My Latest Read on Oil (Or Why It Gets Better From Here)

As the Saudi-led oil war rolls on, all eyes are on U.S. production.

Yet instead of retreating, the flow of American crude oil continues to set new records.

However, given the rapid decline curves experienced in unconventional oil wells, it won’t be long now before the shale-inspired oil glut finally begins to shrink.

In fact, that’s one of the issues I’ll be tackling in my keynote address to a conference of Gulf of Mexico drilling support companies in Houston tomorrow.

This supply “problem” has become a major concern for companies in the region, as the current situation could mean even further cuts in offshore production.

As a result, the group has asked for my latest read on oil.

As is my normal approach, I’d like to give you my market analysis of the situation first

U.S. Production Climbs as the Rig Count Falls

One of the things to remember is that we have a very paradoxical situation in the oil market right now. For the first time in my 40-plus years in the business, the supply side of the equation is no longer a worry.

In fact, despite a record number of rig withdraws from the oil patch – marking an almost 50% decline in the past five months – we still ended up with the chart below:

This is one of the slides from my presentation tomorrow. So are the next two. Together they provide a stark indication of what’s been going on in the market.

As you can see, the results are a bit counter-intuitive: U.S. production is still climbing even though the rig count is dropping like a rock.

Add the following chart to the mix and the disconnect is even more pronounced. It’s a chart of cap-ex spending, and it’s projected to fall by 25% this year.

So despite huge cuts in forward capital expenditures and falling rig counts, the market continues to increase production with the forward projections, showing that those increases are likely to continue into May:

So how is it possible that production continues to increase despite rig layoffs and expenditure reductions?

Let me explain…

Thanks to the shale oil boom, we now have significant extractable oil reserves in North America (especially in the U.S.) that can rapidly be brought on line to meet any demand surge, along with a historically high volume of oil in storage.

And the little known fact is, unconventional reserves are even more plentiful elsewhere in the world, although regulations, infrastructure cap-ex needs, and different modes of property ownership mean the development of this global resource will take longer.

Nonetheless, there is plenty of oil on the supply side, now and far into the future.

The challenge now is to establish an ongoing equilibrium in what’s suddenly become a very different environment.

Thanks to the Decline Curve, the Fall is Inevitable

However, it is not the overall supply surplus that’s the biggest issue. Instead, it’s the source of this excess. This is where the pundits consistently miss the boat in their analysis.

The steady rise in production is coming from a wave of wells that were completed in the last two years. These include both the shale/tight oil wells and those utilizing more traditional vertical drilling – even shallow, formula drilling, which is now the most cost-efficient method.

On average, these wells provide the bulk of their production over the course of the first 12 to 18 months. Specifically, in the case of shale and tight oil wells, the ramp up in production at the outset of a project is very pronounced. But so is the decline on the other side of the production peak.

Now normally, once this production peaks, an operator will advance secondary and enhanced oil recovery (SOR and EOR) techniques to lessen the rate of decline in the early stages of the curve. SOR and EOR involve approaches like water flooding, associated gas injection, chemical treatments, among others.

These techniques simply increase the cost of the operating wells. And while that’s not an issue when oil prices are north of $80 a barrel, it’s considerably less attractive in today’s environment where most companies are operating at razor thin margins or net losses.

Certainly a few companies will re-frack wells and use new technology to improve production. But most won’t take that route since it’s not cost-effective for the majority of existing projects. It’s just too expensive.

My latest figures indicate a break-even cost today of $72 a barrel for the more expensive deeper, horizontal, fracked wells, with that figure increasing to $76 by the end of the year.

With West Texas Intermediate (WTI) trading under $50 a barrel, adding additional expense to lift up surplus production is simply not justified.

That means something interesting is about to happen.

Between July and September of this year, production will finally start to decline from the wells that were recently put on line. Remember, these are the wells that have provided most of the excess volume.

And given the mothballing of rigs and the cuts in cap-ex, there will also be a massive void in new drilling.

The translation? Eventually, the glut will begin to recede.

Once this begins to take hold, the price of oil will be going up. Some analysts are already predicting $80 and more for WTI in 2016. As for my read, it’s a bit less – in the mid-$70s.

That means a recovery is now in sight. In fact, futures contract traders have already moved in that direction. Most major oil short positions have now been closed and the big money is betting on higher prices, as evidenced by the current contango condition of the futures market.

Yet, with the excess of extractable reserves, any deficit in production resulting from declines in current wells can be quickly overcome. That’s what makes this supply-heavy environment so unique.

But again, in order to avoid a boom and bust cycle in the industry, a genuine production equilibrium needs to be established to allow for operations within realistic margins.

The question now is whether the window of opportunity will be slammed shut by companies whose debt load is so large they have little alternative but to flood the market with new volume.

Either way, the market is going to hand us some highly profitable plays in short order.

The post My Latest Read on Oil (Or Why It Gets Better From Here) appeared first on Oil & Energy Investor | Dr. Kent Moors.

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