This news is classified in: Traditional Energy Oil and Gas
Oct 15, 2019
Turmoil in the oil market is nothing new, and recent events in the Middle East, including the missile attack on Abqaiq and the apparent attack on an Iranian tanker, have overshadowed developments in the oil market fundamentals, but further out the latter should drive market trends. One factor looming especially over the next few quarters is the trend in U.S. oil production, which many have noticed is slowing. This has led some to predict U.S. production has peaked and others to argue that prices might soar.
Since the beginning of the year, the number of oil rigs operating in the United States has dropped by 150, with nearly all of the decline in Oklahoma and Texas, the Permian and Cana Woodford in particular. Year-on-year production growth has slowed significantly, especially in the Permian. (Figure below) To some, this has suggested that U.S. production, and especially shale oil production, is near a peak which would be of immense benefit to other producers and certainly signal higher prices. There are reasons for skepticism, however.
The idea that the Permian has reached a peak due to geological limitations does not appear well-supported by the facts. The claim that recent production gains have been driven by reliance on “sweet spots” or exploitation of the most attractive drilling sites, is interesting but the concept that a small portion of shale basins are “sweet” and the rest “sour” appears too simplistic, as opposed to a gradual reduction in well productivity.
Unfortunately, most of the recent discussion about shale production has been dominated by poor performance of so-called “child wells” which are drilled near existing wells. This phenomenon might be nothing more than an interim effort which could be improved with more experimentation, or in the worst case a failed experiment, which will be abandoned. It does not mean that further productivity improvements are no longer possible, but it does suggest that shale production methods might have matured.
And the role of capital discipline in reducing upstream investment might be exaggerated. For one thing, this year’s drop in spending is important but hardly represents a permanent shift in spending trends, which are notoriously volatile, primarily depending on prices. And seems to be overlooked is the role of pipeline constraints suppressing oil and gas prices in the Permian.
For oil, Permian prices are depressed by both the local glut and the higher costs of transportation when pipeline capacity is inadequate. The figure below shows the difference in the “first purchase price” for crude oil that is very light, above 40 degrees API, and heavy, below 20 degrees API, as well as the difference between Brent and WTI. These are rough proxies for the Permian discount, but the implication is that the Permian glut has cost producers $10/barrel.
Natural gas is a similar story, with Permian gas prices discounted by $2/Mcf and more during 2019. Recently, that has shrunk to a discount to $0.65/Mcf with the startup of the 2 Bcf/d Gulf Coast Express Pipeline.
The implication is that more pipelines will translate into something like $15 billion per year in additional revenue for producers, but it also suggests a different possible for the fall-off in Permian drilling: why produce oil now if the price will be 20% higher in a year? And the higher prices should translate directly into higher profits, since production costs won’t change, meaning profits per barrel could rise 50-100%.
Without a doubt, prices will be affected by many other factors over the next twelve months, but there seems a very distinct possibility that producers balance sheets will improve sharply, drilling will grow, the large number of drilled but uncompleted wells in the Permian will be reduced, and a new surge of production can be expected next year. In such a case, the Saudis might become more concerned about their market share and prices could come under renewed pressure. Never forget that the only time shale has underperformed expectations is when oil and/or gas prices collapsed, and that producers have repeatedly proved better at raising production than we pundits have been at predicting it.
