How quickly will U.S. energy producers respond to rising prices?

March 23, 2016 08:07 AM
Daily Energy Market Analysis

As crude oil prices mount a rebound against a backdrop of oil company bankruptcies and rig count cuts, the focus turns to how quickly U.S. energy producers will respond to rising prices. The bearish argument is there will be a cap on prices because as soon as prices start to rise, producers will bring rigs back on line and cap prices. Yet, this argument really does not address the longer term structural damage that has occurred in the energy space.

Crude oil produced by shale made up 48% of total U.S. crude oil production in 2015, up from 22% in 2007 according to the Energy Information Administration (EIA), which warns that the horizontal wells drilled into tight formations tend to have very high initial production rates--but they also have steep initial decline rates. Some wells lose as much as 70% of their initial production the first year. With steep decline rates, constant drilling and development of new wells is necessary to maintain or increase production levels. The problem is that many of these smaller shale companies do not have the capital nor the manpower to keep drilling and keep production going.

This one of the reasons that the EIA is predicting that U.S. oil production will fall by 7.4%, or roughly 700,000 barrels a day. That may be a modest assessment as we are hearing of more stress and bankruptcies in the space. The EIA warns that with the U.S. oil rig count down 76% since the fall of 2014, that unless capital spending picks up, the EIA says that U.S. oil production will keep falling in 2017, ending up 1.2 million barrels a day lower than the 2015 average at 8.2 million barrels a day.

The bearish argument that shale will save the day and keep prices under control does not fit with the longer term reality. When more traditional energy projects with much slower decline rates get shelved, there is the thought that the cash strapped shale producers can just drill, drill. Drill to make up that difference is a fantasy. The problem is that while shale may replace that oil for a while, in the long run it can never make up for the loss of projects that are more sustainable.

In the short term though, oil traders are trying to figure out the massive 8.8-million-barrel increase in crude oil supply as reported by the American Petroleum Institute. Yet while we see inventories at record highs, we did see a drop in Cushing, Olka., supply as the Gulf Coast seems to be a global dumping ground for crude supply. The bearishness was offset by the fact that we also saw a 4.3-million-barrel decrease in gasoline supply, reflecting lower production and strong demand. We also saw a 397,000-barrel drop in distillate supply as farmers get ready to plant out nations crop.

Despite the current glut, the bankruptcies and cap x cuts are staggering. We are seeing pain on Petro China that is losing money. Their net profit fell a whopping 70% last year, hitting the lowest level since 1999, the last time oil put in a major bottom. We also know that OPEC and non-OPEC producers are passed their point of pain as they agree to a production freeze. While the International Energy Agency says that this may be a meaningless gesture, they are the same group that just lost 800.000 barrels from oil inventory. Still, the IEA says they expect the wide gap between supply and demand to narrow later this year, paving the way for an oil price recovery in 2017. "We think the worst is over for prices ... Today's prices may not be sustainable at exactly $40 a barrel, but in this mid-$30s and upward range, we think there will be some support unless there's a major change in fundamentals.”

We see a major change in fundamentals as the comparisons to the bottom in 1998-1999 continue. Long term this looks like a historic bottom like so many oil bottoms before.

About the Author

Phil Flynn is a senior energy analyst at The PRICE Futures Group and a Fox Business Network contributor. Phil is one of the world's leading market analysts, providing individual investors, professional traders, and institutions with up-to-the-minute investment and risk management insight into global petroleum, gasoline, and energy markets.