Countdown To OPEC’s Nov 30 Meeting – Part 4

Part 4: Oil Growth Returning To US At $50 Oil, But Not To Most Non-OPEC Producers

Part 3 of our blog series on the Countdown to OPEC’s Nov 30 meeting was posted yesterday and focused on Iran and why it may well be the best possible time for Saudi Arabia to grit their teeth and accommodate Iran.

Another reason why it is timely for OPEC to do their deal now is that they should now have confidence that most non-OPEC oil production isn’t likely to come back at $50 oil. There isn’t much more to gain by having oil at $40 as opposed to $50.  So why not get their deal done and move oil back to base for oil at $50.

Saudi Arabia can say it was successful in driving out higher cost oil production around the world for those non-OPEC countries that did not have major projects coming onstream that were started in high oil prices such as Canada oil sands, UK and Norway North Sea, Kazahkstan.  In 2015, the top 9 countries outside of OPEC with oil/NGLs production >1 million b/d were, in order, US, Russia, Canada, China, Mexico, Brazil, Norway, Kazahkstan and Colombia.   US Oct oil production was 8.5 million b/d, down 6.5% YoY.  China Oct oil production was 3.79 million b/d, down 11.2% YoY.  Mexico Sept oil production was 2.113 million b/d, down 7.0% YoY.  Colombia Sept oil production was 0.86 million b/d, down 14.9% YoY.

And they learned that to the most part, they were right – low oil prices would drive these marginal high cost barrels off the market and they aren’t likely to come back until oil prices are much higher ie. $60 or $70.  But at $50 oil, those barrels are not likely coming back and the declines will continue.  A good example is Mexico.  Last week, PEMEX released its Business Plan 2016-2021 [LINK]  and based its forecast under Brent $55 (note current Brent is $43.73 and WTI is $43.68).  Even under Brent $55, PEMEX forecasts Mexico oil production to average 1.944 million b/d in 2017, which is down 8.7% YoY from 2016 average oil production of 2.130 million b/d, which was in turn down 6.0% YoY from 2.267 million b/d in 2015.

The one area that likely surprised them is the US.  Good old Yankee Ingenuity looks like it won the day in proving that the US shale plays work (can grow modestly) under $50 oil and likely for the next few years.

1. Low oil prices created a problem worth solving as each saving/improvement on a particular well brings benefits to tens of thousands future wells going forward. They may have underestimated the importance of the US having all the technology, equipment, knowledge and determination to deal with a solvable problem.  A good example of the future wins is Pioneer Natural Resources, who has cut their drilling and completions costs down by up to $1.5 million per well in 2015 and 2016 and they have >20,000 more Permian locations. We have seen this play out in every US oil play – the break even price is down dramatically in the past 1 to 2 years.
2. Most of the costs savings are sustainable. Producers have benefited from the oil and gas service companies cutting prices.  But the cost savings from better engineering to drill wells cheaper that produce better rates are sustainable.  There are a wide range of examples from simply drilling multiple locations from one pad reduce per wells costs, to walking rigs to minimize time between drilling wells, and to using cheaper brown frack sand than the higher price white sand for fracking without impacting performance. The producers generally say that 50% to 75% of the cost savings will be kept even if the service sector raises prices.  Plus with land positions established and tens of thousands of locations to drill, the relevant costs are half cycle and not full cycle costs.
3. The data to show its working is producers are back to drilling more wells. The weekly oil rig count has steadily increased since the spring even with oil only being above $50 for a small portion of the time.   US oil rigs have increased from 316 oil rigs at the end of May to 452 oil rigs now, and US oil rigs are up 43% from the Q2 trough.  Producers are putting their money where their mouth is and this is before any potential help from the new Trump administration.
4. Then there is the large inventory of DUCs to add production on top of new drills.  The DUC economics are outstanding.  In its Q3 call, Continental Resources noted that its Bakken new drills have a 40% IRR at $50 oil, whereas its Bakken DUCs have returns “through the roof”, in excess of 100% IRR at $50 oil. The below table is the EIA’s estimate [LINK]  that there are 5,155 drilled uncompleted wells (DUCs) in the key oil and natural gas shale plays.  The Bakken and Niobrara should be all oil DUCs and its reasonable to assume that almost all of the Eagle Ford and Permian should also be oil DUCs.  If so, this would be 4,232 oil DUCs in total.  If we assume 10% to 15% of the oil DUCs are just likely old and marginal at best locations, that would still leave over 3,500 oil DUCs.  If you assume an average IP30 of 1,000 b/d of oil, these 3,500 oil DUCs represent a huge potential support to increasing US oil production at $50 oil.

The data is showing US shale/tight oil works at much lower costs than anyone expected, and US oil production is “predictably” returning back to growth.  There is a strong correlation between rig count and oil production growth or decline.  And the historical production didn’t have the benefit of moving on DUCs.  But now as industry moves on DUCs, it should provide added support for US oil production increasing predictably with the recent increase in drilling rigs.  We created the below graph to show plot US oil production lagged by six months against US oil rigs, and it shows how US oil production, lagged by six months, is following the increasing oil rig count.  US oil production was 8.45 million b/d at the end of Sept but is now up to 8.692 million b/d.  We expect US oil production to continue to modestly grow with the 43% increase in US oil rigs since late May and the >3,500 oil DUCS.

Oil prices under $44 are saying there are more skeptics for OPEC to get a deal done at its Nov 30 meeting.  Our blogs have recognized the increasing challenge for OPEC to get down to the Algiers target of 32.5 to 33.0 million b/d and that the biggest burden to do so will fall upon Saudi Arabia and its close allies (ie. Kuwait, UAE). We certainly do not expect any deal to come together until the last moments.  But as our Nov 14 blog noted, it may well be the best possible time for Saudi Arabia to grit their teeth and accommodate Iran.  Another reason why it is timely for OPEC to do their deal now is that they have been successful in shutting in higher cost oil and they should now have confidence that most non-OPEC oil production growth isn’t likely to come back at $50 oil. On the flip side, OPEC must also now realize that US shale/tight oil is here to stay and can modestly grow at $50 oil.  So there isn’t much more to gain or lost against non-OPEC for OPEC to keep producing at max levels and have oil at $40 as opposed to $50 or more.  So why not get their deal done and move oil back to a base of $50 or better?