output. The talk of an agreement had a strong impact on oil prices that had been languishing in the mid-$40/barrel range two years after crashing from over $100/barrel in the fall of From Sept. 27, the day before the Algiers agreement, to three weeks later on Oct. 18, crude prices on the CME Group Nymex WTI crude futures exchange (for November 2016 delivery) increased by $5.62/barrel, or nearly 12%, to $ Exhibit 1 shows the changes in crude prices for successive delivery months out on the WTI forward curve over this period. The steepest price increases were in nearby months, with the impact gradually tailing off to about $2.00/barrel increase in The stepped lines are the calendar-year average price changes, up by $4.95/barrel for 2017, $4.10/barrel in 2018, and $3.35/barrel in 2019.

2 Nov-16 Mar-17 Jul-17 Nov-17 Mar-18 Jul-18 Nov-18 Mar-19 Jul-19 Nov-19 Mar-20 Jul-20 Nov-20 Mar-21 Jul-21 Nov-21 Mar-22 Jul-22 Nov-22 Mar-23 Jul-23 Nov-23 Mar-24 Jul-24 Nov-24 $/barrel Page 2 of 6 Exhibit 1 Changes in WTI Futures Prices September 27 October 18, Change in price Calendar Average Source: CME Group, Morningstar After this 12% jump in crude prices, analysts speculated about whether the price increase will encourage U.S. shale producers to spend more on drilling in 2017 and raise domestic crude output as a result. The thought process is that with prices reaching $50/barrel, producers would increase hedging for future production to lock in the higher prices for shale production next year. The price hike to over $50/barrel has seen crude at the highest level since July 2015, nearly double the $26/barrel level at the bottom of the bust in February With an OPEC agreement on the horizon, analysts are watching intently to see how much new production from shale basins occurs as a result, and at what price. The market sentiment is that if crude prices increase anywhere close to June 2014's $100/barrel, then U.S. shale rigs would roll back into the drilling fields en masse and quickly reignite the levels of annual growth seen between 2011 and 2014 (1 million barrels/day per year). That kind of production expansion would in turn cause a new glut of crude in the market, leading to a renewed price collapse. Alternatively, if crude prices stay much lower than today s $50/barrel, then U.S. producers will be discouraged from drilling, and the current supply surplus will be run down during 2017, tightening the market and pushing prices up again in the years following. If an OPEC accord effectively limits production, that will reduce the surplus more rapidly and encourage higher prices earlier. The trick to managing a smooth return to higher crude prices to satisfy OPEC members hurting because of lower revenue from oil is to move the market higher without causing a dramatic increase in production that in turn brings back the surplus. Nobody knows what the magic crude price number is that both satisfies OPEC and other big producers and at the same time restrains U.S. shale producers

3 Page 3 of 6 from going crazy. At the moment, the market appears to believe that the magic number is somewhere between $50 and $60/barrel. New Hedging Back in June we noted that any return to increased shale production would take longer than most people thought because of the logistics associated with getting drilling underway (see Shale Crude Production Recovery to Take Longer Than Expected). However, any increase in production has to start somewhere, and market watchers have been following recent increases in the number of oil-directed drilling rigs deployed in the U.S. as well as signs of increasing production in basins like the West Texas Permian, where break-even costs make drilling more attractive. We ll have more on these fundamental signals in a minute. First, we look to the Nymex crude futures market for signs of a more immediate response by producers to the recent 12% price increase. Any such response should occur in the form of a discernable increase in producer hedging. This would indicate that producers are locking in today s prices for future crude production, a leading indicator of decisions to increase their capital expenditure drilling budgets early next year. Futures market evidence of increased hedging is available in the Commitment of Traders, or CoT, report produced each week by the U.S. Commodity Futures Trading Commission. The report indicates changes in the open interest, or number of open positions that the various categories of traders hold, every Tuesday. The report is released on Friday evenings. We discussed the CoT report, which shows changes in accumulated futures positions for different categories of traders, in the context of market price volatility and the impact on speculative hedge fund trading last month (see Short Speculators Chase Crude Price Volatility). This time, instead of looking at the futures positions held by noncommercial speculators, we are looking at the positions held by commercial players more specifically, the group of traders categorized as producer/merchant/processor/user, or PMPU, meaning any entity that predominantly engages in the production, processing, packing, or handling of a physical commodity and uses the futures markets to manage or hedge risks associated with those activities. The latest CoT report for Nymex WTI futures contains data as of Oct. 18, reported on Friday, Oct. 21. We compared positions in that report with those for the report for Sept. 27, immediately preceding the OPEC Algiers announcement. As the PMPU category represents both consumer groups such as refiners or airlines and producers, we need to assume that consumer groups will most likely be holding long positions meaning that they have bought crude futures to hedge their exposure to rising prices and that producers (the group we are interested in) will most likely be holding short positions meaning that they sold futures contracts to hedge their exposure to falling prices. Based on these assumptions, the data indicates that producers have actually decreased their hedging since the Algiers meeting. The CoT data shows that short crude futures positions decreased by 43,297 between Oct. 11 and Oct. 18, after increasing by 21,986 positions during the two weeks between Sep. 27 and Oct. 11. After an initial boost in hedging in the two weeks after the Algiers meeting, producers therefore became less confident about new hedging and reduced their positions.

4 open positions $/barrel Page 4 of 6 The reason for the big reduction in producer hedging last week is not clear. One of the drawbacks of the CoT report is that it does not reveal the delivery timing of the changes in futures positions. As a result, we don t know which future delivery periods are being hedged by producers. In this case the latest CoT report covered the final week before the November 2016 futures contract expired on Oct. 20. Many producers may have waited until last week to close out hedges for their November or December production, accounting for the big drop in hedges over the past week. We should also add that by looking exclusively at the CoT PMPU group, we are missing the hedging of other trading groups, in particular the swap dealers group. This group is primarily financial players making futures trades to hedge derived contracts that they enter into with oil consumers and producers. Some of these trades are effectively producer hedges, but there is not enough detail available to isolate which ones. However, despite the mixed signals in the CoT data over the past three weeks regarding producer hedging, previous reports show that these positions have increased significantly since the $26/barrel low point in crude prices on Feb. 11, Exhibit 2 shows total PMPU short positions since the beginning of 2016 (left axis) as well as the WTI crude futures price (right axis). The chart shows producer hedges increased steadily throughout 2016 and that the pace of hedging picked up, along with crude prices, since August, before dipping lower last week. In fact, the total number of producer short positions reached over 540 thousand on October 11 the highest level since 2007, before dropping back in the past week. Exhibit 2 Commitment of Traders: CME Group WTI Nymex PMPU Shorts WTI Price Source: CFTC, CME Group, Morningstar

5 Page 5 of 6 Producers Drilling and Investors Paying As we said earlier, futures market activity is just one early signal of increased production. Other indicators show growing producer confidence. The weekly Baker Hughes drilling rig count shows the total number of U.S. oil rigs deployed by producers increasing since June from 316 to 443 (up 127, or 40%) and up by 25 rigs since the OPEC meeting. That is still a long way from a peak of nearly 1,600 rigs in October 2014, but the productivity of these rigs has increased considerably, so we are unlikely to see such a high number again. Note that there will likely be a six-month lag between adding a new rig and when new wells start producing. The EIA's Drilling Productivity Report estimates production from seven major shale basins. The October report included a revised estimate for October production up 54,000 barrels/day to a total of 4.46 million barrels/day compared with the September report's estimate. This revision and several others like it in prior months, suggest that shale production is increasing faster than expected. However, actual production from shale is still falling in most basins except the Permian in West Texas as decline rates for existing wells exceed production from new drilling. The short-term EIA energy market outlook update issued in October expects U.S. crude production to begin increasing again in the first quarter of 2017 to reach 8.8 mmb/d by the end of 2017 from 8.4 mmb/d now. In the financial markets, there are positive signs of increased confidence in U.S. production. The yields on energy producer company debt have fallen from a high of 21% in February to 7% today. Last week also saw the successful IPO of Extraction Oil & Gas on Oct. 12, raising over $600 million. The company drills in the Denver Julesburg Basin in the Wattenberg sweet spot sector of the Niobrara Shale. This was the biggest IPO in the U.S. energy sector this year. Embers in the Fire Most of these indicators are positive for U.S. shale production as crude prices increase. There is no cumulative weight of evidence to suggest that crude prices above $50/barrel will herald a new boom in shale production. Nevertheless, the embers are alive in the fire. We expect prices to remain in the $50/barrel range in the run-up to the OPEC meeting in November and to push toward $60 if the producer group comes up with a plausible accord to cut production. Details of U.S. shale producer hedging and estimated production for 2017 will become clearer in the next two weeks as they report third-quarter earnings. K

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