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Good News – Bad News

Posted on April 29, 2016 in James A. Gibbs, Producer Articles

The US Energy Information Agency (“EIA”) recently announced that production from wells drilled since the start of 2014 made up 48 percent of total US crude oil production in 2015. With the increased use of hydraulically fractured horizontal wells, new production as a percentage of total US production has more than doubled from 22%in 2007, according to the EIA. These are startling facts.

Crude oil production from hydraulically fractured wells now makes up the majority of oil produced in the United States. As of 2015, 51% of crude oil produced in the US came from wells targeting tight oil formations, most significantly the Eagle Ford and Permian Basin in Texas, and the Bakken and Three Forks formations of Montana and North Dakota.

Crude Oil Production

Consider what the combined technologies of hydraulically fracturing and horizontal drilling has meant to our country. Without them, if the average annual rate of US production in 2007 had continued to decline at the same rate it had during the past decade, US average daily production would now be at about 4.3 million barrels of oil per day (“bopd”), rather than 9.4 million as it was in 2015. We would now be importing 75%of our oil supply.

The benefits of increased oil production have been significant. Analysts and politicians agree that decreased reliance on foreign crude in the past few years has allowed the US to be more flexible in its foreign policy and given the US more global heft.

The US is now much less reliant on oil from the Mideast and elsewhere. Think of what that means, not just to our trade-account deficit, but to the reduced necessity of deploying many of our young men and women in the military to protect oil transportation routes.

Literally billions of dollars have poured into the hands of individuals, companies, and state and federal treasuries as a result of new production. Hundreds of thousands of land and mineral owners, many of whom live in areas that previously produced little or no oil or natural gas, now receive monthly royalty checks. That’s the good news.

US Oil Production and Imports

The bad news is that US crude oil production is falling in response to the collapse in oil prices that started in mid-2014. Output is now poised to drop below 9 million bopd—700,000 bopd off its April 2015 peak—and the rate of decline is accelerating, perhaps losing at least another 750,000 bopd by year end, a total drop of 16% in 18 months. That raises all-important questions of how low will US production go, and how much will oil prices need to rise to reverse those declines?

Rig Count by Drilling Direction

Of course, because the decline rate of production from horizontal wells is so high—as much as 90% from year to year—it takes a minimum of about 1,000 active drilling rigs to sustain the current rate of production. However, the total number of active rigs in the United States continues to fall. At the end of March, the number of oil-oriented rigs had fallen to 372, down 15 from the previous week, and down over 1,200 from the recent peak of October 2014. Further reductions are anticipated.

Oil Rigs in Operation

Producers fear they may never again experience the robust oil prices they enjoyed during the 2010-2015 period. The few oil-producing nations with spare production capacities, primarily Saudi Arabia, Iran, Iraq and, to a lesser degree, Russia, have demonstrated that, by maintaining high production levels, they can drive prices lower, and keep them there for extended periods. The effect has been to enable them to maintain their market share, and to make oil from US horizontal drillers non-competitive. For almost all the world’s oil exporters, today’s low prices are unsustainable over the longer term, but today they are successfully damping out aggressive drilling in the US.

At $40 per barrel, and with today’s drilling and completion costs, there are only a few spots in the major US shale plays where it makes economic sense to drill and produce more oil. For there to be a meaningful response from producers, prices must not only be higher than $55 per barrel, but producers must believe that it will stay at that level long enough to recover their investment and make a profit, and hopefully, continue to increase. Even though this is far below the $100 per barrel price of the shale heydays, many producers can make this work, especially if they have undrilled locations on leases held by currently producing wells. Progressively higher prices will bring on additional production. Estimated stable prices of $70 to $80 per barrel are required to put most of the US rig fleet back to work.

The bad news for U.S producers is that shale has so fundamentally changed the oil market that the word “recovery” is no longer relevant. That is because oil prices are now range bound, locked into a bracket which is capped at the high end, and with a floor at the low end. Above $55 per barrel, US production starts to increase, the oil market builds supply, and prices respond by going down. Based on recent experience, a price floor appears to be some number below $35 per barrel.

As conventional supply in the Middle East continues its inevitable depletion, the world oil supply/demand balance is likely to reach equilibrium and become less volatile and more predictable. Some analysts suggest this will occur in two years or so. Until then, a stable, higher price is not a condition we should expect to see.