As we approach the end of what has been a miserable year for the price of crude oil, analysts are now directing attention toward indications of a floor forming.
Over 2015, a persistent surplus in oil production has offset significant cuts in forward capital commitments and a decrease in drilling – the number of drills in the field is now less than one-third of what it was when the slide began last year.
But U.S. oil production has remained high, despite a clear contraction in operations. This is perhaps the least understood event of the past year.
There were essentially three reasons why this occurred… and they explain the next phase in oil markets…
Front-Loaded Wells Make Pumping Oil Worthwhile at Almost Any Price
First, as the brunt of American output moved from traditional drilling to emphasize unconventional shale and tight oil, drilling became deeper, horizontal, fracked, and much more expensive.
Yes, future projects in this class were the initial ones shelved. With prices diving below $50 a barrel and then below $40, wells requiring $70+ oil prices became untenable – especially once the price collapse gave notice that it was hanging around for a while.
Nonetheless, there was a double early premium from the more expensive drilling. For one thing, these deeper horizontal drillings produce more volume on average than standard vertical wells. For another, most of that volume comes out up front, usually within the first 18 months.
Since over 80% of project expenses are front-loaded, with costs expended before anything comes out of the ground, operators will maintain initial runs at wells once open regardless of wellhead price (what they receive when the oil is sold to a distributor, usually at least 15% below what the market charges).
That is the only way to recover sunk costs.
In higher-priced scenarios, a producer will use secondary or enhanced oil recovery (SOR/EOR) techniques to lessen the normal production decline. These include water flooding, natural gas reinjection, and chemical treatments.
The problem here is that for already expensive shale/tight oil drilling projects, these SOR/EOR techniques drive costs up even further. In the current environment, most companies will forego these ways of increasing volume and rely on "creaming" initial production and then allowing the well to decline naturally. That downward curve can be rather steep.
Therefore, the initial pop in production from shale/tight wells is unsustainable when the same number of new wells are not being spudded to replace old ones.
In other words, we are in the initial stages of a U.S. production decline now expected by both domestic and OPEC analysts. There will be a short-term increase in prices as a result, until a balance is struck and new projects are undertaken.
But there's another reason why U.S. oil production remained high throughout the year…
New Techniques Have Increased Drilling Efficiency
The second factor leading to higher production despite the decline in both capital commitment and rigs involves improvements in drilling efficiency.
Simply put, the last year has witnessed some refinements in both technique and operations that have reduced per-well costs appreciably. This allows drilling to continue in marginally profitable locations, even though the longer-term prospects show little marked improvement.
Still, most companies have been staying above water (or one step ahead of the sheriff) by hedging prices forward. Unfortunately, that approach is no longer viable: Spreads are not sufficient to allow cash-poor operators sufficient leverage, and the debt crunch is hitting.
Simply put, even with lower per-well costs, companies cannot roll debt over at rates allowing them to stay in business.
These considerations are accentuated by the realization that the vast majority of producers have been cash poor for more than a decade. This means that they have been spending more on ongoing and new projects than they've obtained from sales from existing production.
Normally, when prices are higher, this is of little consequence. Cash on hand can be used for dividends, stock buybacks, or asset replacement, while the expected oil market price provides debt at affordable rates. The interest merely becomes a cost of doing business.
Today, however, it is combining with other factors to bring about a wave of corporate bankruptcies, insolvencies, mergers, and acquisitions.
About the Author
Dr. Kent Moors is an internationally recognized expert in oil and natural gas policy, risk assessment, and emerging market economic development. He serves as an advisor to many U.S. governors and foreign governments. Kent details his latest global travels in his free Oil & Energy Investor e-letter. He makes specific investment recommendations in his newsletter, the Energy Advantage. For more active investors, he issues shorter-term trades in his Energy Inner Circle.