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By Robert Rapier on Jun 10, 2015 with 4 responses

OPEC Crashed the U.S. Rig Count

The OPEC Free Fall

There is a popular narrative going around that I want to address in today’s article. Last November, after several months of plummeting crude oil prices, the Organization of the Petroleum Exporting Countries (OPEC) met to discuss the oil production quotas for each country in the months ahead. Many expected OPEC to cut production in order to shore up crude prices that had been falling since summer. This was the strategy favored by OPEC’s poorer members, as many require oil prices at $100/barrel (bbl) in order to balance government budgets.

Instead, OPEC announced that they would continue pumping at the same rate. They chose to defend market share against the surge of supply from U.S. shale producers, and in doing so the fall in the price of crude oil accelerated. A look at the U.S. rig count shows the swift impact to U.S. shale drillers in the aftermath of that meeting:

Rig Count

Rig counts went into free-fall after it became clear that OPEC was not interested in propping up the price of oil for the benefit of rapidly expanding shale oil producers. While that approach hurt OPEC’s income in the short term, it also immediately impacted rig counts in the shale oil fields. But — and here is the narrative — shale oil producers continue to make gains in production even as rig counts have been slashed because they are becoming more and more efficient.

Dissecting the Narrative

There is some truth to the narrative. Yes, oil production has continued to grow even though rig counts have plummeted. The week before OPEC’s meeting last November the number of rigs drilling for oil stood at 1,574. Oil production that week was 9.1 million bpd. Today, with the rig count at 642, production is 9.6 million bpd — a gain of just over half a million bpd.

Yes, producers are getting better at squeezing oil and gas from these shale formations. And natural gas production has indeed continued to expand for years despite a sharp drop in the rigs drilling for gas.

But oil production isn’t expected to follow the same pattern as natural gas. The gains are already slowing as a result of the drop in rig counts. There have been some weekly declines in recent weeks, and the Energy Information Administration (EIA) is projecting a 91,000 bpd drop over the next month.

Bloomberg put together a nice graphic showing the expected impact in the country’s shale oil basins:

Shale Output

OPEC’s Latest Decision

Leading up to OPEC’s June 5th meeting there had been much speculation about the direction OPEC might go now that one of its key objectives had been achieved. Most believed it wouldn’t do anything drastic enough to shake up the oil markets again. I placed the odds of either a big production cut or a production increase at under 10%. I estimated a 40% chance that production would be left unchanged, and a somewhat greater than 50% probability of a modest production cut.

There was risk either way. Leaving production unchanged ran the risk of sending crude prices back toward $40/bbl. This would hurt the poorer members of OPEC, which have historically favored higher prices. On the other hand, low prices would continue to slow down the U.S. shale oil boom.

A modest production cut would have satisfied OPEC’s poorer countries, but would have also likely boosted oil prices toward $70/bbl. This would start to bring marginal shale oil production back online.

There were also variations of these two outcomes. OPEC could have announced production cuts but not actually made any. The organization is notorious for exceeding its production quotas, so that wouldn’t have been a big surprise. Or, it could have left production unchanged, while attempting to talk up the demand side of the equation in order to limit a marker overreaction. That is in fact exactly what OPEC did.

In announcing a decision to leave production unchanged — the same decision that led to last winter’s plunge toward $40/bbl — OPEC noted that world oil demand is forecast to increase in 2015 and in 2016, with growth driven by developing countries. On the supply side, non-OPEC growth in 2015 is expected to drop below 700,000 barrels per day, about one-third of the supply growth in 2014. With supplies expected to tighten in the months ahead, OPEC therefore saw no need to cut production.

While the exporters’ club is certainly known for self-serving statements, I believe it is correct here in noting the trajectory of supply and demand in the months ahead. Shale oil production growth is going to continue to slow (if not decline), while global demand growth will start to outpace the new supplies coming online. By leaving the production quotas unchanged OPEC is letting growing demand catch up to North American output growth, and counting on this to prevent an extended slump.

It is interesting to note that the price of WTI has already moved up 6% in the wake of the OPEC meeting. It looks like traders accept the tightening supply narrative, which runs contrary to the narrative that shale oil production will continue its growth trajectory at $60/bbl oil due to the increased efficiency of the shale oil extraction technologies.

The odds look good that OPEC will also have to accommodate production from Iran should sanctions soon be lifted as anticipated. But this won’t impact the global supply/demand balance for a few months, and is something that will probably be a big topic at OPEC’s next meeting in December.


Link to Original Article: OPEC Crashed the U.S. Rig Count

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  1. By Joe Clarkson on June 11, 2015 at 3:04 am

    Two aspects of this post that you might wish to expand on:

    1) Reasons for the time lag in the relationship between oil rig counts and oil production. My understanding is that the lag is caused by the delay between a well being drilled and the well going into production. There may be more to it than that. If so, an explanation would be welcome.
    2) The reason for the increase in gas production despite a decline in gas drilling rigs. Perhaps much of the gas production increase is from gas associated with oil drilling. Perhaps the per foot rate of gas drilling per rig has increased. More information would be welcome on this subject too.

  2. By Forrest on June 11, 2015 at 9:36 am

    If it makes any difference, I would think the drillers would focus drilling on best formations. The efficiency may be more from prime drilling locations. I remember you stating once, the rig count is not as important present day as they are better managed to quickly stop drilling to save expenses and also to quickly start when experiencing better economics. Also, may Middle East tensions play into this? U.S. and Iraq friendly deals a big angst for Saudis that would like to dwindle oil wealth out of the region and improve their coffers for war time footing. True, they think international economies may be improving and thirsting for more oil in future.

  3. By Russ Finley on June 12, 2015 at 11:58 am

    Interesting. How does all of this affect the corn ethanol industry?

  4. By Ben on June 23, 2015 at 9:10 pm

    Yes, this analysis is quite objective, cogent and consistent with real-world dynamics. As someone familiar with the OPEC’s member jockeying (and posturing), the objective of the key swing producer is price/production sustainability which is predicated on economic stability internationally. The relative success of a “soft landing” orchestrated by the central banks via policies of financial repression have permitted much greater latitude than anticipated by many policymakers in the EU, US and beyond. In fact, China had predicated its revised GDP estimates for 2014-16 on an anticipated marked decline in global commerce. The central bankers, while still concerned about a lingering debt hangover, are breathing a sigh of relief that 2014 and the first two quarters of ’15 continued to deliver solid results compared to original expectations.
    Thanks for the analysis, Robert, your interest in just the facts are a welcome counterweight to the aimless reed-bending nonsense out of Washington.

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