Tier 1 activity in US LTO set to reach record high share of 47% in 2020

Our previous assessment of the remaining Tier 1 or premium inventory in major US liquid basins suggested that capital discipline boosted drilling activity in Tier 1 acreage to record highs in 2019, with another 8 to 16 years of Tier 1 drilling left if operators kept up the pace of 2019. Five months into 2020 and three months into the downturn and the resulting drilling-activity collapse, we see that operators are increasingly focusing on sweet spots. This is likely to result in Tier 1 acreage making up a record 47% share of this year’s total drilling activity, up from between 36% and 40% in the 2016 to 2019 period.

We define Tier 1 locations as the 25% most commercial locations in each play, based on the ranking of average service-cost-adjusted wellhead economics across “location clusters”. Location clusters are defined as square blocks with an area of 36 square miles (roughly corresponding to townships in the states using the public land survey system PLSS). Average wellhead breakeven prices are calculated for each cluster with service costs set at the level of 2014. The clusters are further ranked, and the top 25% clusters are defined as Tier 1 acreage in each play (the next 25% is Tier 2, etc.). Acreage quality is therefore a relative classification, with Tier 1 having lower breakeven prices in some plays than in others.
Looking at the major liquid basins (Midland, Delaware, Bakken, Eagle Ford and DJ Basin) combined, we see that Tier 1 acreage generally accounted for 17% to 18% of total drilling activity in 2010–2013. The most significant high-grading and reallocation towards the sweet spots happened during the previous downturn (2015–2016), but started in 2014. The share of Tier 1 acreage reached 37% in 2016 and remained relatively stable at 36% to 40% through 2019. Based on preliminary estimates for 2020, the share of Tier 1 activity is set to climb sharply from 40% to 47%. This means that while total horizontal spud activity is set to drop 50% on a full-year basis this year, Tier 1 drilling will probably only fall by 40%. This is still a material decline, but for example the Delaware play is likely to see Tier 1 drilling decline  only 36% as the epicenter of activity is rapidly shifting from Texas to New Mexico.

What are the actual recent economics of Tier 1 drilling in the different basins? If we look at the actual wellhead breakeven oil prices for 2017 to 2020YTD vintages (i.e. not recalculated with service costs from 2014), we see that most plays have a median (P50) wellhead breakeven of $30 per barrel, and even lower in the case of the DJ Basin which has less productive but also the cheapest wells. These wellhead breakeven oil prices do not account for such overhead costs as G&A, infrastructure, transportation costs and price differentials, which typically add about $10 per barrel on top of wellhead breakeven oil prices. Tier 1 activity in most basins therefore requires $40 WTI for sustainable generation of 10% return on new projects from a half-cycle perspective. Non-core acreage (Tier 3–4) have P50 wellhead breakeven oil prices, which are typically $10 to $20 higher than in Tier 1. It should be noted that this is based on the actual activity from 2017 to 2020YTD. In reality, Tier 4 acreage offers significant inventory with much higher wellhead breakeven prices, but there was little to no activity in those areas in the price environment of 2017–2020.

The latest estimates for the remaining Tier 1 inventory range from about 6,000 locations in the Bakken and Eagle Ford to 15,000–19,000 locations in the Midland and Delaware. In all plays, the inventory size corresponds to 17 to 25 years of drilling at the expected pace of 2020. However, the current activity level is affected by the oil-price crash and is not necessarily representative for the average pace we will see in the next few years. If Tier 1 activity returns to the record level of 2019, then we can have 8 to 11 years of Tier 1 drilling in the Eagle Ford and DJ Basin, 13 years in the Bakken and Midland, and still a staggering 16 years in the Delaware play. In the Permian Basin, the total size of the remaining Tier 1 inventory exceeds 34,000 locations, assuming no changes in the currently utilized well spacing strategies. This roughly corresponds to a long-term share of Tier 1 acreage of 40% as we model about 86,000 future locations in the Permian in our base case.

It should still be noted that while in the Midland the revision in the remaining size of Tier 1 inventory from our previous assessment in December 2019 largely corresponds to the number of Tier 1 locations drilling in 1H20, the Delaware lost almost 2,000 Tier 1 locations from December 2019. The actual number of drilled Tier 1 locations in 1H20 will not exceed 500 wells. The major driver of reclassification was more conservative well spacing assumptions, supported by recent projects for some operators in both the Texas and the New Mexico parts of the basins. Similar revisions have been made for the DJ Basin, as for example we now model the development of legacy Anadarko acreage with larger, more intensive completions and looser well spacing applied by Occidental. The Bakken and Eagle Ford both saw some reclassifications of Tier 2 into Tier 1 inventory, which supported the remaining inventory size.