Drill Baby Drill
Until OPEC’s late November announcement that the oil exporters’ club would cut production in order to balance the energy markets, crude prices had spent most of 2016 below $50 a barrel (bbl). Since that announcement, prices have been consistently above $50.
But there are plenty of skeptics who doubt the price of oil will go much higher in the short term, or even hold above $50. They cite two factors that could render the OPEC cuts ineffectual. The first is simply that OPEC members cheat, as they have historically done.
Certainly some members may overproduce their quotas, but OPEC is going to be watching global crude inventories. Those inventories had already begun to come down from record highs prior to the OPEC announcement, partly in response to a decline in U.S. shale oil production:
Source: International Energy Agency Oil Market Report
If inventories don’t go down as quickly as OPEC wants, expect the group to announce additional export cuts. Further, since Saudi Arabia is bearing the brunt of the current limits as the largest OPEC producer and the driving force behind the cuts, I believe it is likely that the supply reduction deal will hold.
But the second factor cited by skeptics is beyond OPEC’s control, and that is that U.S. shale oil producers will simply ramp up production as oil prices rise, negating the OPEC cuts. That’s a reasonable concern, so let’s delve a bit deeper.
The total cuts targeted by OPEC and other producers who agreed to cooperate is 1.8 million barrels per day (bpd). According to Saudi Arabia, about 80% of that has already been implemented, and tanker-tracker Petro-Logistics has confirmed that crude oil shipments from OPEC plunged in January.
At the height of the shale boom, U.S. producers were adding more than a million bpd of oil production each year. At that growth rate, the OPEC production cuts could indeed be offset in a couple of years. But a look at the relationship between the number of oil rigs drilling for oil and oil production at first glance implies that a rapid turnaround is unlikely:
Between about 2000 and 2008, U.S. oil rigs doubled from around 200 to 400, but oil production hardly responded (though that was before the spread of modern shale drilling technology.) The rig count plunged in 2008 along with oil prices, but once oil rallied the rig count began a steep climb. Production did eventually respond, but there was a lag of more than a year between the start of the rig rush and a meaningful increase in oil production.
However, if you look at the last six months of the graph above, you will notice that the rig count began to climb again after bottoming in May. Meanwhile, oil production, which had been steadily falling for more than a year reversed course and began to grow in October.
This rapid turnaround is likely a result of drilled but uncompleted wells (DUCs). Many of these wells would have been drilled by producers during the rise in rig count, but not finished as a result of the drop in oil prices. Completing the well involves casing, cementing, perforating and (usually) hydraulic fracturing.
Data from the Energy Information Administration shows an uptick in completions over the past year in four key shale oil producing regions — Bakken, Eagle Ford, Niobrara and Permian Basin. The DUC inventory in those basins in December stood at 4,509 wells. This uptick in completions helps explain why recent oil production responded more quickly than during the previous rig surge that began in 2009.
Given this data, how soon might the U.S. manage to offset 1.8 million bpd of production cuts? The production gains since early October have been impressive, and if they could be maintained would amount to ~1.5 million bpd over the course of a year. It’s going to be very important in coming months to see if these fast gains were a short-term response to $50 oil, or if they are sustainable.
If by mid-year U.S. producers have added another half million bpd, OPEC may once again find itself facing a difficult decision. As always, we will keep close tabs on this situation in The Energy Strategist, and help subscribers profit no matter how this drilling upturn shakes out.