Primary Vision Insights – August 4th, 2021

By Mark Rossano

SUMMARY

U.S. Completions Update Breakdown of the U.S. GDP Data U.S. Completions Update

[ihc-hide-content ihc_mb_type="show" ihc_mb_who="10,13,14,16,18,19" ihc_mb_template="1"]

The U.S. completions progress remains on pace based on what we saw last week with very little update vs last week. Below is a quick breakdown of where we are and how the year will progress.

The completion market has seen a robust recovery off the bottom in 2020, with frac spreads leading the charge higher. We believed that companies wanted to limit 2020 decline curves at 10%–15% (final was about 13%) making it easier to stem declines in 2021 and get back to stable growth. The production profile has been altered, though: instead of being in full growth mode, the U.S. energy industry had to reset and reassess the market demands and local capacity constraints. In 2018, the U.S. oil and gas market experienced broad shortages of proppant, pipe capacity, horsepower—essentially everything needed to carry out an efficient process. At 13M barrels a day and growing, the U.S. refiners couldn’t handle the deluge of light-sweet crude, and we quickly found out neither could the international markets. There was not only a shortage of export capacity, but also underlying demand for U.S. product. Now we shift to 2021, where the addition of frac spreads has been very measured and steadily moving higher to reach a more comfortable 11.5M–11.7M barrels-a-day exit rate, with the potential for steady growth in ’22 to 12M–12.3M barrels per day. We are currently running 243 spreads, which will expand to about 255 by the end of summer and set up well for one last push to 275 in Sept/Oct before slowing for the holiday season (when activity typically takes a pause). The holiday break won’t be as extreme as other years due to the low gross activity, but normal weather and vacation time will still force some reductions.

Rig additions are catching up as we see the pace of frac spreads slowing, but rigs are being deployed at a rising pace to reach about 650 by the end of the year. The trend will continue into next year, with more activations of rigs and spreads, but we expect to see rigs outpace completion crews in Q1’22 as well. At peak levels, the spread between crews and rigs was .48, but we currently sit at .4949 (after peaking at an all-time high of .5011). We expect to see the spread drift lower to a more reasonable .45 ratio, and it won’t be because spreads are dropping, but rather rigs are catching up with activity. The pace of spread additions was robust off the lows with a near 45-degree angle as companies worked through DUC inventory to stem decline curves and set up for growth (recovery) in 2021. The industry was drilling wells throughout 2019 and early 2020 to keep production growing and above 13M barrels a day. Wells were also drilled for the “parent-child” programs that were found to cause communication, loss of pressure, and weaker results, which is a long way of saying: not all DUCs are created the same.

The EIA data is a rough estimate. Some of these assets may never be completed due to issues like falling out of zone, failed drilling programs, poor acreage, or just higher prices needed in a specific area. There are also more DUCs in some regions vs. others, providing additional running rooms. E&Ps effectively used the excess capacity (that is no longer necessary at those elevated levels) to stabilize decline curves and recover some production growth. We are now back down to the 2018 DUC levels, which just so happens to be a similar level of shale production.

There are still some available DUCs depending on the basin, but some areas—like Bakken and Eagle Ford—need to see rigs coming back to start replacing inventory at a faster pace.

The goal going forward is NOT to reach 13.2–13.5M barrels a day, but rather to fit within the confines of what the market can tolerate: 11.7–12M barrels a day. Depending on the global recovery, there is a chance that the market can support 12.3M barrels a day, but that would be the peak in the next few years. OPEC+ countries and non-OPEC nations (like Latin America) will be increasing their output and baseline production levels. This will provide a “steady” flow of baseline capacity at a higher rate, requiring a “lower” call on the U.S., which has already been factored in with our adjusted production numbers.

So, where do we go from here? And how do we get to 275 spreads? We reached a high of 463 in 2019, averaging about 388, and exiting the year with 302 active spreads. In 2020, we started the year with about 358 spreads working, but as COVID19 struck activity dropped, resulting in an average of 154 spreads, and exiting the year at about 138. The steady rise carried into 2021 with the lower 48 states currently operating 243 spreads in the market. This works out to roughly 115 spreads sitting in the yard, looking at peak activations of 358 from 2020 and current operations of 243. It is very very unlikely there are 115 perfect spreads available: some have been scrapped and others ripped apart for parts, but some can be repaired or pieced together to close the gap. With a target of 275 fleets, we only need 33 spreads to come out of the “potential” 115 currently cold or warm stacked.

A relatively new technique has also absorbed some of the spare capacity. The use of simulfracs (simultaneously frac’ing two wells) has accelerated in the Permian, accounting for about 15%–20% of completions, which translates to about 18–20 crews. This technique has been deployed in some other areas—most recently the Anadarko—but for the most part, carried out in the Permian. Each spread needs about 35% more horsepower for the process, so out of the 115 idled equipment, horsepower has been added to current configurations, but more can be assembled to bring some spreads back to life. While it won’t be as easy as an E&P calling on a Monday and the spread moving into position by Friday, there will be enough spare equipment and parts on order to bring 33 spreads back to life. It is also important to consider that not every well is completed the same way, allowing for some older equipment to come back to market. There doesn’t have to be max intensity, most efficient horsepower, or huge proppant loadings for every well to be completed. At the right price and frac design, the less efficient spreads can get to work as well, accounting for some of the additional spreads coming back to the field.

We are coming into peak months for activity, and given recent comments from companies, it is likely we see 275 spreads working with a trend closer to 300 in Q1’ 2022. There will be some seasonal slowdown in Nov/Dec of 2021, but it won’t be at the same rate we have seen in the past due to this year’s slow start. The comments from corporations and what we are seeing on the ground confirms our view of a U.S. crude production rate of 11.5–11.7M barrels a day. On the completion side, there has been a step up in stages per day, with a rough 2019 baseline of 8–12 with 2021 holding steady at 10–14. If you include simulfrac, we are seeing 20–30 stages per day, but the baseline is still a bit skewed due to the early adoption.

Soon, OFS will have to make a decision on new spreads. The price for equipment and parts is being pushed higher by supply chain issues, raw materials price increases, and backlogs of orders. There is still some spare capacity floating around that is being sold off, but given the logistical nightmare and inflation, a new spread could easily take over 6 months to be delivered. We just aren’t at that point yet given the cost, but the backlog might push some companies to put in orders early for delivery in 2022. With more efficiency in the oil patch comes increased wear and tear, requiring more parts, maintenance, and eventually new spreads. But the biggest overhang remains labor, as companies struggle to hire and train new employees to work in the field. Wages have to be competitive, resulting in sign-on and stage bonuses to sweeten the compensation package. All of these equipment bottlenecks and personnel issues are being managed now, but as we approach 2022, the OFS world will need to replenish inventory of parts and begin the process of replacing some aged equipment. As we look back on all the hardships the previous year has thrown at the U.S. energy industry, it is once again showing its underlying resilience in the face of hurricanes, freeze-offs, and now a global pandemic: it always rises to the occasion.

The NGL basket has shifted higher again with the average Mt. Belvieu barrel coming in at $24.44. There has been a steady rise across all components driving the total number higher. Given the underlying demand in the international market and stable demand in the U.S., we expect to see prices remain strong into the end of summer and supported even in shoulder season.

The shortage of naphtha in the market will be supportive of NGL pricing- especially LPG on a global level. Even as NGL prices rise, the shortages in the condensate market and inherent price increases remains supportive for NGL flows even as propane and ethylene costs rise and trade at premiums. If there was enough naphtha available, the arb would be closed quickly but due to the broad shortage- it is forcing companies to pay up for LPG/ ethane.

The rising costs across all feedstocks is hitting underlying margins (cracks) at the petrochemical level.

Breakdown of the U.S. GDP Data

The market saw a spike in nominal GDP hitting 13%, but when we look at nominal it misses some key elements with the biggest one being inflation. We have had about $15T in stimulus dumped into the market over the last year and a half so it is important to break it apart into its pieces. It also helps identify what kind of growth we can expect over the next few quarters.

When we factor everything down to “Real Gross Domestic Product” we hit 6.5%. The market was expecting 8.4%, but with inflation running well over expectations and the pace of activity rolling over- real GDP had a big swing and a miss. I have been very adamant over the last few months that the market was expecting to much and would be disappointed with some of the economic updates. This is just confirmation that expectations need to be reset lower- especially as many current and leading indicators are rolling over.

Where did the pent-up demand go? We just got a data dump over the last 48 hours with our first look at Q2 GDP. I have been asked- “why are you so negative?” This leads me to highlight that I am not negative like we are going to see a broad contraction, but rather we are going to see a big miss in underlying estimates and accepted growth. Estimates of 2Q was 8.4% and instead we printed a total of 6.5%- almost a 2% miss on the topline. The consumer was going to be strong following several stimulus bills, but the pace of buying has slowed considerably with government transfers being reduced again.

Once we factor in inflation or the GDP Price Index coming in at a red hot 6%- expected at 5.4%- the U.S. achieved underwhelming growth. The consumer saw another steady buying spree, but a large part of it was driven by residual government transfers and elevated unemployment payments. The elevated level of the GDP Price Index also points out that people were paying a higher cost and not necessarily buying more volume. This problem is playing out now in June/ July data that has seen durable goods and retail sales miss estimates and post a slowdown. All of the recent economic leading indicators highlight that we have already reached peak growth with the consumer slowing. “Weaker-than-expected June durable goods orders, +0.8% vs. +2.2% est. & +3.2% in May (rev up from +2.3%); ex-trans +0.3% vs. +0.8% est. & +0.5% in May (rev up from +0.3%) … cap goods orders nondefense ex-air +0.5% vs. +0.7% est. & +0.5% in May (rev up from +0.1%).” The consumer saw the last surge in this quarter as the government spending paired back, our trade balance worsened, and fixed investment continues to weaken from a corporate CAPEX expanse and real estate. The cost of labor is trending higher but is still not keeping pace with the rate of inflation striking the consumer. Everyday items are up 10%-15% already with another 10% expected by year end. As we head into the holiday season, many ports will have to operate at record setting paces to even keep up with the flow of goods let alone get ahead of the backlogs.

On the other hand, retail sales topped estimates as the pivot from physical items converted more into services. Total value surged to the highest on record and topped the pre-COVID trend.

The below chart puts into context just how much higher we are versus pre-pandemic trends. A large part of the surge was driven by government transfers with the latest (enhanced unemployment benefits) expiring in the Sept. About 28 states have already opted out and the remaining will be by the beginning of Sept. The next round of buying is going to be slow as companies continues to raise prices- especially on everyday items as we have seen from P&G, Kimberly, and Unilever. There will also be a broad movement of people back into the workforce that will be at lower income levels vs what they are collecting on unemployment.

The credit card data is already confirming some of that slowdown as we complete the first month of Q3 and the end of excess stimulus. There is the “Child Credit” still coming into the market, but when it comes to the end of UI- it will force individuals to take jobs that may be “below” their expectations.

Personal income had a nice upside surprise +0.1% vs. -0.3% est., though prior month revised down from -2% to -2.2% … personal spending +1% vs. +0.7% est. & -0.1% in prior month (rev down from 0%) … real personal spending +0.5% vs. +0.3% est. & -0.6% prior (rev down from -0.4%). It is important to put this into nominal dollars given the amount of inflation sloshing around the system. The consumption side in dollars is moving higher, which brings us back to the discussion of volume vs value of purchases. As consumer prices rise across the board, they must either pay higher prices, find a substitute, or just cut back on volume.

With excess savings and government transfers still there, it makes it a bit easier to afford the elevated price, but that is rapidly ending based on credit card data and underlying personal savings. The excess savings is now almost entirely gone with the savings rate back to 9.4%, which is the lowest since pre-COVID. I have been saying that a large amount of savings was weighted towards the richest percent, but we are seeing that almost fully pushed back into the economy and the lowest income levels seeing the least amount of the pent-up savings- having their costs explode and draw down savings further.

Wage velocity has picked up for the bottom level, but as we have said- their underlying prices are rising faster. When we think about “discretionary income”, it is weighted MASSIVELY to the top two quartiles which have seen their wealth velocity gradually slow. This is a problem when we consider how week Q2 was and what needs to be done in Q3 to make the 2021 estimates even remotely possible.

It will take real spending gains averaging roughly 0.7% from July to September to hit the latest consensus estimate of 6.1% annualized consumer growth in 3Q. Real spending rose 0.5% in June and was only 0.5% annualized above the 2Q average -- a weak liftoff point. With prices surging and inventories low -- particularly in the goods sector, including autos -- that could be a challenge. A firmer-than-expected result for incomes -- still a small advance -- obscures that revisions lowered the prior track for total income. This occurred due to a new methodology for estimating housing services, lowering rental income. In turn, the savings rate was revised down by about 2 percentage points over April-May and fell in June (9.4% vs. 10.3% prior). Core PCE prices rose less than anticipated, up 0.4% (compared with consensus expectations for 0.6% and Bloomberg Economics’ estimate of 0.7%). The year-on-year acceleration to 3.5% from 3.4% in May was also weaker than forecast.

Another key issue is the “value” of purchases vs “volume. There has been an acceleration of pricing across the complex with more behind it. Even as there are signs of a leveling off, we are still far away from a decline based on regional Fed branch calculations, international PPI, freight costs, and U.S. import prices. “June PPI inflation hotter than expected at +7.3% y/y (+1% m/m) vs. +6.7% est. & +6.6% in prior month; core PPI at +5.6% y/y (+1% m/m) vs. +5.1% est. & +4.8% in prior month.” Even as some of these prices normalize, companies are still pushing through more price increases to recover some margin erosion over the last few months.

The price increases are starting to show buying fatigue based on expectations and credit card data starting to roll over a bit. This is limiting the amount of activity at the industrial level as PMIs and other leading indicators have come under some pressure.

The below chart helps to drive home how core sales are trending as inflation pressures rise, which just leads to more pressure in Q3’21. This Q2 number was supposed to be a “blow-out” but it fell flat with limitations on investments, government spending, and a steep trade imbalance. Due to the broad shortages within the U.S. markets, it won’t be changing any time soon. U.S. companies remain price takers as inventories are at record lows.

Real spending has moderated as it flips further from goods into services. This is shifting the burden of “financial health” of households that are starting to reject some of the higher prices and reverting back to a more “normal” spending pattern that includes services. The shift in spending on a dollar-for-dollar basis will be LOWER, but on a percentage level prices are incrementally moving higher for BOTH goods and services.

The low inventory levels you see below will be a tailwind over the coming quarters because it is pent up buying that corporations must do, but because of supply chain issues, raw material costs, and labor- the prices will remain elevated. This will push companies to replenish inventories at a slower pace to avoid locking in at absurdly elevated pricing. But, with inventories at these levels- companies are forced to keep orders flowing regardless of price. This is putting upward pressure on what they charge customers and staying power at least through the end of the year.

The Fed balance sheet has seen endless expansion since March 2020, and there is no way they can be happy the economic data of Q2. The fact that inflation is elevated but not hitting a blow off top, and growth was well below expectations- monetary stimulus is showing fatigue and the impacts of the law of diminishing returns. The Fed is also facing an uphill battle with easy monetary policy since 2008 that has left trillions of dollars in the market. Instead of creating jobs and business investments (and expanding CAPEX), it has generated a negative feedback loop of share buybacks, asset appreciation, and zombie companies. The below chart speaks volumes of what the expanding balance sheet has done- drive bubble stocks and growth to the moon as well as underlying home prices.

With rising home prices and stagnate income factoring in the revisions lower in previous months, the pressure is mounting.

As the government transfers abate, personal income needs to be replaced by wage growth, which remains well off pace from expectations and pre-COVID levels. While personal consumption increased with rising prices, it is still slowing down as consumers pull back from spending levels and savings accounts “normalize.”

The underlying costs to consumers (and the Fed’s preferred way to look at inflation) is far from rolling over but rather just rising at a slower pace. This is 100% inline with my views that the shift from goods to services will “slow” the pace of inflation but not stop it.

On the back of fiscal stimulus comes a lull due to the drag created on the underlying economy. The government has to borrow to provide these services and essentially “borrow” from future cash flows in order to provide a quick shot in the arm. It is a key reason why it is described as a “Drug” because it creates a bad hangover. The government (especially the Fed) have avoided dealing with the hangover by just repeatedly administering liquidity in greater quantities to offset the hangover. But like anything… the higher the dosage- the worse the hangover. Inventory shortfalls will provide some stabilizing impacts as will business investments as some money is deployed back into CAPEX. The problem for wages and underlying jobs- a lot of this capital is being slated for automation and ways to replace or reduce responsibility of the worker.

The U.S. consumer going forward is starting to pick up a bit with additional searches for “activities” such as movie theaters, flights, hotels, and other non-residential activities. It is important to appreciate we saw a similar bump in 2020 when we consider from July to beginning of Sept, but it faded hard in Sept driven by a rise in COVID cases and school starting. The below chart helps to confirm our views that people will be active, but still not back to pre-COVID levels keeping us fairly plateaued on refined product/ crude demand. As the uncertainty of jobs, wages, and inflation rise with savings accounts dwindling- it will be difficult to take that extra trip or maybe look to stay closer to home to save some money on the trip.

Here is another example of how gasoline prices are changing spending patterns and shifting travel plans. “While the recent spike in demand shows that Americans are still determined to get out this summer, wavering confidence in road trips says people might be worried about budgeting for high gas prices and seeking adventures closer to home. In early May, 57 percent of Americans were planning to take a road trip, according to GasBuddy’s 2021 summer travel survey. Since then, gas prices have risen to a seven-year high, a new variant of Covid-19 has spread throughout the country and a pipeline shutdown brought gasoline shortages to the Southeast. Today, only 46 percent have or are still planning to hit the road. Gas prices have been steadily climbing since early November to prices we haven’t seen since 2014, with a national average of $3.14 per gallon. Fifty percent of Americans now say high gas prices are deterring them from taking a road trip, up from 46 percent in May.”

If we take these issues and expand them into rent and housing- things get even more complicated as asset prices have moved further away from people. Wages still have a long way to go to even get remotely close to catching up with inflation, but as wages rise so do the underlying costs of goods. Labor is one of the biggest components of price- so as wages rise so will the underlying costs. The rent chart looks very similar as rents have exploded and the CPI calculation has been slow to catch up. With a renewed surge in the case-Shiller index- living costs are only moving in one clear direction.

It is why it is important to see what salary many employees will accept to change jobs or accept one. “Wages, too, are on the rise. Data from the New York Fed show that the mean salary employers must offer to entice a new worker into the labor force, known as the “reservation wage”, is up nearly $10,000 in the past year to $71,403. The Bureau of Labor Statistics found that Americans are leaving their jobs in record numbers, peaking at 4m in April, in part because they see better opportunities elsewhere.” As companies look to higher, they will have to account for how many people they can afford. It has resulted in a slow addition of employees and an increase of the workweek for those currently employed.

The shift in PMIs is flagging many of these problems as we head forward. We are still going to see expansion, but it will be moderating over the coming months. This makes the year end targets for 2021 difficult to hit given some of the underlying problems in the market.

While government transfers have slowed- they are still very very elevated vs pre-COVID. As federal spending moderates and excess savings are worked through, we will see many of these key drivers abating and leading to a broader slowdown. After 40 years of exporting inflation and offshoring our supply chain, we will be beholden to rising prices and the underlying import markets.