Permian Basin Doomsday? Sell-off Overdone

Energy investors have become concerned about the effect of rapidly growing Permian Basin crude oil and natural gas liquid production and how the ballooning volumes will be transported to market. The Permian Basin is supplying roughly one-half of the increased volumes needed to meet rising global demand, so the volumes are material to the global marketplace.

The International Energy Agency, in their latest forecast, expects oil demand to increase by 1.4 million barrels per day in 2018. We think this estimate is low and expect global oil demand to grow by 1.7 million barrels per day, if not a bit more, due to the surging global economy. Add in potential production disruptions in Venezuela, Iran, Libya and elsewhere and the excess capacity available to meet growing demand becomes quite thin, increasing the value of Permian production.

Attending a midstream conference in Midland recently, we were able to network with a number of producers, analysts, and pipeline operators to get a feel for the extent of the Permian Basin transportation problem, how long it might last, and how it will be solved.

It was clear that the Permian Basin production had grown much faster than some expected. The potential transportation shortfall in the second half of 2018 was expected to be 200,000 barrels per day. As a result, the price for Midland Basin crude oil is expected to be roughly $10 to $25 a barrel below that of crude oil located on the Gulf of Mexico.

When a price gap of this magnitude occurs, the economics tend to provide solutions, sometimes much quicker than many expect. One solution that was suggested was to truck the oil from Midland to the Gulf of Mexico markets. This solution is inherently expensive, risky, and inefficient.

This is especially true due to the fact that the trucking of sand and water has created a substantial demand for experienced drivers and equipment. Nonetheless, some experts expect some Permian oil will be trucked to markets due to the economics. Some mentioned that even with a driver making $200,000 a year, the economics would work, assuming the gap between Midland crude prices and Gulf Coast prices was maintained.

A second solution was to increase the rail shipments from the Permian Basin. This solution, while more expensive than pipeline transportation, seems to make more sense than trucking. The problem is that many of the rail facilities are committed to transporting the ever increasing amount of frack sand to the area, which limits oil take away capacity. That said, experts were of the opinion that train shipments from the area would increase, possibly substantially.

A third solution was to increase storage facilities in the Permian Basin. This would be a temporary solution. Many expect the transportation bottleneck to be solved within the next two years. We saw a number of massive storage tanks under construction outside of Midland.

Many experts noted that while the price gap between Permian Basin crude and Brent is large and growing, it will benefit local refineries, chemical plants, as well as any entity involved in crude oil transport or export. The spread between West Texas Intermediate and Brent on the Gulf Coast means exported products and crude will find attractive buyers and robust demand.

Solving the transportation problem with pipeline and gathering system buildouts will take 18 to 24 months, according to many. The relatively short period of the transportation shortfall will probably limit the amount of capital trucking or railroad companies will be willing to invest to address the problem.

Several other issues are limiting Permian oil production. One is the fact that natural gas takeaway capacity is also short. Regulators and mineral owners are becoming more stringent with regard to proposed flaring activities. This natural gas transportation shortfall is expected to be addressed in the near future.

Another issue that has limited production, or has the potential to, is the lack of water resources for hydraulic fracturing operations. Experts noted that water is much more complex an issue than processing natural gas liquids or crude oil. Mixing water can substantially impact its quality and effectiveness in a completion operation. Operators noted after spending $7 million to drill, well developers want to ensure the completion goes as efficiently as possible. Water will remain an issue for the foreseeable future, as a short term fix is not in the cards.

When building out the pipeline system to add capacity, one of the issues that caught suppliers by surprise was the substantial increases being seen in the steel market. We were told that roughly twenty-five percent of the cost of a transmission line is the cost of steel.

Due to steel tariffs the price of rolled steel has increased by 50 percent since the first of the year. Costs are passed along by the pipe manufacturers. Those who did not lock in steel or pipe prices have seen the economics of their projects deteriorate significantly with each price increase. Steel pipe manufacturers should do very well over the next year, and even PVC piping is in short supply due to the lingering impact of the fall hurricane that shut down Houston’s manufacturing plants.

With all the attention on the transportation bottlenecks and the price gap between Permian oil and that produced elsewhere, is the substantial underperformance by Permian Basin producer and service company stocks warranted?

Our answer is no. The one to two year gap where Permian Basin crude oil is substantially undervalued, when inserted in the standard cash flow model, reduces the fair value of most enterprises by less than five percent. Many Permian Basin stocks have been adversely impacted by three to four times that amount, a substantial overreaction.

In our opinion Permian Basin producers and service companies are selling at a substantial discount to fair value if the models are an accurate reflection of reality. Over the next two years, refiners, chemical plants, and transportation firms using Permian crude will perform well. As it becomes apparent that the transportation shortfall will solve itself in relatively short manner, Permian Basin producers and service companies will also recover in what we expect to be a robust rally.

Executive Director -

Joseph R. Dancy is Executive Director of the University of Oklahoma College of Law’s Oil & Gas, Natural Resource, and Energy Center. He regularly speaks to professional groups on pressing energy issues and teaches Energy Law and Finance.


OILMAN has compiled a list of oil and gas museums around the country that you don’t want to pass up.

Take time out to visit a few or ALL the museums this summer while on vacation or traveling on business.

The oil and gas museum list includes Museum Name, Address, Clickable Website and Phone Number. 

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