Oil Prices To Remain Capped In The Short Term, Despite Fewer Shale Oil Barrels
The most recent Drilling Productivity Report from the U.S. Energy Information Administration (EIA) reveals that the phased impact of lower oil prices on U.S. tight oil production growth, is finally starting to show up and is expected to increase in magnitude over the next couple of months. The agency estimates crude oil production from the seven key regions in the Lower 48 states to have declined by around 44,000 barrels per day, or 0.8% month-on-month in May, and expects the decline rate to increase to around 91,000 barrels per day, or 1.7% month-on-month by July of this year. According to the EIA, these seven regions accounted for almost 95% of the total domestic crude oil production growth between 2011 and 2013. Therefore, production growth trends in these regions are a good proxy of the overall growth in U.S. crude oil production. [1]
What does this mean for global crude oil prices? Should we expect a sharp rebound in the Brent and WTI prices now that the primary cause of the supply glut is showing signs of abating? We do not think so. That’s because we are talking about a sequential month-on-month decline in U.S. crude oil production from these seven regions, which does not reflect the fact that it has already grown by more than 29% year-on-year during the first five months of the year. So even if the sequential rate of decline accelerates to around 5% by the end of this year, full-year average production from the region would still be around 630,000 barrels per day, or 13% higher than last year. This increase would easily offset almost 60% of the projected increase in global crude oil demand this year. To this, if you add the supply growth from other non-OPEC countries (assuming OPEC supply remains stable) such as Russia and Brazil, the gap between global supply and demand is not expected to shrink significantly in the short term, which is why we expect benchmark crude oil prices to average below the marginal cost of production in the short to medium term. [2]
Secondly, a sustained decline in the U.S. tight oil production is itself a risky assumption to make, especially given the fact that extracting crude oil from the relatively impervious shale formations has become so much more efficient over the past few years. The chart above shows how crude oil production per active rig from the seven key regions in the Lower 48 states, has surged to more than 8x the average level in 2007. This has primarily been driven by continued efficiency improvements in drilling techniques and the increased application of multi-well pad drilling. Because of these efficiency improvements, drillers can now pump profitable oil at far lower prices than what they could not even think of in the early days of the Shale party. For example, EOG Resources (NYSE:EOG), one of the pioneers in the U.S. shale oil industry, has been able to reduce the average drilling time per well in the Eagle Ford shale from over 22 days in 2011 to less than 10 days currently. Not only this, it has also been able to increase the average cumulative crude oil production from a standardized well in the region by almost 67%, while reducing the average completed well cost by around 15% over the same period. All of this effectively means that the company can today generate the same level of return from its core asset with crude oil at $65 per barrel, as it did when it averaged around $95 per barrel in 2012. Therefore, we believe that any sharp gains in crude oil prices would be quickly undone by a large increase in well completion activities by these companies. [3]
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Notes:- EIA Drilling Productivity Report, eia.gov [↩]
- IEA Oil Market Report, iea.org [↩]
- EOG Resources Investor Presentation, eogresources.com [↩]