Oil on the turn as US shale firms cut back spending

The oil markets have reached a turning point since oil prices started to decline six months ago.

Brent broke the US$80 per barrel threshold four months ago, leading rig counts to collapse in the United States. Onshore production, powered by phenomenal growth in the shale plays, continues to hit record highs. Nevertheless, the unwind is progressing rapidly.

Onshore oil-directed drilling rigs have been falling at the pace of 5 to 7 per cent per week, and capital expenditures of US shale operators are set to plunge by 25 o 60 per cent this year.

Of these operators, EOG Resources is the most important. The company is the premier producer of shale oil in the US.

It has secured some of the best properties and proved the most innovative with drilling practices, driving production growth averaging 37 per cent annually over the past three years. EOG reached positive cash flow before its competitors and showed the greatest promise to create lasting profits in the shale business.

Nevertheless, the company has just announced plans to slash capital expenditures by a staggering 40 per cent and cut drilling by half, although it does expect to hold production steady this year.

The company’s chief executive, Bill Thomas, explained EOG’s thinking at a quarterly conference call: “We do not think it’s wise or prudent to accelerate oil when oil prices are low, especially when the rebound in price could come this year or maybe even next year.”

This is new. It suggests that at least some shale oil companies are not under the same pressure to drill as were the shale gas companies. When natural gas prices collapsed in the US in the latter half of 2011, shale gas operators continued to drill to hold leases, thereby exacerbating the glut even in the face of uneconomic production. Clearly, not all shale oil producers are under pressure to drill at any cost.

Further, rate-of-return thresholds are not all that matter. Some of the wells that EOG could drill would no doubt be profitable at least on an incremental, if not full cycle, basis. The decision to hold back production suggests that producers want to maximise returns, not just meet thresholds – and with good cause.

Shale wells decline rapidly, by 70 per cent from the first to the second year of production, and an additional 50 per cent in the following year. Therefore, completing a well in a low-cost environment implies losing a significant portion of the value of the well in total. There is no opportunity to catch up. If initial production begins in a low oil price environment, the value of the well is essentially lost. Shale operators are therefore cutting production even faster than pure well economics might dictate.

By contrast, a deepwater or oil sands project typically has a longer run-out, and therefore, the returns from the first year of production are less important. But the news is not good here either.

Capital-intensive projects slated for this year are unlikely to be delayed. But design, engineering and procurement of new projects are sliding. Industry sources have indicated that orders related to deepwater projects have all but stalled since January. This matters, because capital-intensive projects cannot be quickly restarted once they are deferred. A recovery of oil prices late in the year would not prevent the decline of deepwater production in 2016.

Of particular concern is Brazil’s Petrobras, which was to be the cornerstone of global deepwater production. Corruption scandals at the Brazilian company are likely to delay projects scheduled for 2017 and beyond.

At the same time, demand is beginning to respond. US demand is up more than 2 per cent. Europe is also up notably, and demand from China and non-Organisation for Economic Cooperation and Development Asia looks robust. Indeed, by some counts, December demand was up more than 2 million barrels per day, more than twice Opec’s entire demand growth forecast for this year. Both supply and demand are responding quickly, much more quickly than Opec’s forecasts.

This creates a challenge for Opec, and particularly the Arabian Gulf states. If consumers respond as we expect, demand will soar about the end of the second quarter and supply will start to fall off from the third quarter. Saudi Arabia may not have enough spare capacity to handle the resulting imbalance.

If so, then price pressures will reverse.

The UAE, Saudi Arabia and Kuwait must, therefore, carefully weigh the options – including a production cut. Act too soon, and the Arabian Gulf states will lose market share. Act too late, and risk a price increase at the end of the year. The data, even if tentatively, now supports a near-term production cut to start lifting prices. In another month, the data should be clear.

If the numbers remain on trend, the Gulf states may find it desirable to talk up the price of oil, starting somewhere in the March 15 to April 15 window. A modest, but indicative, production cut may also be warranted at that time. Slowing shale production growth is in Opec’s interests. Causing an oil price increase is not.

Oil markets are moving, and moving fast. Supply and demand are responding dynamically to lower oil prices. The time is right for the Gulf states to prepare the next move.

Steven Kopits is president of Princeton Energy Advisors

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