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Permian - the premier play

In the first of our series assessing producer economics, we analyse the Permian, where things are on the up

The shale business took some time to arrive to the Permian Basin in West Texas, but it has thrived there more than just about anywhere else. In the Permian, which produces 20% of US oil, shale drillers have found better returns than other tight oil plays, low geological and political risk and vast tracts of oil-rich land under-pinning huge growth potential.

It is little surprise then that the Permian is at the leading edge of US shale's nascent recovery. The rig count is an imperfect indicator of what is going on in the oil patch, but it does point to where drillers are putting their money. And it shows that since oil prices started to rebound earlier this year most of the action has been in the Permian. Of the 90 oil rigs added in the US between late May and mid-August, around two-thirds have gone into the play, according to Baker Hughes. Almost four times as many oil rigs now operate in the Permian than in the Eagle Ford and Bakken combined. Nearly half of all onshore oil rigs in the US are now in the Permian.

The region is made up of two main sub-basins-the Delaware in the west and the Midland to the east-that stretch across about two dozen counties in West Texas and southeast New Mexico. It is in many ways more geologically complex than the Bakken or Eagle Ford. Multiple oil-rich formations, including the Wolf- camp, Spraberry and Bonespring, are stacked on top of each other and dip and dive across the play, making high-quality seismic data and precise directional drilling key tools in unlocking the shales.

Although the geology is complex and can be harder for explorers to predict, the formations are thick-thousands of feet compared with hundreds of feet in other shale plays-and have proved highly productive so far.

Drill formations

The arrival of tight oil development in the Permian quickly reversed decades of declining production from the area's ageing conventional wells-most of which produce fewer than 10 barrels a day. From the mid-1970s to 2010, output fell steadily by more than 1m b/d to 0.9m b/d. Then in one of the greatest drilling booms the US has ever seen production shot back up to around 2m b/d from the start of 2011 to early 2016-about 0.5m b/d of this is from legacy conventional output, with the rest being pumped from newly exploited tight formations.

Over this time, drillers have honed their ability to tap into the Permian, improving the economics along the way. Wells have more frack stages, operators are pumping more sand and proppant into the ground and using more advanced fracking fluids.

The most important trend has been drilling longer and laterally, covering more area within the formation and producing higher volumes from each well. In the early days of the drilling boom, most wells were drilled laterally to around 3,000 feet. Now companies drill 7,000- to 8,000-foot laterals in the Midland section and 5,000- to 6,000-foot laterals in the Delaware area, though that is quickly catching up with the Midland wells, according to Bernstein, an investment bank.

These laterals are likely to continue to get longer as well. Pioneer Natural Resources says it has plans to add 70 wells in its core Midland area with laterals of around 9,000 feet. Cimarex has reported better-than-expected results from wells it has drilled with 10,000-foot laterals. Others are following suit.

Drilling longer wells comes at a cost. Permian well-drilling and completion costs tend to be higher than the Bakken and Eagle Ford and take longer to drill. EOG, for instance, says that its average Permian well cost $6.7m in the first half of this year, compared with $5.1m in the Eagle Ford and $6.3m in the Bakken. Those figures are in line with of other companies' reporting. Three-quarters of capital expenditures on Permian wells go to rig and fracking-pump costs, completion and drilling fluids, proppants and casing steel and cement, according to a study done for the Energy Information Administration by the consultancy IHS.

Operating costs are more volatile and variable, ranging from around $13 a barrel to $33/b, according to the IHS study. Artificial lift, labour, gathering and processing, pumping and water-disposal costs tend to be stable across both the Midland and Delaware. However, transport costs from wells in the Delaware, which is farther from the main markets in the Gulf Coast, can be as much as $8/b higher.

Drillers will eventually hit a point where the higher cost of drilling more complex wells with longer laterals outweighs the production benefits, but they don't seem to be there yet.

Moving up

Wells are much more productive than they were just a couple of years ago and those improvements show little sign of slowing down. Initial-production rates are a key indicator for how quickly a well will pay for itself as well as its overall oil recovery and economic returns. In the Permian, average initial-production rates have surged from just under 300 b/d of oil in 2011 to 700 b/d this year, rising about 10% a year, according to Bank of America Merrill Lynch, an investment bank. By contrast, average initial-production rates in the Bakken are around 450 b/d and around 350 b/d in the Niobrara, according to the bank.

These superior well performances make the Permian an attractive place to invest, even at relatively low oil prices. Large swathes of the Permian have well-head breakeven prices of less than $40/b while most of the play breaks even at between $40/b and $70/b, according to Rystad Energy, a consultancy.

With WTI at around $48/b drillers are likely to be focused on counties such as Reeves, Eddy and Culberson, around the Texas-New Mexico, border where wells in the Bonespring formation in the Delaware basin breakeven at less than $40/b. Further east, areas around Midland and Martin counties, where Pioneer Natural Resources has focused much of its drilling, break even at low prices, while drillers will move to opportunities farther south in Upton county as prices rise.

Bernstein looked at the breakevens on a company-by-company basis, and found similar numbers. Assuming 8,000-foot laterals become the norm, it found the average breakeven in the Delaware section was about $44.40/b and $48/b in the Midland areas, making the Delaware the more attractive place to be as development progresses.

But this varies by company. No firm breaks even at $30/b and only a handful of companies' Permian operations look profitable at $40/b. Oil at $50 starts to separate the wheat from the chaff, with roughly half of operators in the black and half in the red.

EOG's Delaware acreage, for instance, breaks even at around $35/b, while Chevron would need just over $50/b and Shell more than $56/b, according to Bernstein. Those figures highlight the difficulties the majors have had keeping up with independents in shale plays. In the Midland section of the basin, SM Energy has the lowest breakeven at $34.50/b, with ExxonMobil at $46/b and Pioneer Natural Resources at $56/b.

Permian producers have been rewarded with surging share prices that have outpaced rivals elsewhere in the US. Petroleum Economist compiled an index of Permian producers and compared their share price performance to the broader S&P exploration and producers (E&P) index. Since the start of the year, the group of Permian-focused companies has seen its share price rise by 52% compared with 24% for the broader E&P index. Standouts include Clayton Williams (118%), Callon Petroleum (74%) and Parsley Energy (84%).

It is also little surprise that the Permian has been the locus of US oil deal-making this year, especially during the summer after several months of rising prices brought some confidence back to the oil patch. The Permian has accounted for $7.8bn of the $20bn in shale deals done across the US this year, according to Raymond James, an investment bank. Most recently, Concho Resources bought up a huge 40,000-acre position in the Midland Basin from Reliance Energy for $1.63bn and Parsley Energy snapped up around 10,000 acres in the Midland for $400m.

The frenzy of deals is driving land values higher even at a time of relatively low prices. Transactions over the past year in the Midland have valued land there at between $10,000 per acre and $25,000/acre. But the trend has been rising higher. Concho's deal in mid-August was worth around $40,000/acre and Parsley's deal was valued at around $34,000/acre. Acreage in the Delaware, where development is at an earlier stage, has gone for somewhat less, though it is quickly catching up with the Midland.

As long as prices remain above about $45/b, deal-making should remain fairly brisk, though rising acreage costs and inflated equity valuations could scare some off. Companies already in the Permian will be looking to fill out their positions to allow for drilling longer lateral wells and add to their inventory of drilling prospects. Those that have been left on the outside looking in will be keen to get into the Permian while oil prices remain relatively low.

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